Chapter 14 Flashcards
Realized return: (1)
-Realized return is what was actually earned during the period, it can be positive, zero or negative.
Modern Portfolio Theory: (1)
- Investor has given sum of money to invest for a particular holding period
- At t=0 the investor must decide what securities to purchase and hold to t=1
- Portfolio selection problem: to select an optimal portfolio from the set of possible portfolios
Optimal Portfolio: (2)
- Goal of maximizing return
- Goal of minimizing risk
Risk Tolerance of individuals: (2)
- Risk Neutral
- Risk Adverse
Risk Neutral: (1)
-Individuals or entities that make decisions based on expected return alone
Risk Adverse: (1)
-Individuals or entities that consider a trade off between risk and return in making decisions
Non Satiation and Risk Aversion: (3)
- Investor always prefer higher levels of terminal wealth to lower levels of terminal wealth.
- Assumed that investors are risk-averse
- Not assumed that investors have identical degrees of risk aversion
Investment risk: (2)
- Investment risk pertains to the probability of realized returns being less than expected return.
- Greater the chance of low or negative returns, the riskier the investment.
Risk Factors: (5)
- Default risk
- Interest rate risk
- Liquidity risk
- Reinvestment risk
- Inflation risk
Why is the T-Bill return independent of the economy?: (1)
-It will return the promised 5% regardless of economy.
Do T-Bills promise a completely risk free return?: (1)
No, T-bills are still exposed to risk of inflation. However not much unexpected inflation is likely to occur over a relatively short period.
Stand-alone risk: (3)
- contains diversifiable company specific risk
- contains non-diversifiable market risk
- measured by dispersion of returns about the mean and is relevant only for assets held in isolation.
Diversifiable risk?: (2)
- Caused by company specific events. ex. lawsuits, winning or losing major contracts
- effects of such events on a portfolio can be eliminated by diversification
Market risk: (3)
- From external events as war, inflation, recession and interest rates.
- Firms are affected simultaneously by these factors, market risk can’t be eliminated by diversification.
- Market risk also known as systematic risk since it shows degree to which a stock moves systematically with other stocks.
Portfolio expected return: (2)
- Contribution of each security to portfolio’s expected return depends only on expected return and proportionate share of the initial portfolio market value.
- investor who wants greatest expected return only should hold the one security with highest return.
Beta: (1)
- Stocks with beta greater than 1.0 are known as aggressive stocks
- Stocks with beta less than 1.0 are known as defensive stocks
Diversification: (1)
-Total risk of any security measured by its variance consists of two parts: Market/systematic risk and unique/unsystematic risk.
Portfolio Risk: (1)
-total risk of any portfolio is measured by its variance and consists of two parts: market risk and unique risk
Portfolio ‘Market’ risk: (2)
- Portfolio beta is an average of the beta of its securities
- unless an attempt is made, diversification will not cause the portfolio beta to change in a particular direction.
What would have to the riskiness of a 1 stock portfolio as more randomly selected stocks were added?
-Standard deviation of portfolio would decrease because added stocks would not be perfectly correlated.
If you chose to hold a one-stock portfolio, thus exposed to more risk than diversified investors, would you be compensated for all risk you bear?: (4)
- No, if you hold only one stock, you will not be compensated for additional risk you bear.
- stand alone risk (measured by st. dev) is not as important to a well-diversified investor.
- Rational risk averse investors are concerned with st. dev. or portfolio, based on market risk.
- Can only be one price, thus market return for a given security. Thus no compensation can be earned for additional risk of one-stock portfolio.
Three forms of market efficiency: (3)
- Weak form: past prices
- Semi strong form: Publicly available info
- Strong form: all info, public and private.
What should investor do in efficient market: (4)
- determine desired risk-return mix
- Diversify within type of investment, across types of investments, internationally
- Reduce costs to use a buy and hold strategy, trade less, use a discount broker
- Minimize taxes by sheltered investments, capital gains, dividends and interest.
Time diversification: (2)
- Holding risker assets over long time period will almost certainly return more than a less risky portfolio.
- Invest in equity during early and middle stages of life cycle.
Expected return: (1)
-Expected return is what is expected to happen in the future
