5. Risk and Markowitz

Question 1

Assumptions CAPM

Answer 1

1. Individual investors are price takers.
2. Single-period investment horizon.
3. Investments are limited to traded financial assets.
4. No taxes and transaction costs.
5. Information is costless and available to all investors.
6. Investors are rational mean-variance optimizers.
7. There are homogeneous expectations about expected return and about risk.

Question 2

Betas

Answer 2

• Beta = 1, asset has essentially perfect correlation with market
• Betas > 1 are considered aggressive
• Betas < 1 are considered defensive
• Beta negative: on average if market has positive price movement, asset has negative price movement (hedging)

Question 3

Markowitz Portfolio Theory

Answer 3

Determine optimal complete portfolio of K risky assets and risk-free asset (by determining optimal investment weights w)

Question 4

Combinations portfolio

Answer 4

1. Combining RF and 1 risky asset
2. Combining 2 risky assets
3. Combining 2 risky assets and RF
4. Combining K risky assets - matrix notation
5. Combining K risky assets and RF

Question 5

Three step approach

Answer 5

1. Visualize all investment portfolios by calculation MV frontier (Efficient Frontier)
2. Maximize Sharpe Ratio
3. Maximize utility function

Question 6

Credit default swap

Answer 6

Insurance of product with negative beta