Chapter 6 - Capital Allocation to Risky Assets

Question 1

The process of constructing a portfolio requires you to?

2

Answer 1

1. Select the composition of the risky portfolio
2. Decide how much to invest in it, directing the remaining budget investment into a risk free investment. aka allocation to risky assets

Question 2

What model reveals the appropriate objective function for the construction of a risky portfolio?

Answer 2

The utility model - this explains how an industry can serve investors with highly diversified preferences without the need to know each of them personally.

Question 3

What is used to measure portfolio risk?

Answer 3

Risk premium and standard deviation of excess return.

Question 4

What is meant by speculation?

Answer 4

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.

Question 5

What does it mean to gamble?

Answer 5

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.

Question 6

What is meant by speculation?

Answer 6

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.

Question 7

What does it mean to gamble?

Answer 7

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.

Question 8

Utility of risk averse investors?

Answer 8

Risk averse = higher utility factor
Risk neutral with A= A - judge solely on return
Risk Lover with A<0

Question 9

What does a capital allocation decision imply?

Answer 9

An asset allocation choice among broad investment classes, rather than specific securities within each asset class.

Question 10

How is the Capital Market Line (CAL) derived?

Answer 10

With the risk-free and the risky portfolio

Question 11

Money market instruments are virtually free from what?

Answer 11

Interest rate risk due to their short term maturities and fairly safe in terms of default or credit risk

Question 12

How is the Capital Market Line (CAL) derived?

Answer 12

With the risk-free and the ricky portoflop/

Question 13

A passive strategy describes..

Answer 13

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

Question 14

By how much did the portfolio of S&P 500 outperform t bills in terms of sharpe ratio vs standard deviation from 1926-2012?

Answer 14

0.4% average excess return over T bills for every 1% of standard deviation

Question 15

Costs of passive portfolio?

Answer 15

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

Question 16

Other reason to pursue passive strategy?

Answer 16

The free rider benefit. If there are many active knowledgeable investors who quickly bid up prices of undervalues assets and force down prices of overvalued assets (by selling) it can be concluded that at most points assets will be fairly priced.

Question 17

What does a passive strategy involve?

Answer 17

It involves an investment in two passive portfolios: virtually risk free short term T bills (or a money market mutual fund) and a fund of common stocks that mimics a broad market index. The capital allocation line representing such a strategy is called the capital market line.

Question 18

What is the simplest way to reduce risk?

Answer 18

Shifting funds from the risky portfolio to the risk-free asset.

Question 19

What is an investors risk portfolio characterised by?

Answer 19

Its reward to volatility ratio. This is also the slop of the CAL, a line that, when graphed, goes from the risk free asset through the risky asset. All combinations of risky asset and risk free asset lie on this line.

Question 20

Investors degree of risk aversion can be characterised by?

Answer 20

The slop of his or her indifference curve. This shows the required risk premium for taking on additional risk.