Asset Allocation(two risky)

Question 1

Why do we diversify?

Answer 1

When 2 risky assets and risk- free rate, we choose the best portfolio obtained combining the risk-free and the tangency portfolio.

Question 2

Why diversification works?

Answer 2

Because of negative correlation, diversification works.

Question 3

Idiosyncratic and systematic risk

Answer 3

There are limits of diversification: idiosyncratic risk(sth different) can be diversified, systematic risk(sth the same) can not

Question 4

Classify world, country, industry and firm sources of risk

Answer 4

Total risk = idiosyncratic risk + systematic risk

Question 5

Efficient diversification

Answer 5

optimal weights that provide the lowest possible risk

Question 6

Covariance of a random variable with itself.

Answer 6

The variance of the portfolio os a weighted sum of covariances, and each weight is the product of the portfolio proportions of the pair of assets in the covariance

Question 7

Covariance of a random variable with itself, it is variance

Answer 7

The variance of the portfolio os a weighted sum of covariances, and each weight is the product of the portfolio proportions of the pair of assets in the covariance term

Question 8

The efficient frontier of risky assets is

Answer 8

the portion of the investment opportunity set lies above the global minimum variance portfolio.
Portfolios on the efficient frontier are those providing the greatest expected return for a given amount of risk. Only those portfolios above the global minimum variance portfolio meets the criterion.

Question 9

The capital allocation line provided by a risk- free security and N risky securities is

Answer 9

the line tangent to the efficient frontier of risky securities drawn from the risk- free rate.

Question 10

Portfolios that are efficient are those that

Answer 10

provide the highest expected return for a given level of risk

Question 11

An investor who wishes to form a portfolio that lies to the right of optimal risky portfolio on CAL must

Answer 11

both borrow some money at the risk- free rate and invest in optimal risky portfolio and invest in risky securities(will not hold any risk- free assets).

Question 12

Portfolio theory as described by Markowitz is most concerned with

Answer 12

the effect of diversification on portfolio risk. He concerned with reducing portfolio risk by combining risky securities with differing return patterns.

Question 13

The measure of risk in a Markowitz efficient frontier is

Answer 13

sd of return

Question 14

The individual investor’s optimal portfolio is designated by

Answer 14

The point of tangency with the indifference curve and the capital allocation line.
The indifference curve represents what is acceptable to the investor; the capital allocation line represents what is available in the market. The point of tangency represents where the investor can obtain the greatest utility from what is available.

Question 15

The line representing all combinations of portfolio expected returns and sd that can be constructed from two available assets (a portfolio of risky assets) is called

Answer 15

the portfolio opportunity set

Question 16

The sd of a 2-asset portfolio is a linear function of assets’ weights when the assets have a correlation coefficient equal to

Answer 16

one.
When there is a perfect positive or negative correlation, the equation for the portfolio variance simplifies to a perfect square. The result is that portfolio’s sd is line relative to assets’ weights in portfolio.

Question 17

The separation property refers to the conclusion that

Answer 17

the determination of the best risky portfolio is objective and the choice of the best complete portfolio is subjective.
The determination of the optimal risky portfolio is purely technical and can be done by a manager. The complete portfolio, which consists of the optimal risky portfolio and the risk- free asset, must be chosen by each investor based on preferences.

Question 18

Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum variance portfolio has a standard deviation that is always

Answer 18

equal to zero

Question 19

The efficient frontier of risky assets is

Answer 19

the portion of the investment opportunity set that lies above the global minimum variance portfolio.
Portfolios on the efficient frontier are those providing the greatest expected return for a given amount of risk. Only those portfolios above the global minimum variance portfolio meet this criterion.

Question 20

Why tangency portfolio is the best portfolio to combine with risk- free?

Answer 20

Because the portfolio has the highest sharpe ratio.