Lecture 4 Flashcards
Capital allocation
Between risky portfolio and risk free assets
Asset allocation
In risky portfolio across broad asset classes
Security selection
Of individual assets within each asset class
Diversification reduces
Portfolio risk
Systematic/ non-diversifiable risk =
Market risk
Cannot eliminate
Market risk > risk that affects all firms
Portfolio variance is higher when
The correlation coefficient is higher
Perfect positive correlation (p = 1) occurs when
Standard deviation of the portfolio = weighted average component standard deviation
if correlation (p = -1)
Perfect negative correlation
Expected return is a function of
Standard deviation
Optimal portfolio exists where
Intersection of the CAL (with the highest slope) and opportunity set of assets curve
CAL objective =
To find weights (wD and wE) that result in the highest slope of CAL
Minimum variance frontier =
Graph of lowest possible variance attained for a given portfolio’s expected return
Best risk return combinations (candidates for optimal portfolio) are provided on
Any portfolio that lies on the MVF from the global minimum variance portfolio and upwards
Optimal CAL is
One with highest reward to volatility ratio (steepest slope)
