Chapter 7 Flashcards
What is the formula for standard deviation?
sqrt((Sum(r-rbar)^2)/n)
When it comes to probabilities, what % of the outcomes is:
1 standard deviation from the mean?
1.65 standard deviation from the mean?
1.96 standard deviation from the mean?
2.58 standard deviation from the mean?
68.3%
90%
95%
99%
Who developed modern portfolio theory?
This was Markowitz
What was Markowitz modern portfolio theory all about?
It is about how diversification can maximise returns for a given level of return.
What are the assumptions of the modern portfolio theory?
It assumes that all investors are risk averse, rational, and also perfectly diversified in their assets.
What is the efficient frontier?
The efficient frontier is the most efficient combination of assets that will maximise returns for a given level of risk
What are the X and Y axis of the efficient frontier?
The Y axis is the expected return and the x axis is the standard deviation
What concept do we have to use to identify the optimal set of assets for an investor?
We will use utility.
We use utility to understand which sets of assets are the most suitable for a specific investor.
Who introduced the risk free asset into modern portfolio theory?
Sharpe introduced the risk free asset.
What changes to efficient frontier did the introduction of the risk free asset bring?
As we introduce the risk free asset into the efficient frontier graph, we will see that instead of the linear capital allocation line starting at 0, it will now start at an expected return that is higher than 0%
Why did Sharpe say that all investors will choose the CML market portfolio?
He said so as that for regardless of the risk attitude of the investor, they will receive higher returns than being on any other portfolio.
The optimal portfolio is always tangent to the efficient frontier.
How do we work out the slope of the CAL?
This is the Sharpe ratio!
(Rp-Rf)/(stdv(m))
What two risk components does assets have (broadly)?
Systematic and unsystematic risk
Which statistical method is used to ensure that we have diversification benefits?
We use covariance, and we want assets that have a low covariance with one another
What is the formula for covariance?
(SDa)(SDb)(correlation coefficient)
What does the efficient market hypothises weak form mean?
This means that all prices reflect all past market information.
It is not possible to predict future price changes based on past price changes. Price changes are random
What is a random walk?
An random walk is the theory that yesterdays returns can not explain tomorrows returns.
What does the efficient market hypothises semi-strong form mean?
This means that prices reflect all past market and publicly available information and that stock prices will react to news and adjust to a new level (instantly)
This means that it is not possible to beat the market by using fundemental analysis
What does the Efficient markets hypothesis strong form mean?
This means that all public and private information is reflected in the prices.
What does CAPM measure?
It measures systematic risk of the portfolio compared to the benchmark portfolio
What beta does the market protfolio have by default?
A beta of 1
What is the CAPM formula?
E(r) = Rf + Bp(Rm-Rf)
What are the axis of the securities market line?
The Y axis is expected return and the X axis is the beta
What do we use to produce the securities market line?
We use the CAPM formula