Lecture 3- Portfolio Theory

Question 1

What are the 2 main approaches to portfolio management and construction?

Answer 1

• Top down/macro approach

- Bottom up approach

Question 2

How does the top down/macro approach work?

Answer 2

A manager looks at the major macrodrivers of asset returns and obtains a view (forecast) about these drivers in the form of a macroeconomic forecast

Question 3

How does the bottom up approach work?

Answer 3

It focuses on the micro analysis of individual asset issues, sectors, and specific industries

Question 4

What are 3 main variables considered in the top down approach?

Answer 4

• Monetary policy
• Fiscal policy
• Exchange rate movements

Question 5

What are the 3 main variables considered in the bottom up approach?

Answer 5

• Credit analysis
• Industry analysis
• Relative value analysis

Question 6

What is the formula for portfolio return?

Answer 6

r_p = w1r1 + w2r2

where r is return and w is the weighting of each asset

Question 7

What is a security’s unsystematic risk?

Answer 7

Firm-specific risk which can be diversified away

Question 8

What is systematic risk?

Answer 8

Market risk which cannot be eliminated by diversification

Question 9

What are efficient portfolios?

Answer 9

Portfolios that maximize the expected return from an investment subject to a given level of risk

Question 10

What is the efficiency frontier?

Answer 10

The mean-standard deviation frontier, representing different weights of assets 1 and 2., where the correlation coefficient is zero