Portfolio Management: Portfolio Risk & Return

Question 1

Capital allocation line

Answer 1

CAL) A graph line that describes the combinations of expected return and standard deviation of return available to an investor from combining the optimal portfolio of risky assets with the risk-free asset.

Question 2

Correlation coefficient

Answer 2

A number between −1 and +1 that measures the consistency or tendency for two investments to act in a similar way. It is used to determine the effect on portfolio risk when two assets are combined.

Question 3

Covariance

Answer 3

A measure of the co-movement (linear association) between two random variables.

Question 4

Efficient market

Answer 4

A market in which asset prices reflect new information quickly and rationally.

Question 5

Global minimum-variance portfolio

Answer 5

The portfolio on the minimum-variance frontier with the smallest variance of return.

Question 6

Holding period return

Answer 6

The return that an investor earns during a specified holding period; a synonym for total return.

Question 7

Indifference curve

Answer 7

A curve representing all the combinations of two goods or attributes such that the consumer is entirely indifferent among them.

Question 8

Internal rate of return

Answer 8

(IRR) The discount rate that makes net present value equal 0; the discount rate that makes the present value of an investment’s costs (outflows) equal to the present value of the investment’s benefits (inflows).

Question 9

Kurtosis

Answer 9

The statistical measure that indicates the combined weight of the tails of a distribution relative to the rest of the distribution.

Question 10

Leverage

Answer 10

In the context of corporate finance, leverage refers to the use of fixed costs within a company’s cost structure. Fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.

Question 11

Liquidity

Answer 11

The ability to purchase or sell an asset quickly and easily at a price close to fair market value. The ability to meet short-term obligations using assets that are the most readily converted into cash.

Question 12

Markowitz efficient frontier

Answer 12

The graph of the set of portfolios offering the maximum expected return for their level of risk (standard deviation of return).

Question 13

Minimum-variance portfolio

Answer 13

The portfolio with the minimum variance for each given level of expected return.

Question 14

Money-weighted return

Answer 14

The internal rate of return on a portfolio, taking account of all cash flows.

Question 15

Normal distribution

Answer 15

A continuous, symmetric probability distribution that is completely described by its mean and its variance.

Question 16

Risk averse

Answer 16

The assumption that an investor will choose the least risky alternative.

Question 17

Risk aversion

Answer 17

The degree of an investor’s inability and unwillingness to take risk.

Question 18

Risk premium

Answer 18

An extra return expected by investors for bearing some specified risk.

Question 19

Risk Tolerance

Answer 19

The amount of risk an investor is willing and able to bear to achieve an investment goal.

Question 20

Skewness

Answer 20

A quantitative measure of skew (lack of symmetry); a synonym of skew.

Question 21

Time-weighted rate of return

Answer 21

The compound rate of growth of one unit of currency invested in a portfolio during a stated measurement period; a measure of investment performance that is not sensitive to the timing and amount of withdrawals or additions to the portfolio.

Question 22

Two-fund separation theorem

Answer 22

The theory that all investors regardless of taste, risk preferences, and initial wealth will hold a combination of two portfolios or funds: a risk-free asset and an optimal portfolio of risky assets.

Question 23

Beta

Answer 23

A measure of the sensitivity of a given investment or portfolio to movements in the overall market.

Question 24

Capital asset pricing model

Answer 24

(CAPM) An equation describing the expected return on any asset (or portfolio) as a linear function of its beta relative to the market portfolio.

Question 25

Capital market line

Answer 25

(CML) The line with an intercept point equal to the risk-free rate that is tangent to the efficient frontier of risky assets; represents the efficient frontier when a risk-free asset is available for investment.

Question 26

Homogeneity of expectations

Answer 26

The assumption that all investors have the same economic expectations and thus have the same expectations of prices, cash flows, and other investment characteristics

Question 27

m2

Answer 27

A measure of what a portfolio would have returned if it had taken on the same total risk as the market index.

Question 28

M2 Alpha

Answer 28

Difference between the risk-adjusted performance of the portfolio and the performance of the benchmark.

Question 29

Market model

Answer 29

A regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index.

Question 30

Multi-factor model

Answer 30

A model that explains a variable in terms of the values of a set of factors.

Question 31

Nonsystematic risk

Answer 31

Unique risk that is local or limited to a particular asset or industry that need not affect assets outside of that asset class.

Question 32

Performance evaluation

Answer 32

The measurement and assessment of the outcomes of investment management decisions.

Question 33

Return-generating model

Answer 33

A model that can provide an estimate of the expected return of a security given certain parameters and estimates of the values of the independent variables in the model.

Question 34

Security characteristic line

Answer 34

A plot of the excess return of a security on the excess return of the market.

Question 35

Security market line

Answer 35

(SML) The graph of the capital asset pricing model.

Question 36

Sharpe ratio

Answer 36

The average return in excess of the risk-free rate divided by the standard deviation of return; a measure of the average excess return earned per unit of standard deviation of return.

Question 37

Short selling

Answer 37

A transaction in which borrowed securities are sold with the intention to repurchase them at a lower price at a later date and return them to the lender.

Question 38

Systematic risk

Answer 38

Risk that affects the entire market or economy; it cannot be avoided and is inherent in the overall market. Systematic risk is also known as non-diversifiable or market risk.

Question 39

Treynor ratio

Answer 39

A measure of risk-adjusted performance that relates a portfolio’s excess returns to the portfolio’s beta.