Chapter 6 - Efficient Diversification

Question 1

Define Active Portfolio

Answer 1

The portfolio formed by optimally combining analyzed stocks.

Question 2

Define Alpha

Answer 2

A stock’s expected return beyond that induced by the market index, its expected return when the market’s excess return is zero.

Question 3

Define Beta

Answer 3

The sensitivity of a security’s returns to the market factors.

Question 4

Define Diversifiable Risk/Unique Risk/Firm Specific Risk/Nonsystematic Risk

Answer 4

Risk that can be eliminated by diversification.

Question 5

Define Efficient Frontier

Answer 5

Graph representing a set of portfolios that maximizes expected return at each level of portfolio risk.

Question 6

Define Excess Return

Answer 6

Rate of return in excess of the risk free return.

Question 7

Define Index Model

Answer 7

Model that relates stock returns to the returns on a broad market index and firm-specific factors.

Question 8

Define Information Ratio

Answer 8

Ratio of alpha to the standard deviation of the residual.

Question 9

Define Investment Opportunity Set

Answer 9

Set of available risk-return combinations.

Question 10

Define Market Risk

Answer 10

Risk factors common to the whole economy. This remains after diversification.

Question 11

Define Optimal Risky Portfolio

Answer 11

The best combination of risky assets to be mixed with the safe assets to form the complete portfolio.

Question 12

Define Residual Risk

Answer 12

Component of return variance that is independent of the market factor.

Question 13

Define Security Characteristic Risk

Answer 13

Plot of a security’s predicted excess return from the excess return of the market.

Question 14

Define Separation Property

Answer 14

The property that implies portfolio choice can be separated into two independent tasks:
1 - Determination of the optimal risky portfolio, which is purely a technical problem.
2 - The personal choice of the best mix of the risky portfolio and the risk-free asset.

Question 15

Define covariance

Answer 15

Probability weighted average - measures the average tendency of the asset returns to vary in tandem, that is, to co-vary.

Question 16

What are the steps to constructing an effective portfolio?

Answer 16

• Choose the asset allocation mix (stock, bond)

- Decide what sort of stock, bond, and mutual funds you want to own. (large cap, small cap, etc)

Question 17

Define Correlation coefficient

Answer 17

The covariance divided by the product of the standard deviations of the returns on each fund.

Question 18

What constraints prevent a person from choosing portfolios on the efficient frontier? 3

Answer 18

• Institution is prevented from taking short positions in any asset.
• Client may want to ensure a minimum level of expected dividend yield.
• May be not allowed to invest in companies engaged in “undesirable social activity”.

Question 19

What are cyclical stocks?

Answer 19

Stocks that have a greater sensitivity to the economy than the average stock. Beta > 1

Question 20

What are defensive stocks?

Answer 20

Stocks that have less sensitivity to the economy than the average stock. Beta < 1.

Question 21

What does a positive alpha suggest?

Answer 21

An underpriced security.

Question 22

What is use of a security with a negative beta?

Answer 22

To use as a hedge against systematic risk.

Question 23

What is perfect correlation?

Answer 23

When a security returns correlation coefficient is either 1 or -1. In other words, the security return is fully explained by the market return and there is no firm-specific effects.

Question 24

For diversified investors, what is the relevant measure of risk for a security?

Answer 24

The security’s beta.