Capital allocation Flashcards
What is optimal portfolio allocation? How much should we invest in risky and risk free assets?
Optimal portfolio allocation is the weighting of assets within a portfolio that achieves an investor’s given risk – reward ratio
The optimal portfolio of risky assets is … … for all investors, independent of level of … …
The optimal portfolio of risky assets is the same for all investors, regardless of level of risk aversion
As investors are willing to take on more risk, they move along the … … line
Capital allocation line
The lower the risk, the more concentrated returns are around the …
Mean
What are portfolio weights? And the formula?
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)
Portfolio weights must sum to …
One
What are the 2 steps of portfolio construction?
Decide upon an optimal level of risk or return, then calculate the necessary weights of assets.
What gives default-free short-term treasury bills a level of risk?
Default-free short term treasury bills carry a level of risk due to their exposure to interest rate changes
Define the risk premium
The risk premium is the difference between the expected return on an asset or portfolio and the risk free rate
How do we write the formula for the expected return of a two asset portfolio?
W1E(r1) + W2E(r2)
Why is the volatility of the two-asset portfolio simply the weighted variance of the risky portfolio?
The volatility of the two asset portfolio is simply the weighted variance of the risky portfolio because the risk free asset carries no volatility
What is the correlation between the risky and risk free asset?
The correlation between the risky and risk free asset is zero
Why can you have a weighting of higher than 1 in a long/short portfolio?
You can have a weighting of higher than 1 in a long/short portfolio because you may have borrowed to short a stock.
What are two key steps in basic portfolio construction?
- Construct the risky portfolio
- Decide upon allocation weights between the risky and risk free portfolio
Why can even default free short-term treasury bills carry risk?
Even default free short term treasury bills can carry risk due to the exposure of treasury yields to interest rates
What is a risk premium?
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
What is the formula for return of the 2 asset portfolio?
W1E(r1) + w2E(r2) is the formula for the return of the 2 asset portfolio
In a 2 asset portfolio with a risk free asset, why can you calculate overall volatility using a single asset?
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
What does a weighting higher than 1 imply?
Weighting higher than 1 implies the investor has borrowed money to short or invest in an asset.
The Sharpe ratio is the price per unit of … …
The Sharpe ratio is the price per unit of risk premium
What sort of prospects do risk-averse investors consider?
Risk avers investors consider prospects with positive risk premiums/higher Sharpe ratios
Utility increase with return but decreases with …
Risk
What is the difference in indifference curve steepness between more and less risk averse investors?
More risk averse investors have a higher indifference curve steepness because they’re willing to take on less risk for additional return
What is the capital allocation line (CAL)/what does it show?
The Capital allocation line shows the combinations of optimal risk and return for an investor. The Sharpe ratio is the slope.
A utility function with regards to portfolio construction shows investor preferences over … and …
A utility function with regards to portfolio construction shows investor preference over risk and return.
