Chapter 5.4-6.3 Flashcards
What does the Sharpe ratio measure?
The Sharpe ratio measures the reward-to-volatility ratio by evaluating the performance of an investment relative to its risk, using excess return and standard deviation.
What is the risk premium?
The risk premium is the difference between the expected return on a risky asset and the risk-free rate.
What is excess return?
Excess return is the difference between the actual return on a risky asset and the risk-free rate.
Why is the normal distribution important in investment returns?
The normal distribution allows investment managers to use standard deviation as a measure of risk and simplifies the calculation of correlation between returns.
What is a risk-averse investor?
A risk-averse investor prefers lower risk and requires a risk premium to take on higher-risk investments.
How do risk-neutral investors make decisions?
Risk-neutral investors focus solely on the expected returns of investments, ignoring the level of risk.
What is the utility function in investment decisions?
The utility function is used to evaluate portfolios by balancing expected returns against the risk taken, with higher utility indicating a more desirable portfolio.
What are the two steps in portfolio construction?
The two steps are: (1) deciding how much to allocate between risk-free and risky assets, and (2) determining the composition of the risky assets.
What is the capital allocation line (CAL)?
The CAL plots the risk-return trade-off by showing combinations of risk-free assets and risky portfolios. Its slope represents the Sharpe ratio of the risky portfolio.
What is the risk-free asset in practice?
T-bills and other government-issued securities are considered risk-free, but only if they match the investor’s holding period.
What happens to portfolio utility as expected return increases?
As expected return increases, the utility of the portfolio generally increases, making it more attractive to investors.
What type of investor accepts lower expected returns for higher risk?
A risk-loving investor is willing to accept lower expected returns for higher amounts of risk.
What does it mean if a portfolio dominates another under the mean-variance criterion?
It means the portfolio offers a higher expected return for the same level of risk or has lower risk for the same expected return.
What is the significance of indifference curves in portfolio selection?
Indifference curves connect portfolios with the same utility value, helping investors choose portfolios that best match their risk-return preferences.
How can risk aversion levels of investors be estimated?
Risk aversion levels can be estimated through questionnaires, observations of portfolio changes over time, and by examining average behaviors of groups of individuals.
