Lecture 2

Question 1

For the bottom-up approach, please outline:
Security selection
Asset allocation
Capital allocation

Answer 1

Security selection:
Produce the input list with the estimates of assets’ expected returns and a covariance matrix by performing a security analysis

Asset allocation:
Select the composition of risky portfolio across broad asset classes (stocks, bonds etc.) Find the optimal risky portfolio P. Calculate its expected return and variance

Capital allocation:
allocate funds between risky portfolio and risk-free asset (e.g. Treasury bills) based on the degree of risk aversion. Find the optimal complete portfolio (C), calculate its expected return and variance.