Flashcards in week 7 Deck (6)
explain portfolio and risk management
– Risk minimization can be achieved by diversifying across different assets.
– A portfolio’s expected return is the weighted average of the returns of the assets that make up the portfolio.
– A portfolio’s variance is the weighted average of the variances of the assets that make up the portfolio and the covariance between the pairs of securities.
– There is diversification benefit so long as the assets are not perfectly correlated to each other.
What is correlation coefficient in finance? What is the range of correlation
In finance, correlation coefficient (ρ) denotes the systematic relationship between two
The range of values of correlation coefficient is between -1 and +1 (both inclusive)
Range of ρ Direction of co-movement
ρ = -1 perfect negative correlation Negative ρ, two assets move in the opposite
-1 < ρ < 0 negative correlation direction
ρ = 0 no correlation
0 < ρ < +1 positive correlation Positive ρ, two assets move in the same
ρ = +1 perfect positive correlation directions
ow do you calculate return of a 2 asset portfolio?
– Find the weighted average of the expected returns of the assets that comprise the portfolio (weights are the % of the investors wealth invested).
explain risk of a portfolio
– Standard deviation of a portfolio σp is not simply the weighted average of the standard deviation of the securities in the portfolio.
– The riskiness of the portfolio depends not only on the riskiness of the individual securities but also on the relationship between the returns on those securities. The variance of the return on a portfolio of two securities is given by:
explain risk reduction
– The real advantages of diversification result from the risk reduction caused by combining securities whose returns are less than perfectly positively correlated.
o As long as the correlation coefficient is less than 1, (even at 0.9 or 0.5), there is a benefit of diversification through forming a portfolio i.e. σp