chapter 11

Question 1

portfolio weights

Answer 1

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.

Question 2

return on the portfolio (RI)

Answer 2

the weighted average return on the investments in the portfolio, where the weights correspond to the portfolio weights.

Question 3

expected return of a portfolio

Answer 3

the weighted average of the expected returns of the investments within it, using the portfolio weights.

Question 4

covariance

Answer 4

the expected product of the deviations of two returns from their means.

Question 5

correlation

Answer 5

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.

Question 6

equally weighted portfolio

Answer 6

a portfolio in which the same amount is invested in each stock.

Question 7

variance of a portfolio

Answer 7

equal to the weighted average covariance of each stock with the portfolio.

Question 8

inefficient portfolio

Answer 8

a portfolio when it is possible to find another portfoflio that is better in terms of both expected return and volatility.

Question 9

long position

Answer 9

a positive investment in a security.

Question 10

short position

Answer 10

an investment in stock of a negative amount. it is assigned a negative portfolio weight in a portfolio.

Question 11

short sale

Answer 11

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.

Question 12

efficient frontier

Answer 12

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.

Question 13

buying stocks on margin/using leverage

Answer 13

borrowing money to invest in stocks.

Question 14

levered portfolio

Answer 14

a portfolio that consists of a short position in a risk-free investment.

Question 15

Sharpe ratio

Answer 15

the slope of the line through a given portfolio P. it measures the ratio of reward-to-volatility provided by a portfolio.

Question 16

tangent portfolio

Answer 16

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.

Question 17

efficient portfolio

Answer 17

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.

Question 18

required return

Answer 18

the expected return that is necessary to compensate for the risk investment i will contribute to the portfolio.

Question 19

tangent line

Answer 19

graphs the highest possible expected return that we can achieve for any level of volatility.

Question 20

capital market line (CML)

Answer 20

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.

Question 21

security market line (SML)

Answer 21

the line along which all individual securities should lie when plotted according to their expected return and beta.

Question 22

beta of a portfolio

Answer 22

the weighted average beta of the securities in the portfolio.

Question 23

homogeneous expectations

Answer 23

occur when all investors have the same estimates concerning future investments and returns.

Question 23

relative value of a security

Answer 23

equal to the aggregate market value of the security divided by the total market values of all assets.

Question 24

market portfolio

Answer 24

consists of all traded assets in which the proportion invested in each is equal to its relative market value.

Question 25

alpha

Answer 25

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.