Capital allocation

Question 1

What is optimal portfolio allocation? How much should we invest in risky and risk free assets?

Answer 1

Optimal portfolio allocation is the weighting of assets within a portfolio that achieves an investor’s given risk – reward ratio

Question 2

The optimal portfolio of risky assets is … … for all investors, independent of level of … …

Answer 2

The optimal portfolio of risky assets is the same for all investors, regardless of level of risk aversion

Question 3

As investors are willing to take on more risk, they move along the … … line

Answer 3

Capital allocation line

Question 4

The lower the risk, the more concentrated returns are around the …

Answer 4

Mean

Question 5

What are portfolio weights? And the formula?

Answer 5

Portfolio weights are the size of the investment in each asset relative to the size of the portfolio, and the formula is size(asset) / size (portfolio)

Question 6

Portfolio weights must sum to …

Answer 6

One

Question 7

What are the 2 steps of portfolio construction?

Answer 7

Decide upon an optimal level of risk or return, then calculate the necessary weights of assets.

Question 8

What gives default-free short-term treasury bills a level of risk?

Answer 8

Default-free short term treasury bills carry a level of risk due to their exposure to interest rate changes

Question 9

Define the risk premium

Answer 9

The risk premium is the difference between the expected return on an asset or portfolio and the risk free rate

Question 10

How do we write the formula for the expected return of a two asset portfolio?

Answer 10

W1E(r1) + W2E(r2)

Question 11

Why is the volatility of the two-asset portfolio simply the weighted variance of the risky portfolio?

Answer 11

The volatility of the two asset portfolio is simply the weighted variance of the risky portfolio because the risk free asset carries no volatility

Question 12

What is the correlation between the risky and risk free asset?

Answer 12

The correlation between the risky and risk free asset is zero

Question 13

Why can you have a weighting of higher than 1 in a long/short portfolio?

Answer 13

You can have a weighting of higher than 1 in a long/short portfolio because you may have borrowed to short a stock.

Question 14

What are two key steps in basic portfolio construction?

Answer 14

• Construct the risky portfolio

- Decide upon allocation weights between the risky and risk free portfolio

Question 15

Why can even default free short-term treasury bills carry risk?

Answer 15

Even default free short term treasury bills can carry risk due to the exposure of treasury yields to interest rates

Question 16

What is a risk premium?

Answer 16

A risk premium is the increased return an investor gains in return for taking on additional risk. It is defined by the equation E(R) – Rf

Question 17

What is the formula for return of the 2 asset portfolio?

Answer 17

W1E(r1) + w2E(r2) is the formula for the return of the 2 asset portfolio

Question 18

In a 2 asset portfolio with a risk free asset, why can you calculate overall volatility using a single asset?

Answer 18

In a 2 asset portfolio with a risk free asset, you can calculate overall volatility using just the weighted volatility of the risky asset, as the risk free asset has zero volatility

Question 19

What does a weighting higher than 1 imply?

Answer 19

Weighting higher than 1 implies the investor has borrowed money to short or invest in an asset.

Question 20

The Sharpe ratio is the price per unit of … …

Answer 20

The Sharpe ratio is the price per unit of risk premium

Question 21

What sort of prospects do risk-averse investors consider?

Answer 21

Risk avers investors consider prospects with positive risk premiums/higher Sharpe ratios

Question 22

Utility increase with return but decreases with …

Answer 22

Risk

Question 23

What is the difference in indifference curve steepness between more and less risk averse investors?

Answer 23

More risk averse investors have a higher indifference curve steepness because they’re willing to take on less risk for additional return

Question 24

What is the capital allocation line (CAL)/what does it show?

Answer 24

The Capital allocation line shows the combinations of optimal risk and return for an investor. The Sharpe ratio is the slope.

Question 25

A utility function with regards to portfolio construction shows investor preferences over … and …

Answer 25

A utility function with regards to portfolio construction shows investor preference over risk and return.