Optimal diversification

Question 1

What is market risk?

Answer 1

Market risk results from the marketwide risk sources, and remains even after diversification

Question 2

What type of risks can be eliminated by diversification?

Answer 2

Firm specific or diversifiable risk can be eliminated by diversification

Question 3

What is firm specific risk?

Answer 3

Firm-specific risk is risk that is a result of specific shocks and events to do with a certain stock in the portfolio, such as a problem with production. Firm-specific risk is easily eliminated by diversification.

Question 4

What is systematic risk?

Answer 4

Systematic risk is market risk that affects all stocks, and cannot be eliminated by diversification. It is the “minimum” level of risk a portfolio faces.

Question 5

When correlation coefficient p=1, what is the standard deviation?

Answer 5

When p=1, the standard deviation is the weighted average of the component standard deviations.

Question 6

When correlation coefficient p < 1, standard deviation is … … the … …

Answer 6

When p<1, standard deviation is less than the weighted average

Question 7

What is a perfectly hedged position, and what is the p condition?

Answer 7

A perfectly hedged position is one in which variance is reduced to zero due to the perfect negative correlation between the 2 stocks in the portfolio, noted by p=-1

Question 8

What makes a portfolio inefficient?

Answer 8

A portfolio is inefficient when it possible to find another portfolio that is better in terms of both expected return and volatility.

Question 9

What are the general names for portfolios above and below the inflection point of the portfolio opportunity set?

Answer 9

All portfolios above the inflection point of the portfolio opportunity set are efficient portfolios, and those below it are inefficient.

Question 10

The portfolio on the inflection point of the portfolio opportunity set is called the minimum … …

Answer 10

The portfolio on the inflection point of the portfolio opportunity set is called the minimum variance portfolio.

Question 11

We refer to a positive position in a security as a … position

Answer 11

We refer to a positive position in a security as a long position

Question 12

In what scenario is short selling profitable?

Answer 12

Short selling is profitable when the share price of a stock falls over time.

Question 13

On what frontier are the best risk-return combinations?

Answer 13

The best risk-return combinations are on the efficient frontier

Question 14

What are all portfolios dominated by?

Answer 14

All portfolios are dominated by portfolios on the efficient frontier

Question 15

Why can’t we obtain portfolios to the left of the minimum efficient frontier?

Answer 15

We cannot obtain portfolios to the left of the minimum efficient frontier because they are simply unattainable.

Question 16

What is our optimal CAL condition?

Answer 16

Our optimal CAL condition is the CAL with the highest Sharpe ratio, and therefore the steepest slope.

Question 17

What is the expected return formula for the complete portfolio?

Answer 17

The expected return formula for the complete portfolio is wrf + wrp

Question 18

What is the optimal condition regarding the CAL and efficient frontier?

Answer 18

The condition for optimality is the point where the minimum efficient frontier is tangent to the CAL.

Question 19

We choose the optimal portfolio that maximises the … ratio given the …

Answer 19

We choose the optimal portfolio that maximises the Sharpe ratio given the constraints

Question 20

What is the main constraint of portfolio construction?

Answer 20

The main constraint of portfolio construction is that weights must sum to 1.