Lecture Four Flashcards by Sidra Iqbal

What is portfolio

Refers to any collection of financial assets e.g. stocks, bonds, cash

characterized by their mean, variances and covariances of their returns

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Who are portfolios usually held by

Individual investors, managed by financial professionals, hedge funds or other financial intributions

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What is hedge fund

an investment instrument with pooled funds that is managed to outperform average market returns

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How are portfolios characterized by?

potential risk and return

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what is there always in risk and return

a trade off

= u will get into an investment that will u pay u a high return if the risk is also high

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What do we aim for in terms of risk and return

aim to minimize the risk/maximise the return

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what is the portfolio expected return

simply a weighted average of the expected returns on individual assets

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What is the equation for the portfolio expected return

the same as normal return:

new-old
———— x100
old

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What is usually used to work out where to invest

gets the prices for an assert and u work out the return of the investment to determine where u invest

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What essentially is the expected return

The mean

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How to work out the expected return using asset 1&asset 2

= weight of asset 1 x mean of asset1 + weight of asset2 x mean of asset2

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Are weights always going to be equal

No, not going to invest equally bc ur not going to invest the same for every assets
- Its based on probabilities of observing different values

=weights will be different

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What is the variance of portfolio

simply the weighted average of variances and covariances

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what is the symbol and name for variance

σ^2 -sigma squared

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How to work out the variance

-the variance of the first asset x squared weight + the variance of the second asset x squared asset of the second weight + 2 x the weight x the covariance

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What effect does a negative correlation have on the variance portfolio =-1

decreasing the variance of the portfolio (negative = pushing it down)

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What effect does a positive correlation have on the variance portfolio =1

increasing the variance of the portfolio (positive= pushing it up)

What if the covariance is between -1 or 1

not perfectly either side
=u are decreasing the portfolio variance - controlling the risk - combining money into diff assets
-not just investing in one asset = spreading risk

How to work out the standard deviation of the portflio

Square root of the variance

are we sure for what the risk will be for a portfolio

The concept of risk in a portfolio of assets relates to the stylized
fact that the return from a portfolio is not constant over time.
Thus, at each point in time we are not sure about what the return
on a portfolio is going to be.

What is diversification

Process of combining assets in a portfolio to reduce total risk without sacrificing portfolio return

-investing in diff assets to reduce risk

What risks are companies exposed to

-every company has a risk specific to the company
-every company is exposed to the market risk

What risk does the diversification get rid of?

-diversify the risk that is specific to the company

What does a correlation of 1 mean for the variance of the -diversify the risk that is specific to the company portfolio

correlation is 1 = 1 never decrease variance of portfolio

What does a correlation of -1 mean for the variance of the -diversify the risk that is specific to the company portfolio

-correlation is -1 = portfolio variance = 0 , no risk

What if two values are negative

-two values are negative - variance is always lower

Is -1 correlation common

ever find correlation that is exactly -1, bc theres always risk/ always exposed to a certain risk

What happens to correlation when there is a global risk?

-when theres global risk = all move in the same direction =correlation in bad times, ALWAYS increase SIGNIFICANTLY -always exposed to losing large amounts of £

some changes of global risk

shifts in exchange rates, new regulations, protectionism, debt crises, and political unrest.

how can diversification affect the variance in the equation

N is the uncorrolated assets: the variance will turn into 1/N^2 *variance + 1 -the 1/n indicates that the assets are divided and spread across the variance -SPREADING RISK =e.g. if n = 1000000000, variance will be closer to 0 -ASSUMING variance Is same for ALL assets

What does MVP stand for

Minimum Variance Portfolio

What is the MVP

is a collection of non-correlated, volatile securities that has the lowest possible risk (variance) among all portfolios of risky assets A portfolio with the lowest risk (variance) among all portfolios of risky assets

What is the objective of the MVP

to find the weights that will render a portfolio with the lowest possible variance

What is used for the MVP

return patterns and correlations

what is the relationship for the portfolio expected returns compared to the portfolio variance

Ex return is a linear combination of two assets and weights But portfolio variance is not

What is the relationship between variance and expected return for the variance

the lower the variance = the lower the expected return

Where is the MVP

The lowest point -can be the one on the curve on the curved angle on a risk/return diagram =guaranteed smallest variance