Chapter 7

Question 1

What are the two types of portfolio risks?

Answer 1

Market risk (systematic) and firm-specific risk (non-systematic).

Question 2

What is market risk?

Answer 2

Market risk is the risk that affects the entire market, which cannot be diversified away.

Question 3

What is firm-specific risk?

Answer 3

Firm-specific risk is the risk associated with an individual company, which can be eliminated through diversification.

Question 4

How is expected return calculated for a portfolio of two risky assets?

Answer 4

The expected return is the weighted average of the expected returns of the component securities in the portfolio.

Question 5

What is portfolio risk?

Answer 5

Portfolio risk is the variance of the portfolio, which is a weighted sum of the covariances between the assets in the portfolio.

Question 6

What is covariance?

Answer 6

Covariance is a measure of how two assets move together.

Question 7

What is the range of values for the correlation coefficient (ρ)?

Answer 7

The correlation coefficient (ρ) ranges from -1.0 to 1.0.

Question 8

What does a correlation of 1.0 indicate between two assets?

Answer 8

A correlation of 1.0 means the two assets are perfectly positively correlated, providing no diversification benefits.

Question 9

What does a correlation of -1.0 indicate between two assets?

Answer 9

A correlation of -1.0 means the two assets are perfectly negatively correlated, allowing for a riskless hedge.

Question 10

What is the minimum-variance portfolio?

Answer 10

The minimum-variance portfolio has the lowest standard deviation and risk compared to the individual assets in the portfolio.

Question 11

What does the Sharpe ratio measure?

Answer 11

The Sharpe ratio measures the reward-to-volatility ratio, or the excess return per unit of risk.

Question 12

What is the objective in the Markowitz Portfolio Optimization Model?

Answer 12

The objective is to maximize the Sharpe ratio (the slope of the capital allocation line) for any given portfolio.

Question 13

What is the efficient frontier?

Answer 13

The efficient frontier represents portfolios that offer the highest expected return for a given level of risk.

Question 14

What is the separation property in portfolio selection?

Answer 14

The separation property states that portfolio selection can be separated into two tasks: finding the optimal risky portfolio and choosing the allocation between the risk-free asset and the risky portfolio based on personal preferences.

Question 15

How does diversification reduce risk?

Answer 15

Diversification reduces risk by spreading investments across assets with less-than-perfectly correlated returns.

Question 16

What is the impact of covariance on portfolio variance?

Answer 16

The greater the covariance of an asset with other assets in the portfolio, the more it contributes to the overall portfolio variance.

Question 17

How does the size of a portfolio (n) affect risk reduction?

Answer 17

The larger the portfolio, the greater the risk reduction, as risk decreases as the number of assets increases.

Question 18

What is Value at Risk (VaR) and how is it used?

Answer 18

VaR measures the maximum loss expected over a specified period with a given confidence level.

Question 19

What is Expected Shortfall (ES)?

Answer 19

Expected Shortfall (ES) measures the average loss in worst-case scenarios beyond the VaR threshold.

Question 20

What happens if portfolios have non-normal returns?

Answer 20

Portfolios with non-normal returns may have extreme values of VaR and ES, which can affect the portfolio’s risk profile.