Lecture 6 Flashcards
Is there a positive relationship between volatility and average returns for individual stocks
yes
What are the difference between larger stocks and smaller stocks
Larger stocks tend to have lower volatility
What is market risk (systematic or non diversifiable)
It’s the risk that comes from the whole market and sticks around even if you try really hard to spread your investments around.
Firm Specific risk (diversifiable or non systematic)
Risk that can be removed by diversification
What are the characteristics of firm specific risk
- Projects may do better or be worse
- Competition may be stronger or weaker
- Entire sector may be affected
Characteristics of market risk
- Exchange rate and political risk
- Interest rate, inflation, news about economy
What are portfolio weights
Fraction of the total investment in the portfolio in each individual investment
What is portfolio return
Weighted average of returns on the investment in the portfolio
What is expected portfolio return
Weighted average of the expected return
What is the volatility of a two stock portfolio
- Reduction of risk bc of diversification
- Amount of risk eliminated depends on the degree where the stock face common risks and price movement
- Finding the risk involve finding where the stock returns move together
What is the covariance of a portfolio
Expected product of the deviations of two returns from their means
What happens when the covariance is positive
Stocks move together
What happens when the covariance is negative
Stocks move in opposite directions
What is correlation
Standardize measure for covariance
What happens when correlation is less than 1
SD of a portfolio will always be less than the weighted average of the asset SD
What is the minimum variance portfolio
Portfolio composed of risky assets that has the smallest standard devision and the portfolio with least risk
Characteristics of risk reduction
R = 1; no risk
R= 0; Variance may be less than the standard deviation of either component asset
R = >1; Riskless hedge is possible
What must be included in the portfolio of a risky asset
Return and risk
What is the criteria to choose the optimal risky portfolio
Compare portfolios based on their expected returns and sd
What is the mean variance frontier
Taking every possible combination of risky asset and find a portfolio that has the least SD
What is efficient frontier
- Best portfolios have the higher expected return for any sd and its the upper part of the curve
What is the mean variance portfolio
The combination of individual securities that have the lowest variance
Where do the efficient portfolio lie
Above the minimum variance portfolio
What are the characteristics of short sale
- Restrictions of weights = WA + WB = 1
- This allows for negative proportions
- Frontiers extend at both ends indefinitely
What happens when we expand our investment choices to include a risk free asset
Investment opportunity set increases
What yields the CAL
Risky free asset and a risky portfolio
What is the best CAL to achieve
Highest slope with our investment opportunity set which will ultimately intersect the efficient frontier of two risky assets at a tangency point
What does the best CAL involve
A portfolio that contains some allocation between the risk free asset and best risky asset portfolioW
What is the risky asset portfolio called
Optimal risky portfolio
What is the CML
Specific CAL where risk free rate = T-bill and optimal risky portfolio is given broad based index of common stocks known as the Market portfolio
What is the theory behind CML
Steepest of all CALs
What does the Two Fund Separation state
Portfolio choice can be divided into two independent tasks
What are the two independent tasks of the Two Fund Seperation
- Identification of the optimal risky portfolio; demonstrating efficient diversification
- Allocation choice between optimal risky portfolio and risk free rate; demonstrating different allocation for investors with different levels of risk aversion
