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Exam 9 > BKM 6-8: Portfolio Theory > Flashcards

BKM 6-8: Portfolio Theory Flashcards

1
Q

Risk premium

A

Expected return in excess of the risk-free rate

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2
Q

Utility function

A
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3
Q

Risk-averse

A

A > 0

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4
Q

Risk-neutral

A

A = 0

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5
Q

Risk-seeking

A

A < 0

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6
Q

Mean-Variance Criterion

A

Portfolio A is preferred to portfolio B if the expected return of A >= expected return of B and risk of A <= risk B

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7
Q

Certainty-equivalent rate

A

Rate of return that would cause the investor to be indifferent between risky and risk-free investment

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8
Q

Indifference curve

A

X: standard deviation, Y: expected return

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9
Q

Expected return of complete portfolio (1 risky, 1 risk free)

A
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10
Q

Standard deviation of complete portfolio (1 risky, 1 risk free)

A
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11
Q

Capital allocation line (CAL)

A

Combinations of risk (x-axis) and expected return (y-axis) for complete portfolio: y-intercept: SD = 0 other point: y = 1

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12
Q

Sharpe ratio

A

Slope of the CAL Also called reward-to-risk ratio

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13
Q

Weight on risky portfolio, based on risk tolerance, in complete portfolio (1 risky, 1 risk free)

A
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14
Q

Capital Market Line

A

If risky asset is based on a broad index of common stocks (i.e. S&P 500) within a complete portfolio

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15
Q

Passive strategies (Indexing)

A

Choosing a risky portfolio to be large, well-diversified (i.e. S&P 500)

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16
Q

Why passive strategies make sense

A

Minimizes cost of information acquisition

Takes advantage of everyone else’s efforts to do so

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17
Q

Criticisms of passive strategies

A

Undiversified Top Heavy Chasing Performance You can do better (few active fund managers beat indices)

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18
Q

Portfolio variance with two risky assets

A
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19
Q

Risk and return, correlation = 1

A

Straight line

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20
Q

Risk and return, correlation = -1

A

Kinked line (sideways V) Will intercept y-axis

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21
Q

Minimum variance portfolio

A

Portfolio with the lowest variance that can be constructed from assets with a certain level of correlation

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22
Q

Optimal risky portfolio

A

Risky portfolio that produces the line tangent to the portfolio opportunity set

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23
Q

Hedge Asset

A

Has negative correlation with other assets in the portfolio

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24
Q

Minimum variance portfolio weight on A

A
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25
Q

When correlation between assets = -1

A

Perfectly hedged position can be obtained by setting weighted SDs equal to each other

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26
Q

Minimum variance portfolio SD

A

Must be smaller than that of either of the individual component assets

27
Q

Diversification and correlation of assets

A

Lower correlation, diversification is more effective and portfolio risk is lower

28
Q

Weights of optimal risky portfolio

A
29
Q

Steps to arrive at complete portfolio

A
  1. Specify returns, variances, covariances
  2. Calculate optimal risky portfolio weights
  3. Allocate weights to optimal risky portfolio
  4. Calculate y*
  5. Distribute y* to weights of risky portfolio, (1 - y*) to risk-free
30
Q

Minimum-variance frontier

A

Lowest possible variance that can be attained for a given portfolio expected return

31
Q

Graph of: CAL

Indifference curve

Optimal risky portfolio

Complete portfolio

Portfolio opportunity set

A
32
Q

Socially responsible investing

A

Cost of lower Sharpe ratio justifiably viewed as a contribution to underlying cause

33
Q

Separation property

A

Two tasks:

  1. Determine optimal risky portfolio (technical)
  2. Capital allocation based on risk preference
34
Q

Market vs. Firm-specific risk (graph)

A
35
Q

Equally weighted portfolio variance

A

First term can be diversified away (firm-specfic risk)

Second term depends on covariances between returns (market risk)

36
Q

Risk pooling

A

Merging uncorrelated, risky projects as a means to reduce risk

37
Q

Results of pooling uncorrelated risks

A
38
Q

Issues with risk pooling

A

Probability of loss declines, but overall standard deviation increases; does not allow shedding of risk

39
Q

Risk sharing

A

Act of selling shares in an attractive risky portfolio to limit risk and maintain Sharpe ratio of resulting position

40
Q

Risk sharing results, two uncorrelated assets

A

Pool tow assets and sell off half of combined portfolio

41
Q

Two factors dampening process of risk sharing in insurance

A

Managing very large firms comes at a risk

Misestimating correlations can cause failure

42
Q

Extending investment horizons for risk

A

Investing completely in risky asset for both periods analagous to risk pooling; investing half in risky asset for each period analogous to risk sharing

43
Q

Issues with Markowitz model

A

Requires (n2 +3n)/2 total estimates

Errors in estimation of correlations can lead to nonsensical results

44
Q

Decomposing rate of return

A
45
Q

Single-factor model

A
46
Q

Total risk of a security

A
47
Q

Single-factor model, systematic risk of a security

A
48
Q

Covariance between any pair of securities

A
49
Q

Regression equation of single-index model

A
50
Q

Single-index model

A

Uses market index to proxy for the common factor

51
Q

Number of single index model estimates

A

n estimates of alpha

n estimates of beta

n estimates of firm-specific variances

1 estimate for market risk premium

1 estimate for variance of common factor

52
Q

Security characteristic model

A

Straight line with intercept alpha and slope beta for a given security

53
Q

Alpha

A

Nonmarket premium

54
Q

Issues with relying on alpha

A

Past does not readily fortell the future; no correlation between estimates of one sample period to the next

55
Q

Hierarchy of preparation of input list for single-index

A
  1. Macroeconomic analysis (risk premium)
  2. Statistical analyses (betas, residual variances)

3.

56
Q

Initial weight in active portfolio, single-index model

A
57
Q

Final weight in active portfolio, single-index model

A
58
Q

Information ratio

A

The contribution of the active portfolio to the Sharpe ratio of the overall risky portfolio

59
Q

Sharpe ratio of an optiamally constructed risky portfolio

A
60
Q

Adjusted beta

A

2/3*sample beta + 1/3

As firm becomes more conventional, it will tend toward 1

61
Q

Variables that help predict betas

A

Variance of earnings

Variance of cash flow

Growth in earnings per share

Firm size

Dividend yield

Debt-to-Asset ratio

62
Q

Tracking portfolio

A

Designed to match the systematic component of a portfolio; must have same beta on index portfolio as P and as little firm risk as possible

Also called beta capture

63
Q

Alpha transport

A

Separating search for alpha from the choice of market exposure

64
Q

σ2(eP), formula

A

Σwi2σ2(ei)

Exam 9 (23 decks)

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