Chapter 7 - Portfolio Theory and Practice Flashcards
Two broad sources of uncertainty:
General macroeconomic factors such as business cycle, inflation, interest rates and exchange rates.
Firm specific: eg R and D and personal changes
Why is it impossible, even through highly diversified portfolios to eliminate all risk?
Because of systematic risk
Risk that can be eliminated through diversification is called nonsystematic risk.
What is the difference between variance and covariance?
Covariance is the measure of how two variables will change together.
Variance is the weighted sum of covariances
What correlation does a hedge asset have?
Negative - these assets are effective at reducing total risk
What is the best correlation?
Lower the better - portfolios less than perfectly correlated always offer some degree of diversification benefit.
What are the three main steps to arrive at a complete portfolio?
- Specify the return characteristics of all securities (expected returns, variances, covariances).
- Establish the risk portfolio (asset allocation)
a. calculate the optimal risk portfolio, P
b. Calculate the properties of portfolio P using the weights determined by efficiency frontier and CAL. - Allocate funds between the risky portfolio and the risk-free asset (capital allocation).
a. calculate the fraction of the complete portfolio allocated to portfolio P (the risky portfolio) and to T bills (the risk free asset).
b. Calculate the share of the complete portfolio invested in each asset and in T-bills.
What determines the risk-return opportunities available to the investor?
The minimum-variance frontier of risky assets.
Security selection: The 3 steps.
- Identify the risk return combination available from the set of risky assets.
- Identify the optimal portfolio of risky assets by finding the portfolio weights with the steepest CAL.
- Choose an appropriate complete portfolio by mixing the risk-free assets with the optimal risky portfolio.
How can we pinpoint the minimum variance frontier?
By using the efficient frontier of risky assets, the minimum variance frontier will lie above the global minimum variance portfolio (as below this is inefficient) and then we can match required expected returns ER of the investor to the corresponding levels of risk (standard deviation). Anything past this, while remaining an efficient risk/reward trade off, is known as the efficient frontier.
Constraints on portfolio selection:
Socially responsible investments (unethical is not chosen)
Client desires
Can portfolio managers use portfolios with the same asset allocation in spite of differing investor risk aversion?
Yes, the frontier portfolios find the optimal portfolios, the only difference between client’s choices is that the more risk-averse client will invest more in risk free assets, thus, capital allocation comes into play. This is called a separation property.
What happens if the quality of security analysis is poor?
Then a passive portfolio such as market index fund will result in a higher sharpe ratio than an active portfolio that uses low quality security analysis to talk portfolio weights toward seemingly favourable securities.
What does it mean when average covariance among security returns is zero?
All firm-specific risk has been fully diversified.
Why are the theories of security selection and asset allocation identical?
Both activities call for the construction of an efficient frontier, and the choice of particular portfolio from the frontier.
