Chapter 6 - Capital Allocation to Risky Assets Flashcards
The process of constructing a portfolio requires you to?
2
- Select the composition of the risky portfolio
- Decide how much to invest in it, directing the remaining budget investment into a risk free investment. aka allocation to risky assets
What model reveals the appropriate objective function for the construction of a risky portfolio?
The utility model - this explains how an industry can serve investors with highly diversified preferences without the need to know each of them personally.
What is used to measure portfolio risk?
Risk premium and standard deviation of excess return.
What is meant by speculation?
The assumption of considerable investment risk to obtain commensurate gain. Considerable risk is sufficient enough to affect the decision. Commensurate gain is the positive risk premium that is, expected to be greater than a risk free alternative. Speculation is taken in spite of the risks associated, hence, speculation and risk aversion are consistent.
What does it mean to gamble?
To gamble is to bet on an uncertain outcome. The difference between speculation and gambling is the lack of commensurate gain. To gamble is to enjoy the risk of gambling itself.
What is meant by speculation?
The assumption of considerable investment risk to obtain commensurate gain. Considerable risk is sufficient enough to affect the decision. Commensurate gain is the positive risk premium that is, expected to be greater than a risk free alternative. Speculation is taken in spite of the risks associated, hence, speculation and risk aversion are consistent.
What does it mean to gamble?
To gamble is to bet on an uncertain outcome. The difference between speculation and gambling is the lack of commensurate gain. To gamble is to enjoy the risk of gambling itself.
Utility of risk averse investors?
Risk averse = higher utility factor
Risk neutral with A= A - judge solely on return
Risk Lover with A<0
What does a capital allocation decision imply?
An asset allocation choice among broad investment classes, rather than specific securities within each asset class.
How is the Capital Market Line (CAL) derived?
With the risk-free and the risky portfolio
Money market instruments are virtually free from what?
Interest rate risk due to their short term maturities and fairly safe in terms of default or credit risk
How is the Capital Market Line (CAL) derived?
With the risk-free and the ricky portoflop/
A passive strategy describes..
A portfolio decision that avoids any direct or indirect security analysis.
- no resources to acquiring information o many individual stock or group of stocks - could mirror value of corporate sector of the us economy e.g. S&P 500
By how much did the portfolio of S&P 500 outperform t bills in terms of sharpe ratio vs standard deviation from 1926-2012?
0.4% average excess return over T bills for every 1% of standard deviation
Costs of passive portfolio?
Negligible costs to purchase t-bills and management fees to either an ETF or mutual find company that operates a market index fund. Vanguard for example operates the Index 500 Portfolio that mimics SP500