Chapter 14

Question 1

Different Types of Asset Diversification

Answer 1

Within an asset class
Asset Allocation diversification
International Diversification
Diversification over time

Question 2

Expected Vs. Realized Return

Answer 2

Realized: the return actually received during the holding period.
Expected: The return expected based on data given.

Question 3

What is an Optimal Portfolio?

Answer 3

Minimizing Risk, Maximizing return

Question 4

Risk Neutral Individuals make decisions based on…

Answer 4

Return alone.

Question 5

Risk Averse Individuals make decisions based on…

Answer 5

trade-off between risk and return in making decisions.

Question 6

Investors in terms of risk are usually…

Answer 6

Risk averse and prefer higher levels of terminal wealth. Risk appetite varies investor to investor.

Question 7

Investment Risk Factors

Answer 7

Default Risk
Interest Rate Risk
Liquidity Risk
Reinvestment Risk
Inflation Risk

Question 8

T-Bill Risk Profile

Answer 8

T-Bill’s will always return the risk free rate but they are exposed to inflation risk, though over short horizons there is very low risk.

Question 9

Stand Alone Risk

Answer 9

Diversifiable Risk + Non-diversifiable risk (market). Measured by dispersion of return about the mean and is only relevant for assets held in isolation.

Question 10

What is diversifiable risk?

Answer 10

Caused by company specific events.

Effects of these effects and associated risk can be eliminated by diversification.

Question 11

What is Market Risk?

Answer 11

Stems from external events like war, inflation, recession, and interest rates.
All firms effected, cannot be diversified.
Also known as systematic risk.

Question 12

What are some general statements regarding risk?

Answer 12

Most stock are positively correlated (0.65). Most stocks have average SD of 35%. Combining these together lowers risk. EQUATIONS FROM 14-34,36,31,25,41,42

Question 13

What is the market model and how is it different than CAPM?

Answer 13

r=a + B + e

CAPM is an equilibrium model. Assumptions differ.

Question 14

Total risk for an individual security is measured by

Answer 14

Its variance which consists of two parts: one part market, one part unique (firm specific, non systematic) Similar with portfolio mix.

Question 15

Portfolio Market Risk is unique because..

Answer 15

Beta is an average of the beta of its securities. Unless deliberate, diversification will not cause the beta to go in a certain direction.

Question 16

Why does risk reduce when random stocks are added and how many are needed to achieve diversification?

Answer 16

By randomly adding stocks the standard deviation of the portfolio decreases because the random stock is probably not correlated with the existing security. At about 40 stocks diversification is achieved.

Question 17

Holding a single stock is a bad idea because

Answer 17

You are not compensated for the additional risk you take on.

Question 18

What are the three forms of market efficiency?

Answer 18

Weak form - Past Prices
Semi-strong Form- Publicly available available info
Strong Form- All information, public and private.

Question 19

How does fundamental analysis make the market more efficient?

Answer 19

Helps identify mispriced securities and drive those prices towards their true values.

Question 20

What strategies should an investor use in a efficient market?

Answer 20

Reduce costs by using a strong holding strategy, trade less or use a discount broker.
Minimize taxes by using sheltered investments - CG, Div, Interest.