Chapter 4: Portfolio Theory

Question 1

Modern Portfolio Theory

Answer 1

assumes that investors make choices based solely on expected returns, such as mean return, and risk.

Question 2

Modern Portfolio Theory assumes (3)

Answer 2

1. there are no transaction fees or taxes
2. perfect competition exists among all market participants
3. all investors have free and instant access to all market information.

Question 3

what is the efficient frontier?

Answer 3

consists of all the combinations of assets that result in an efficient portfolio and can be combined with an investor’s utility function or indifference curves to identify that investor’s optimal portfolio.

Question 4

What does the indifference curve indicate?

AKA Utility

Answer 4

portfolios that the investor would be indifferent to holding

Question 5

the point at which the Capital Market Life and the efficient frontier meet is referred to as what?

Answer 5

“The Market Portfolio” which is a combination of securities at its greatest diversification point and the highest return for the level of risk assumed.

Question 6

how do positively correlated assets move in conjunction of each other?

Answer 6

move together

Question 7

how do negatively correlated assets move in conjunction of each other?

Answer 7

move in opposite directions

Question 8

what does standard deviation measure?

Answer 8

all risk associates with price variations in a security - systematic and unsystematic

Question 9

what is the standard deviation for a portfolio determined by?

Answer 9

1. the SD of each security
2. the correlation between the securities in the portfolio
3. the weightings of each security

Question 10

Strategic Asset Allocation

Answer 10

addresses the risk-return tradeoff of the investments in a portfolio by developing an appropriate diversification strategy across a broad set of asset classes.

Question 11

tactical asset allocation

Answer 11

seeks to outperform the market over shorter periods of time by placing investment dollars in those asset classes that the investor expects will outperform market returns over the period.

Question 12

Security Market Line

Answer 12

Represents the expected return relative to risk as measured by beta.

Question 13

when the market risk premium increases and the risk-free rate remains the same, what changes do we expect from SML?

Answer 13

If the market risk premium increases, then the return for the market portfolio should increase. Since the Rf remains the same, it results in a rotation upward (counter clockwise) with an increased slope.