chapter 7 powerpoint (lessons 3 and 4) Flashcards
Investment decisions fall into which three types
Capital Allocation
Asset Allocation
Security Selection
Capital Allocation
Determines investor’s exposure to risk
Asset Allocation
Optimal portfolio with respect to risk-return tradeoff
–> Across broad asset classes Bills, Bonds, Stocks, etc
Security Selection
Individual assets within a class
–> Which bond in particular to pick?
What type of risk can be reduced through diversification
Firm-specific risk
Two main types of risk
Market risk
Firm-specific risk
Market risk
Reflects the conditions in the general economy
systematic risk
non diversifiable risk
Firm-specific risk
Reflects the conditions of the company itself
Unsystematic risk
diversifiable risk
Unique risk
Idiosyncratic risk
a well diversified portfolio would mainly bear which type of risk?
market risk only
Total risk
Market risk + Firm-specific risk
An efficient portfolio
the one that provides the lowest possible risk for the required level of expected return
Covariance
the measure of comovement between instruments
What does Cov(rD,rD) mean
How does asset D move with asset D
so how does asset D move with itself
The variance of a portfolio
a measure of risk of the portfolio
a weighted sum of covariances
what is the formula for the standard deviation of a portfolio with two risky assets?
the same as comm 308
it has way better formulas and you already have a good idea of it
what is the formula for the standard deviation of a portfolio with two risky assets?
the same as comm 308
write it on a cheat sheet
Correlation coefficient of returns
measures degree of association between
assets – has a direction
symbol: p
formula for correlation coefficient
same as comm 308
is the variance of a portfolio a simple weighted average of the individual asset variances?
nah brooo
it has the weird formula with either the covariance or the correlation coefficient
if p = 1 when we have two risky securities?
perfectly positively correlated
standard deviation is just the weighted average of the standard deviations of the risky securities
if p is not = 1 when we have two securities, is the portfolio standard deviation bigger or smaller than the weighted average of the standard deviations of the risky securities?
smaller
when we have two securities, how can we find the weight of security A if our p = 0 (securities have zero correlation)
wA = 𝜎B / (𝜎A + 𝜎B)
What is hedging?
Sets the variance to minimum, elimination risk, perfect hedge
a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset
also typically results in a reduction in potential profits
Hedging strategies typically involve derivatives, such as options and futures contracts
when put in graphs, as we reduce the correlation, of our portfolio what happens to our returns in regards to our portfolio standard deviation and weights of securities?
two security
the lower the correlation coefficient, the lower the standard deviation for the same returns when the weight of stock A is between 0 and 1
–> also when the weight of stock B = 1 - wA
when wA < 0 or > 1, then the opposite happens
–> the lower the correlation coefficient, the higher the standard deviation for the same returns for p = 1