Chapter 6 - Efficient Diversification Flashcards
Define Active Portfolio
The portfolio formed by optimally combining analyzed stocks.
Define Alpha
A stock’s expected return beyond that induced by the market index, its expected return when the market’s excess return is zero.
Define Beta
The sensitivity of a security’s returns to the market factors.
Define Diversifiable Risk/Unique Risk/Firm Specific Risk/Nonsystematic Risk
Risk that can be eliminated by diversification.
Define Efficient Frontier
Graph representing a set of portfolios that maximizes expected return at each level of portfolio risk.
Define Excess Return
Rate of return in excess of the risk free return.
Define Index Model
Model that relates stock returns to the returns on a broad market index and firm-specific factors.
Define Information Ratio
Ratio of alpha to the standard deviation of the residual.
Define Investment Opportunity Set
Set of available risk-return combinations.
Define Market Risk
Risk factors common to the whole economy. This remains after diversification.
Define Optimal Risky Portfolio
The best combination of risky assets to be mixed with the safe assets to form the complete portfolio.
Define Residual Risk
Component of return variance that is independent of the market factor.
Define Security Characteristic Risk
Plot of a security’s predicted excess return from the excess return of the market.
Define Separation Property
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.
Define covariance
Probability weighted average - measures the average tendency of the asset returns to vary in tandem, that is, to co-vary.
What are the steps to constructing an effective portfolio?
- 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)
Define Correlation coefficient
The covariance divided by the product of the standard deviations of the returns on each fund.
What constraints prevent a person from choosing portfolios on the efficient frontier? 3
- 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”.
What are cyclical stocks?
Stocks that have a greater sensitivity to the economy than the average stock. Beta > 1
What are defensive stocks?
Stocks that have less sensitivity to the economy than the average stock. Beta < 1.
What does a positive alpha suggest?
An underpriced security.
What is use of a security with a negative beta?
To use as a hedge against systematic risk.
What is perfect correlation?
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.
For diversified investors, what is the relevant measure of risk for a security?
The security’s beta.
