CH6 Flashcards
What does the Mean-Variance Criterion state?
If E(rA) ≥ E(rB) and σA ≤ σB, portfolio A dominates portfolio B
What is the Sharpe Ratio? In terms of a specific line (CML or CAL)
The slope of the Capital Allocation Line (CAL) representing risk-adjusted return
The Sharpe ratio compares the return of an investment with its risk
It is calculated as (E(rP) - rf) / σP.
What is the Efficient Frontier?
A graph representing the set of portfolios that maximizes expected return at each level of portfolio risk
What are the three methods to achieve efficient diversification?
- Maximize risk premium for any level of standard deviation
- Minimize standard deviation for any level of risk premium
- Maximize Sharpe ratio for any standard deviation or risk premium
What is the separation property in portfolio choice?
Portfolio choice is separated into two tasks: determining the optimal risky portfolio and personal choice of the best mix of risky portfolio and risk-free asset
Fill in the blank: The correlation coefficient is used to calculate _______.
Covariance
What is the capital market line (CAL)?
The line that represents the risk-return trade-off for efficient portfolios that include a risk-free asset
How does historical data impact the estimation of portfolio risk?
Variability/covariability changes slowly over time and realized returns are used to estimate risk
Precise averages cannot be estimated, and focus is on deviations of returns from average value.
What is the significance of the optimal risky portfolio?
It represents the best combination of risky and safe assets to form a portfolio
What does the term ‘risk-return trade-off’ refer to?
The balance between the potential risk and potential return of an investment
True or False: Systematic risk can be eliminated through diversification.
False
Define unique risk in investing.
Risk that is specific to a single asset or company and can be mitigated through diversification
What does the index model relate to?
Stock returns to returns on broad market index & firm-specific factors
Define excess return.
RoR in excess of risk-free rate
What is beta?
Sensitivity of security’s returns to market factor
What is firm-specific or residual risk?
Component of return variance independent of market factor
Define alpha in the context of stocks.
Stock’s expected return beyond that induced by market index
Fill in the blank: Excess Return 𝑅𝑖 = _______ + α𝑖 + 𝑒𝑖.
β𝑖𝑅𝑀
What does β𝑖𝑅𝑀 represent?
Component of return due to movements in overall market
What does β𝑖 signify?
Security’s responsiveness to market
What is α𝑖 in the excess return formula?
Stock’s expected excess return if market factor is neutral
What does 𝑒𝑖 represent?
Component attributable to unexpected events relevant only to this security
What is the Security Characteristic Line (SCL)?
Plot of security’s predicted excess return from excess return of market
What is the algebraic representation of the SCL?
E(RD) = αD + βDRM
Define the ratio of systematic variance to total variance.
ρ² = Systematic Variance / Total Variance
What is the formula for the portfolio nonsystematic variance?
nonsystematic portion of portfolio return: eP = ∑wi * ei
What is the information ratio?
Ratio of alpha to standard deviation of residual
What is an active portfolio?
Portfolio formed by optimally combining analyzed stocks
True or False: The vast majority of financial advisers believe stocks are less risky if held for the long run.
True
How does the risk premium grow with investment horizon, T?
At the rate of horizon, T
How does standard deviation grow with T?
At √T
Fill in the blank: Sharpe ratio, 𝑆, grows with investment horizon as _______.
1/√T
