Diversification Flashcards
What does the Capital Asset Pricing Model (CAPM) assert?
It asserts that all investors shall hold their optimal portfolio.
What is CAPM a consequence of?
The mutual fund theorem: that all investors hold the same risky asset, ie, the tangency portfolio
What is the tangency portfolio?
The CAPM says that it equals the market portfolio
What is the equity premium puzzle?
Over 200 years US equities have returned 6.6%. Over same time period, short term government bonds returned 2.7%— why?
What is the equity premium supposed to reflect?
The relative risk of stocks over bonds.
What is the relationship between beta and diversification?
Both positive and negative beta stocks are good to have in case of up or down market— for example gold has better returns in a down market and Apple Computer might be better in up markets. Negative beta stocks should be carefully chosen such that they do not kill returns of positive beta stocks in the portfolio
What is the Capital Market Line?
The capital market line (CML) represents portfolios that optimally combine risk and return.
What is the formula for the CML?
r_i = r_f + Beta*(r_market - r_f)
Where r_i = expected return of ith asset
r_f = risk-free return
r_market = expected return on the market
Beta = relationship of return ms between ith asset and market
What does it mean to hold negative quantity of a tradeable asset like a stock?
A broker borrows a stock and sells it. He gives his customer the proceeds. Now the customer is on the hook for the stock, ie, owes the stock. So, the customer waits for the stock to go down, buys it, and gives the stock back to the broker. But the customer keeps the positive difference between the proceeds and what he had to spend to buy the stock to repay the broker
In the CAPM regarding short selling, what two conditions must hold?
A stock cannot have an optimal holding value which is negative
The optimal portfolio is on the efficient frontier
What is the relationship between covariance and variance in a portfolio?
Positive covariance, that is, assets tracking closely, increases variance, which is bad because it means portfolio volatility increases. Negative covariance is better for decreasing volatility.
