Ch. 7 Flashcards
What is a financial asset?
Legal claim to a future cash flow
What is the pricing rule of financial assets?
Price should be determined by present value of the asset’s expected cash flow, which can be MORE or LESS certain
What is the expected rate of return?
The forecast RofR from holding a security, expressed as %/yr
What is the variance of the RofR?
Sum of weighted deviations from the expected return
Define risk (on a security)?
Danger that the RofR on a security will be LESS than the investor expects when purchasing that security
2 measures of association?
1) covariance
2) Correlation coefficent
Define covariance ITO FMs?
Measures the extent to which 2 shares move up/down together
What does it mean if the covariance between two shares, σ(AB) is:
a) Greater than zero?
b) Less than zero?
a) returns on A and B move in same direction
b) “” opposite direction (finish)
What is specific risk?
Risk that is specific to a particular security (eg. a share)
What is systematic risk?
Risk inherent in market fluctuations that cannot be diversified away
What is naive diversification?
A strategy whereby an investor simply invests in a number of different assets in the hope that the variance of the expected return on the portfolio is lowered.
What is efficient diversification?
Investing in a variety of securities and assets taking into account variance and covariance to achieve optimal risk-return portfolios
When are gains to be made from portfolio diversification:
a) non-existent
b) at their maximum?
a) when there is perfect positive correlation between two stocks
b) when there is perfect negative correlation between two stocks
What is an efficiency frontier?
A curve depicting risk-return portfolios where increased return is only possible by increasing risk
(a risk averse investor will want to select the weighted combination of shares that minimises risk for a given return!)
What is the minimum variance portfolio?
A portfolio which minimises the risk of a combination of risky assets