Portfolio Construction

Question 1

Define gamble

Answer 1

To bet on an uncertain outcome

The assumption of risk for no purpose but the enjoyment of risk

Question 2

Define speculation

Answer 2

The assumption of considerable risk to obtain commensurate gains
Risk is sufficient to affect the decision
Undertaken in spite of risk involved because one perceives a favorable outcome

Question 3

Risk aversion and utility : define the axioms of utility

Answer 3

1. Comparability (compare and make choices)
2. Transitivity (consistency of preferences, eg a preferred to b, b to c, therefore a to c)
3. Non-satiety (individual always prefers more to less
4. Diminishing marginal utility (the more one has the less each unit adds to utility)
5. Certainty equivalence (for every risky choice there is a value (certainty equivalent) that the individual is indifferent between the risky choice and the certainty equivalent)

Question 4

Utility model, can you add together utiles?

Answer 4

Models are specific to individuals and cannot be added together, inter personal utility comparisons are invalid.

Question 5

Draw linear, quadratic and logarithmic utility functions

Answer 5

See paper

Question 6

Define “fair game”

Answer 6

Expected payoff is equal to the cost of the gamble, so expected profit is zero.
Risk averse investor should never accept a fair game

Question 7

Risk premium

Answer 7

Difference between expected payoff and its certainty equivalent, the cost of risk

Question 8

Certainty equivalent

Answer 8

The rate that risk free investments would need to offer to provide the same utility score as the risky portfolio.
The rate that, if earned with certainty, would provide a utility score equivalent to that of the portfolio in question.

Question 9

Risk free asset

Answer 9

Reflects the underlying nature of financial assets (ie return should not be compensation for risk)
Absence of experienced risk (eg variance)
Portfolios of money market instruments are often used as proxies for the risk free asset.

Question 10

Capital market line (3)

Answer 10

1. The strauight line that connects the risk free rate to the optimal risky portfolio
2. If a passive investor combines an index portfolio of securities (representing the market) with a risk free proxy, the resulting Capital Allocation Line (CAL) is the Capital Market Line
3. CAL = CML if we have the best Sharpe Ratio

Question 11

Passive investment

Answer 11

Avoids any direct or indirect security analysis
Usually cheaper than active strategies
Free rider benefit, at any time most assets will be fairly priced given that many active knowledgable investors will bid up cheap assets and sell expensive ones

Question 12

Investment decision

3 steps

Answer 12

1. Capital allocation between the risky portfolio and risk free assets
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each asset class

Question 13

Capital allocation

Answer 13

Capital allocation determines an investors exposure to risk
Optimal capital allocation is determined by risk aversion as well as expectations for the risk return trade off of the ultimate risky portfolio

Question 14

Diversification and risk

Answer 14

Extensive diversification cannot eliminate risk. Standard deviation falls but cannot be zero. The risk left after extensive diversification is Market Risk, Systematic Risk, or Non Diversifiable Risk.

Risk that can be diversified is Unique Risk, Firm Specific Risk, Non Systematic Risk or Diversifiable Risk

Question 15

Expected return

Answer 15

Probabily weighted return in all scenarios

Question 16

Variance

Answer 16

Expected value of squared deviations from the expected return

Question 17

Standard deviation

Answer 17

Measure of expected returns around their mean. Square root of the variance

Question 18

Covariance

Answer 18

How the return on 2 assets moves together

Question 19

Correlation coefficient

Answer 19

Standardized measure of covariance

Question 20

When is the power of diversification to reduce portfolio risk unlimited?

Answer 20

When security returns are uncorrelated.

Question 21

What does irreducible risk of a diversified portfolio depend on

Answer 21

Depends on the covariance of returns of the component securities, which in turn is a function of the importance of the systematic factors in the economy.

Question 22

When holding a diversified portfolio, contribution of a security will depend on what?

Answer 22

Contribution to portfolio risk of a particular security will depend on the COVARIANCE of that security’s return to those of other securities, and NOT THE SECURITY’s VARIANCE

Question 23

Markowitz Portfolio Selection Model

Answer 23

1. Identify the risk return combinations available from a set of risky assets
2. Identify the optimal portfolio of risky assets by finding the portfolio weights that result in the steepest CAL (Capital Allocation Line)
3. Choose an appropriate complete portfolio by mixing the risk free asset with the optimal risky portfolio.

Question 24

What is the minimum variance frontier

Answer 24

Minimum variance frontier is the graph of the lowest possible variance that can be obtained for a given portfolio expected return. Given input data for expected returns, variances and covariances, we can calculate the minimum variance portfolio for an targeted expected return.

Question 25

Diversifying investments leads to ?? Expected returns and ?? Standard deviations

Answer 25

Higher expected returns and lower standard deviations. Refer to minimum variance frontier

Question 26

Optimal risky portfolio is identified by?

Answer 26

The optimal risky portfolio is where the Capital Allocation Line is tangent to the efficient frontier. Te CAL dominates all alternatives.

Question 27

Steps to arrive at complete optimal portfolio (3 steps)

Answer 27

1. Specify the return characteristics of all securities (expected returns, variances and covariances
2. Establish the risky portfolio (calculate the optimal risky portfolio, then calculate the properties of Portfolio P using weights determined earlier)
3. Allocate funds between the risky portfolio and the risk free asset
   a) calculate the fraction of the complete portfolio allocated to portfolio P and to Tbills.
   b) calculate the share of the complete portfolio invested in each asset and in TBills.

Question 28

Fair game

Answer 28

expected payoff is the same as the cost to enter the game.
Expected outcome = sum of probability x wealth
* risk averse investor would never accept a fair game, as it has lower utiles.

Question 29

In the context of certainty equivalent, what is the difference between the expected payoff and the certainty equivalent

Answer 29

risk premium.

Question 30

Using the quadratic utility model, what is the certainty equivalent

Answer 30

In the quadratic utility function, the certainty equivalent is the same as the utility value since it is the certain return which an investor views as having the same utility as a risky return

Question 31

Indifference curves

Answer 31

Return - risk combinations that give equal satisfaction

Question 32

what would a risk averse investor’s indifference curve look like
What does the slope look like if more risk averse?
What does a risk neutral investor’s curve look like

Answer 32

upward sloping.Degree of risk aversion is characterised by the slope of the indifference curve.
If more risk averse, the curve will be steeper
If risk neutral, curve will be horizontal as they do not take risk into account

Question 33

How can the Capital Allocation Line and the Sharpe Ratio assist in investment decision making
(4 points)

Answer 33

1. Diversified fund can be combined with cash to provide the optimal mix
2. “Best” diversified fund can be selected from amongst a range of competing products
3. Best portfolio will have the highest Sharpe Raio and the steepest sloped CAL (this is the fund manager’s objective)
4. CAL also indicates to the fund manager how they might build the optimal portfolio; and deliver a suite of products to meet risk aversion needs of clients

Question 34

Define market risk

Answer 34

Market risk is the way underlying economic fundamentals impact the market place as a whole

Question 35

Why is diversification beneficial

Answer 35

Diversification reduces the risks that relate to the specific operations and structure that make a business unique

Question 36

Minimum variance portfolio

Answer 36

Min variance portfolio has SD smaller than any of the individual component assets

Question 37

Kintzel Policy Brief - Life Cycle investing -
1. describe approach
2, Describe improvements

Answer 37

Approach to Life Cycle Investing:
1. Determin risk-return needs of client
2. Move along the efficient frontier (minimum risk)
3. Age determines the allocation
4. Array of asset classes not just B + E
Could be improved by:
1. Assess appetite for risk
2. Could be influenced by education, circumstances, economic environment