Portfolio Construction Flashcards
Define gamble
To bet on an uncertain outcome
The assumption of risk for no purpose but the enjoyment of risk
Define speculation
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
Risk aversion and utility : define the axioms of utility
- Comparability (compare and make choices)
- Transitivity (consistency of preferences, eg a preferred to b, b to c, therefore a to c)
- Non-satiety (individual always prefers more to less
- Diminishing marginal utility (the more one has the less each unit adds to utility)
- 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)
Utility model, can you add together utiles?
Models are specific to individuals and cannot be added together, inter personal utility comparisons are invalid.
Draw linear, quadratic and logarithmic utility functions
See paper
Define “fair game”
Expected payoff is equal to the cost of the gamble, so expected profit is zero.
Risk averse investor should never accept a fair game
Risk premium
Difference between expected payoff and its certainty equivalent, the cost of risk
Certainty equivalent
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.
Risk free asset
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.
Capital market line (3)
- The strauight line that connects the risk free rate to the optimal risky portfolio
- 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
- CAL = CML if we have the best Sharpe Ratio
Passive investment
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
Investment decision
3 steps
- Capital allocation between the risky portfolio and risk free assets
- Asset allocation across broad asset classes
- Security selection of individual assets within each asset class
Capital allocation
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
Diversification and risk
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
Expected return
Probabily weighted return in all scenarios
Variance
Expected value of squared deviations from the expected return
Standard deviation
Measure of expected returns around their mean. Square root of the variance
Covariance
How the return on 2 assets moves together
Correlation coefficient
Standardized measure of covariance
When is the power of diversification to reduce portfolio risk unlimited?
When security returns are uncorrelated.
What does irreducible risk of a diversified portfolio depend on
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.
When holding a diversified portfolio, contribution of a security will depend on what?
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
Markowitz Portfolio Selection Model
- Identify the risk return combinations available from a set of risky assets
- Identify the optimal portfolio of risky assets by finding the portfolio weights that result in the steepest CAL (Capital Allocation Line)
- Choose an appropriate complete portfolio by mixing the risk free asset with the optimal risky portfolio.
What is the minimum variance frontier
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.
