Chapter 6

Question 1

What is considered the risk-free asset in practice?

Answer 1

T-bills are considered risk-free, and government-issued securities that are default-free are used in practice.

Question 2

What is the Sharpe ratio?

Answer 2

The Sharpe ratio is the ratio of excess return to portfolio standard deviation.

Question 3

What is the formula for expected return on the complete portfolio?

Answer 3

Expected return on the complete portfolio is calculated as: E(rc) = (1-y)rf + yE(rp), where rf is the risk-free rate, and E(rp) is the expected return of the risky portfolio.

Question 4

How do you calculate the risk of the complete portfolio?

Answer 4

The risk of the complete portfolio is calculated as the product of y and the standard deviation of the risky portfolio.

Question 5

What is the Capital Allocation Line (CAL)?

Answer 5

The CAL is the graph showing all feasible risk-return combinations of a risky and risk-free asset.

Question 6

What does the slope of the Capital Allocation Line represent?

Answer 6

The slope of the CAL represents the Sharpe ratio, indicating the reward-to-volatility trade-off.

Question 7

What are the key variables in constructing a complete portfolio?

Answer 7

Key variables include ‘y’ (portion allocated to the risky asset) and (1-y) (portion allocated to the risk-free asset).

Question 8

How do lending and borrowing rates affect the shape of the CAL?

Answer 8

Different borrowing and lending rates cause a kink in the CAL at the point where borrowing starts, resulting in two slopes.

Question 9

What is the utility function formula for portfolio allocation?

Answer 9

U = E(r) - ½Aσ², where U is utility, A is risk aversion, σ² is variance, and E(r) is expected return.

Question 10

What does the variable ‘y’ represent in portfolio allocation?

Answer 10

In portfolio allocation, ‘y’ represents the portion of the portfolio allocated to risky assets.

Question 11

How do indifference curves help in portfolio selection?

Answer 11

Indifference curves show combinations of risk and return that provide the same level of utility for an investor.

Question 12

What are ‘non-normal returns’?

Answer 12

Non-normal returns are return distributions that deviate from the normal distribution assumption, often causing issues with standard deviation as a measure of risk.

Question 13

What is Value at Risk (VaR)?

Answer 13

VaR is a measure that assesses the maximum loss over a specific time period with a certain confidence level.

Question 14

What is Expected Shortfall (ES)?

Answer 14

Expected Shortfall (ES) measures the average loss in worst-case scenarios beyond the VaR threshold.

Question 15

What is the passive strategy in portfolio management?

Answer 15

A passive strategy involves avoiding security analysis and holding a diversified portfolio like an index fund.

Question 16

What is the Capital Market Line (CML)?

Answer 16

The CML is the capital allocation line when using the market index as the risky portfolio.

Question 17

What is the difference between active and passive strategies?

Answer 17

Active strategies involve security selection and timing, while passive strategies rely on broad market investments without active management.

Question 18

What is the risk premium for the passive risky portfolio from 1957 to 2019?

Answer 18

The risk premium for the passive risky portfolio from 1957 to 2019 was 4.48%.

Question 19

What are some important considerations when pursuing a passive strategy?

Answer 19

Important considerations include the costs of active management and the potential benefits of free-riding on passive strategies.

Question 20

What is a ‘black swan’ event in financial terms?

Answer 20

A ‘black swan’ event is an extremely rare and unpredictable event that has a severe impact on financial markets.