chapter 11 Flashcards
portfolio weights
the fraction of the total investment in the portfolio held in each individual investment in the portfolio. it represents the way we have divided our money between the different individual investments in the portfolio.
return on the portfolio (RI)
the weighted average return on the investments in the portfolio, where the weights correspond to the portfolio weights.
expected return of a portfolio
the weighted average of the expected returns of the investments within it, using the portfolio weights.
covariance
the expected product of the deviations of two returns from their means.
correlation
controls for the volatility of each stock and quantifies the strength of the relationship between them. it has a similar interpretation as the covariance. it is always between -1 and +1.
equally weighted portfolio
a portfolio in which the same amount is invested in each stock.
variance of a portfolio
equal to the weighted average covariance of each stock with the portfolio.
inefficient portfolio
a portfolio when it is possible to find another portfoflio that is better in terms of both expected return and volatility.
long position
a positive investment in a security.
short position
an investment in stock of a negative amount. it is assigned a negative portfolio weight in a portfolio.
short sale
a transaction in which you sell a stock today that you do not own, with the obligation to buy it back in the future. it can be profitable if you expect a stock’s price to decline in the future.
efficient frontier
the highest possible expected return for a given level of volatility. it improves when the set of investment opportunities increases. it shows the best possible risk and return combinations that we can obtain by optimal diversification.
buying stocks on margin/using leverage
borrowing money to invest in stocks.
levered portfolio
a portfolio that consists of a short position in a risk-free investment.
Sharpe ratio
the slope of the line through a given portfolio P. it measures the ratio of reward-to-volatility provided by a portfolio.
tangent portfolio
the portfolio that generates a tangent portfolio under which all other portfolios of risky assets lie. it has the highest Sharpe ratio (steepest possible line) of any portfolio in the economy and thus provides the biggest reward per unit of volatility of any portfolio available. any investor should invest in it independent of his or her taste for risk.
efficient portfolio
the tangent portfolio with the highest Sharpe ratio in the economy. by combining it with a risk-free investment, an investor will earn the highest possible expected return for any level of volatility he or she is willing to bear. it is efficient if the expected return of every available security equals its required return.
required return
the expected return that is necessary to compensate for the risk investment i will contribute to the portfolio.
tangent line
graphs the highest possible expected return that we can achieve for any level of volatility.
capital market line (CML)
when the tangent line goes through the market portfolio. according to the CAPM, all investors should choose a portfolio on the CML by holding some combination of the risk-free security and the market portfolio.
security market line (SML)
the line along which all individual securities should lie when plotted according to their expected return and beta.
beta of a portfolio
the weighted average beta of the securities in the portfolio.
homogeneous expectations
occur when all investors have the same estimates concerning future investments and returns.
relative value of a security
equal to the aggregate market value of the security divided by the total market values of all assets.
market portfolio
consists of all traded assets in which the proportion invested in each is equal to its relative market value.
alpha
deviations from the SML. if the alpha is below the SML, investors will not want to buy the share except if it has a low price or a compensating rate of return.
