Portfolio Theory (5&6) Flashcards
(18 cards)
What are realised and expected returns?
Realised returns - based on prices that have been observed, looking back in time
Expected returns - based on expectations regarding futures prices, looking forward in time
How do you work out average annual return?
arithmetic mean
What does the expected return equation calculated?
A weighted average of the possible returns, where the weights correspond to the probabilities.
What is the relationship between standard deviation and variance?
Standard deviation SD(R) is the square root of variance Var(R)
What is the systematic and unsystematic risk?
Unsystematic risk can be diversified away whereas systematic risk is undiversifiable.
Where is systematic and unsystematic risk from?
Systematic - interest rates, recessions, inflation
Unsystematic - Lawsuits, poor management
What is diversification and what is it used for?
Strategy designs to reduce risk by spreading the portfolio across many investments.
Gets rid of firm-specific risk
What does x1 and R1 stand for in the portfolio equations?
x1 = fraction of portfolio in first asset
R1 = rate of return of first asset
How do we know what the optimal risk reducing proportions are?
Invest more in the one with lower standard deviation
e.g. if standard deviation for stock1 is 1.56 times higher than stock 2
invest 1.56/2.56 in stock 2 and 1/2.56 in stock 1
What do different values of the correlation coefficient tell us?
p=+1 perfect positive correlation
p=0 no correlation
p=-1 perfect negative correlation
What correlation coefficient gives the maximum benefit of the least risk?
when p=-1
Diversification leads to a reduction risk if?
The securities are not positively correlated
Draw a graph showing the Markowitz portfolio theory
check ppt (1)
What is the capital market line (CML)?
The capital market line (CML), in the capital asset pricing model (CAPM): shows the trade-off between
risk and return for a portfolio of the risk free and the
market portfolio
Where is the market portfolio + graph?
The tangency point of the CML and efficient frontier check ppt (2)
What is the top half of the minimum-variance boundary called?
The efficient frontier
What is the Sharpe ratio equation ?
(rm-rf)/σ
rm = risk market portfolio
rf = risk free rate
What does the Sharpe ratio also represent?
Slope of CML
