Lecture 5 Flashcards
What does the risk free asset act as?
A benchmark rate of return
What must risky assets pay?
A risk premium relative to the risk free rate
What can the investor borrow at the risk free rate and what can they use it alongside/for?
Borrow funds
Use alongside existing funds
To invest in risky asset
Borrowing at risk free rate extends what? What is this called?
Extends the locus of feasible portfolios
Called the capital allocation line
Where is the optimal risky portfolio found at?
The point of tangency between the efficient frontier and the capital allocation line
What is the optimal portfolio called?
The mean-variance efficient portfolio
Any capital allocation line that is not _______ to the efficient frontier will either be impossible (if it’s ______) or inefficient (if it’s _________)
- Tangent
- Steeper
- Flatter
What is risk premium?
Extra return that the investor seek to hold a risky asset
How do you calculate the risk premium?
Market return - risk free rate
What is the premium for holding risky assets?
The amount of increased return that the investors receive to compensate them for increased risk
If the sharp ratio is 0.75, what does it imply?
That for each percentage point increase in the risk of a portfolio along the capital allocation line, the return rises by 0.75 percentage points
What is the reward-to-risk ratio called?
The Sharpe ratio
What is the riskiness of the MVEO portfolio and the risk premium dependant on?
The risk free rate of return
If the risk free rate were higher, and the same efficient frontier attainable then…
The Sharpe ratio would be lower
Mean variance efficient portfolio held by all investors will be more risky
Where must all assets be?
In the mean variance efficient portfolio
What two assets do all investors hold, and what does this mean?
The risk-free asset
Mean variance efficient portfolio
Albeit holding them in differing proportions in their portfolios
For all available assets in the market to be purchased (the market to be in equilibrium)…
Each must be held in proportion to its weight in the market
The MVEP includes all risky assets in proportion to ____________ (market capitalisation). It is therefore a ______________ version of itself and is known as the ____________
- Their weight in the market
- Scaled down
- Market portfolio
Why do share prices fluctuate?
- They move with the market - market-related or systematic risk
- Idiosyncratic reasons - specific or unsystematic risk
What is the line of best fit calculated using and what is it known as?
The mathematical procedure of regression to the mean
Known as the characteristic line for share i
In a portfolio, the contribution of each share to the riskiness of the portfolio is…?
In proportion to its weight
The sensitivity of the portfolio to the market is
The weighted average of the sensitivities of the constituent shares
As the number of shares increases, the variance of the portfolio…?
Converges to the variance of the market
Specific risk can be diversified away until…
Only market risk remains
Rational, risk averse investors can do what to specific risk and therefore…?
Diversify away
Therefore specific risk does not hurt investors and they do not need to be compensated for it.
What type of risk can’t investors diversify away, and what does this mean?
Market related risk
Means that they require a higher rate of return in order to accept the risk
Bc the contribution that a share makes to the market risk of a portfolio is ______ to beta, the ______________ of a share must be ________ to its beta
- Proportional
- Risk premium
- Proportional
