Module 52.3: The Efficient Frontier

Question 1

What is the formula for portfolio variance?

Answer 1

w1^2 * var1 + w2^2 * var2 + 2w1w2*Cov1,2

or

w1^2 * var1 + w2^2 * var2 + 2w1w2p12o1*o2

or

[w1^2 * var1 + w2^2 * var2 + 2w1w2p12o1*o2] ^(1/2)

w1 = proportion of portfolio invested in asset #1
w2 = proportion of portfolio invested in asset #2

Question 2

What is the formula for portfolio standard deviation of the portfolio was perfectly positively correlated?

Answer 2

it would just be the weighted average of standard deviations.

Question 3

AS correlation between the portfolio assets decreases, what happens to the risk of the portfolio?

Answer 3

the risk of the portfolio falls

Question 4

What is the minimum-variance portfolio?

Answer 4

lowest standard deviation of all portfolios given expected return are known.

Question 5

What is the efficient frontier?

Answer 5

portfolios that have the greatest expected return for each level of risk

Question 6

What is the global minimum-variance portfolio?

Answer 6

the portfolio on the efficient frontier that has the least risk.

Question 7

Why do indifference curves slope up for risk averse investors?

Answer 7

because they will only take on more risk if they are compensated with greater expected returns.

Question 8

What is two fund separation theorem? The capital allocation line?

Answer 8

states all investors’ optimum portfolios will be made up of some combination of an optimal portfolio of risk assets and the risk-free asset.

Capital allocation line - represents possible combinations of risk-free assets and the optimal risky asset portfolio is referred to as the capital allocation line.