Book 2_Port1_PORTFOLIO RISK AND RETURN_part1 Flashcards
The major asset classes
- small-capitalization stocks
- large-capitalization stocks,
- long-term corporate bonds,
- long-term Treasury bonds,
- and Treasury bills.
Other factors to analyzing investments
- risk and return
- investment’s liquidity
- non-normal characteristics such as skewness and kurtosis
A risk-averse investor
- dislikes risk
- same return, choose the one with less risk
- will hold risky assets if he feels that the extra return compensated
A risk-seeking (risk-loving)
- prefers more risk to less
- Same return, chose riskier
A risk-neutral investor
be indifferent to risk
Investors’ utility functions
represent their preferences regarding the tradeoff between risk and return (i.e., their degrees of risk aversion)
Indifference curves for risk and return
- A more risk-averse investor will have steeper indifference curves.
- Flatter indifference curves (less risk aversion) result in an optimal portfolio with higher risk and higher expected return
Popular variance
sigma^2 = sum(Rt - mean)^2/T
T: number of periods
Sample variance
sigma^2 = sum(Rt - mean)^2/(T-1)
T: number of periods
Covariance
the extent to which two variables move together over time.
- Positive covariance: move together
- Nagative: move opposite direction
- Zero: no linear
Sample Covariance formula
Cov1, 2 = Sum (Rt1 - R1)x(Rt2 - R2)/(n-1)
Correlation
a standardized measure of co-movement that is bounded by -1 and +1
P1,2 = Cov1,2/(sigma1xsigma2)
Variance of porfolio of 2 assets
= W1^2xSig1^2 + W22xsig2^2 + 2W1W2Cov1,2
= W1^2xSig1^2 + W22xsig2^2 + 2W1W2sig1sig2xP1,2
The standard deviation of returns for a portfolio
Sigma (p) = Can (W1^2xSig1^2 + W22xsig2^2 + 2W1W2Cov1,2)
Sigma (p) = Can (W1^2xSig1^2 + W22xsig2^2 + 2W1W2sig1sig2xP1,2)
The greatest portfolio risk
- perfectly positively correlated
- the correlation decreases from +1 to -1, portfolio risk decreases
- The lower the correlation of asset returns, the greater the risk reduction (diversification) benefit
