Modern Portfolio Theory Flashcards
1
Q
Explain Modern Portfolio Theory
A
- Portfolios can be constructed to maximise returns and minimise risks.
- Assumes investors are risk averse.
- a diversified portfolio of imperfectly correlated asset classes can provide high returns with the least amount of volatility.
- To invest in a risky asset, an investor requires a return that is equal to the risk-free return plus a risk premium to compensate for taking on the additional risk of that asset.
2
Q
What is the most common measure of risk?
A
- Standard Deviation
3
Q
Explain how Standard Deviation works
A
- returns expected to fall within 1 std. dev. 68% of the time.
- returns expected to fall within 2 std. dev. 95% of the time.
4
Q
How do you reduce risk?
A
- Hedging
- Diversification of risk
5
Q
Explain Hedging
A
- protecting an existing investment position by taking another position that
will increase in value if the existing position falls in value. - Achieved by using derivatives
6
Q
Explain diversification
A
- holding a range of different types of asset.
- depends on correlation - best with negative correlation
7
Q
Explain the 3 types of correlation
A
- Positive Correlation:
- Move together
- Negative Correlation:
- Move in opposite directions
- No Correlation:
- Not related in any way.
8
Q
Explain the Efficient Frontier
A
- Describes the relationship between risk and return.
- Plots various portfolios and shows best return for given level of risk.
- Inputs are:
- return of each asset
- std. dev of each assets return
- correlation between each pair of assets
9
Q
Limitations of the Efficient Frontier
A
- Assumes std. dev. is correct measure of risk
- Risk isnt the only factor for investors
- Rely on historical data
- No transaction costs included
- Assumes they are index funds
10
Q
What is systematic risk?
A
- Affect markets as a whole
- The risk that markets go up or down as a result of news or events
11
Q
What is non-systematic risk?
A
- Unique to a particular company.
- independent of external factors.
