Chapter 5 - Portfolio Theory

Question 1

Define Arithmetic Average

Answer 1

The sum of returns in each period divided by the number of periods.

Question 2

Define Asset Allocation

Answer 2

Portfolio choice among broad investment classes.

Question 3

Define Capital Allocation

Answer 3

The choice between risky and risk-free assets.

Question 4

Define Capital Allocation Line (CAL)

Answer 4

Plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio.

Question 5

Define Capital Market Line

Answer 5

The capital allocation line using the market index portfolio as the risky asset.

Question 6

Define Complete Portfolio

Answer 6

The entire portfolio including risky and risk-free assets.

Question 7

Define Dollar-Weighted Average Return

Answer 7

The internal rate of return on an investment.

Question 8

Define Excess Return

Answer 8

Rate of return in excess of the risk-free rate.

Question 9

Define Expected Return

Answer 9

The mean value of the distribution of HPR.

Question 10

Define Geometric Average

Answer 10

The single per-period return that gives the same cumulative performance as the sequence of actual returns.

Question 11

Define Holding-Period Return

Answer 11

Rate of return over a given investment period.

Question 12

Define Inflation Rate

Answer 12

The rate at which prices are rising, measured as the rate of increase of the CPI.

Question 13

Define Kurtosis

Answer 13

Measure of the fatness of the rails of a probability distribution relative to that of a normal distribution. Indicates likelihood of extreme outcomes.

Question 14

Define Mean-Variance Analysis

Answer 14

Ranking portfolios by their Sharpe ratios.

Question 15

Define Nominal Interest Rate

Answer 15

The interest rate in terms of nominal (not adjusted for purchasing power) dollars.

Question 16

Define Passive Strategy

Answer 16

Investment policy that avoids security analysis.

Question 17

Define Price of Risk

Answer 17

The ratio of portfolio risk premium to variance.

Question 18

Define Probability Distribution of HPR

Answer 18

List of possible outcomes with associated probabilities.

Question 19

Define Real Interest Rate

Answer 19

The excess of the interest rate over the inflation rate. The growth rate of purchasing power derived from an investment.

Question 20

Define Risk Aversion

Answer 20

Reluctance to accept risk.

Question 21

Define Risk-Free Rate

Answer 21

The rate of return that can be earned with certainty.

Question 22

Define Risk Premium

Answer 22

An expected return in excess of that on risk-free securities.

Question 23

Define Scenario Analysis of HPR

Answer 23

Process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case.

Question 24

Define Sharpe Ratio (Reward-To-Volatility)

Answer 24

Ratio of portfolio risk premium to standard deviation.

Question 25

Define Skew

Answer 25

Measure of the asymmetry of a probability distribution.

Question 26

Define Standard Deviation

Answer 26

The square root of the variance.

Question 27

Define Value At Risk (VaR)

Answer 27

Measure of the downside risk. The worst loss that will be suffered with a given probability, often 5%.

Question 28

Define Variance

Answer 28

The expected value of the squared deviation from the mean.

Question 29

What is the other name for geometric returns?

Answer 29

Time-weighted average return

Question 30

Why is the effective rate of return used?

Answer 30

Because APR ignores compounding.

Question 31

In scenario analysis, what is the 'surprise' return?

Answer 31

The difference between the actual return and the expected return.

Question 32

What is the market price of risk?

Answer 32

The price of risk of the market index portfolio, which reflects the risk aversion of the average investor.

Question 33

What three types of securities do money market mutual funds typically hold?

Answer 33

- Treasury bills - Bank CDs - Commercial Paper