Capital Allocation( one risky, one risk- free)

Question 1

expected return

Answer 1

We simply assume that investors only care about expected returen and risk.
Future return is unknown, it can be seen as a random variable.

Question 2

risk aversion

Answer 2

Investors who are risk averse are willing to give up in order not to face the risk. In finance we call it certainty equivalent: the guaranteed amout of money that an individual would view as equally desirable as a risky
asset

Question 3

risk and uncertainty

Answer 3

Future is uncertain, and risk is different from uncertainty
Risk is a quantity susceptible of measurement, uncertainty is unmeasurable. In casino we face risk as probability is known and fixed. In real world probability is unknown and time- varying.
The presence of risk means that more than one outcome is possible.

Question 4

utility

Answer 4

A way to assign score to competing portfolios on the basis of ER, Risk and Risk averison. The effect of risk depends on A. For a risk seeking investor (A<0) risk increases utility

Question 5

feasible portfolio

Answer 5

All feasible portfolio lies on captial allocation line , which is a straight line that combines risk- free and risky portfolio. It is the investment opportunity set. The sharpe ratio measures excess return per unit of risk. The highr the sharpe ratio, the steeper the CAL.

Question 6

indifference curve of mean-variance investor and how to rank portfolio

Answer 6

In the 4 quadrant, portfolio above the curve is preferred .When A<0, 2nd Quadrant is all prefered. When A=0, both 1st and 2nd quadrant is preferred.

Question 7

optimal portfolio

Answer 7

Indiffernce curve is tangent to the capital allocation line

Question 8

problems when using past data

Answer 8

1. The past does not always repete itself, especilly the one with high variance. 2. What time period do we choose to compute the mean. 3. How do you choose outliers.

Question 9

problems when applying optimal fraction of risky assets(one risky, one risk- free)

Answer 9

1. what is your utility function?
2. what is your risk aversion
3. what is your estimate of risk and return?

Question 10

Risk aversion questions

Answer 10

1. Risk- averse investors only accept risky investments that offer risk premiums over the risk- free rate.
2. Risk- averse investors reject investments that are fair games.
3. Risk- neutral investors look only at expected returns when making an investment decision.
4. The more risk averse the investor, the less risk that is tolerated for a given rate of return.
5. The level of return a investor prefers has not much to do with his risk tolerance.

Question 11

slope of indifference of mean-sd graph

Answer 11

The risk-return trade-off is one in which greater risk is taken if greater return can be expected, resulting in a positive slope.

Question 12

Indifference curve of a risk- averse investor

Answer 12

Indifference curves plot trade-off alternatives that provide equal utility to the individual (in this case, trade- offs are the risk- return characteristics of portfolios)
An investors indifference curves are parallel (thus they cannot intersect) and have positive slopes. The highest indifference curve (the one in the most northwestern position) offers the greatest utility. indifference curves of investors with similar risk- return trade- offs might intersect.

Question 13

The riskiness of individual assets should be

Answer 13

considered in the context of the effect on overall portfolio volatility and should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio.
The relevant risk is portfolio risk; the riskiness of an individual security should be considered in the context of the portfolio as a whole.

Question 14

The certainty equivalent rate of a portfolio is

Answer 14

the rate that a risk- free investment would need to offer with certainty to be considered equally attractive as the risky portfolio.

Question 15

The capital allocation line is

Answer 15

investment opportunity set formed with a risky asset and a risk- free asset with the intercept of a risk- free rate.
The CAL consists of combinations of a risky asset and a risk- free asset whose slope is the reward- to- volatility ratio
A reward- to- volatility ratio is useful in understanding how returns increase relative to risk increases

Question 16

What does the change from a straight to a kinked capital allocation line implicate?

Answer 16

Borrowing rate exceeding lending rate.
The linear capital allocation line assumes that the investor may borrow and lend at the same rate (the risk- free rate), which obviously is not true. Relaxing this assumption and incorporating the higher borrowing rates into the model results in the kinked capital allocation line.

Question 17

The first major step in asset allocation is

Answer 17

assessing risk tolerance

Question 18

Based on their relative degrees of risk tolerance

Answer 18

By determining levels of risk tolerance, investors can select the optimal portfolio for their own needs; these asset allocations will vary between amounts of risk- free and risky assets based on risk tolerance.

Question 19

Asset allocation

Answer 19

may involve the decision as to the allocation between a risk- free asset and a risky asset
and also involve the decision as to the allocation among different risky assets

Question 20

Why treasury bills are commonly viewed as risk- free assets?

Answer 20

Treasury bills do not exactly match most investors’ desired holding periods, but because they mature in only a few weeks or months they are relatively free of interest rate sensitivity and inflation uncertainty

Question 21

Capital market line

Answer 21

The capital market line is the capital allocation line based on the one- month T-Bill rate and a broad index of common stocks. It applies to an investor pursuing a passive management strategy.

Question 22

What is the maximum fee to charge?

Answer 22

original deduction of expected return minus percentage fee divided by the broker’s sd = the slope of CML
If the broker charges the full amount of the fee, the CAL’s slope would also be 0.1875, so it would rotate down and be identical to the CML.