Lecture Four Flashcards
What is portfolio
Refers to any collection of financial assets e.g. stocks, bonds, cash
characterized by their mean, variances and covariances of their returns
Who are portfolios usually held by
Individual investors, managed by financial professionals, hedge funds or other financial intributions
What is hedge fund
an investment instrument with pooled funds that is managed to outperform average market returns
How are portfolios characterized by?
potential risk and return
what is there always in risk and return
a trade off
= u will get into an investment that will u pay u a high return if the risk is also high
What do we aim for in terms of risk and return
aim to minimize the risk/maximise the return
what is the portfolio expected return
simply a weighted average of the expected returns on individual assets
What is the equation for the portfolio expected return
the same as normal return:
new-old
———— x100
old
What is usually used to work out where to invest
gets the prices for an assert and u work out the return of the investment to determine where u invest
What essentially is the expected return
The mean
How to work out the expected return using asset 1&asset 2
= weight of asset 1 x mean of asset1 + weight of asset2 x mean of asset2
Are weights always going to be equal
No, not going to invest equally bc ur not going to invest the same for every assets
- Its based on probabilities of observing different values
=weights will be different
What is the variance of portfolio
simply the weighted average of variances and covariances
what is the symbol and name for variance
σ^2 -sigma squared
How to work out the variance
-the variance of the first asset x squared weight + the variance of the second asset x squared asset of the second weight + 2 x the weight x the covariance
What effect does a negative correlation have on the variance portfolio =-1
decreasing the variance of the portfolio (negative = pushing it down)
What effect does a positive correlation have on the variance portfolio =1
increasing the variance of the portfolio (positive= pushing it up)
What if the covariance is between -1 or 1
- not perfectly either side
=u are decreasing the portfolio variance - controlling the risk - combining money into diff assets
-not just investing in one asset = spreading risk
How to work out the standard deviation of the portflio
Square root of the variance
are we sure for what the risk will be for a portfolio
The concept of risk in a portfolio of assets relates to the stylized
fact that the return from a portfolio is not constant over time.
Thus, at each point in time we are not sure about what the return
on a portfolio is going to be.
What is diversification
Process of combining assets in a portfolio to reduce total risk without sacrificing portfolio return
-investing in diff assets to reduce risk
What risks are companies exposed to
-every company has a risk specific to the company
-every company is exposed to the market risk
What risk does the diversification get rid of?
-diversify the risk that is specific to the company
What does a correlation of 1 mean for the variance of the -diversify the risk that is specific to the company portfolio
correlation is 1 = 1 never decrease variance of portfolio
What does a correlation of -1 mean for the variance of the -diversify the risk that is specific to the company portfolio
-correlation is -1 = portfolio variance = 0 , no risk
What if two values are negative
-two values are negative - variance is always lower
Is -1 correlation common
ever find correlation that is exactly -1, bc theres always risk/ always exposed to a certain risk
What happens to correlation when there is a global risk?
-when theres global risk = all move in the same direction
=correlation in bad times, ALWAYS increase SIGNIFICANTLY
-always exposed to losing large amounts of £
some changes of global risk
shifts in exchange rates, new regulations, protectionism, debt crises, and political unrest.
how can diversification affect the variance in the equation
N is the uncorrolated assets:
the variance will turn into 1/N^2 *variance + 1
-the 1/n indicates that the assets are divided and spread across the variance -SPREADING RISK
=e.g. if n = 1000000000, variance will be closer to 0
-ASSUMING variance Is same for ALL assets
What does MVP stand for
Minimum Variance Portfolio
What is the MVP
is a collection of non-correlated, volatile securities that has the lowest possible risk (variance) among all portfolios of risky assets
A portfolio with the lowest risk (variance) among all portfolios of risky assets
What is the objective of the MVP
to find the weights that will render a portfolio with the lowest possible variance
What is used for the MVP
return patterns and correlations
what is the relationship for the portfolio expected returns compared to the portfolio variance
Ex return is a linear combination of two assets and weights
But portfolio variance is not
What is the relationship between variance and expected return for the variance
the lower the variance = the lower the expected return
Where is the MVP
The lowest point -can be the one on the curve
on the curved angle on a risk/return diagram
=guaranteed smallest variance
