Portfolio Risk and Return Flashcards
Risk and return relationship
1) Greater average returns pair with greater standard deviation
2) Return distributions are negatively skewed with positive excess kurtosis
Liquidity for investments
Can effect price
- Important for emerging markets, low-quality corporate bonds
Investor preference of Risk
- Risk averse
- Risk seeking
- Risk neutral
Investor utility function
Represents preference regarding tradeoff between risk and return - often show as indifference curve
- Risk averse investor has steeper curve than that of others because they need higher returns to compensate for increased risk
Fund separation theorem
All investor’s optimal portfolios will be made of a combo of risky & risk-free assets
Capital allocation line
Line representing possible combinations of risk-free / optimal risky assets
Variance of individual security
σ2 = ∑ (xi – x̄)2/(n – 1)
Common measure of investment risk
Covariance
Measures extent to which two variables move together over time
Cov(X,Y) = Σ(Xi – μ)(Yj – ν) / (n-1)
Correlation
Standardized value of co-movement
Cor(X,Y) = Cov(X, Y) / σXσY
Portfolio SD
Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2
Efficient frontier
If two risky asset returns are perfectly correlated, SD of portfolo is w1σ1 + w2σ2
Usually this is the case where the greatest portfolio risk occurs
Minimum variance portfolios
Portfolios that have minimum risk for given return rate - together they make up the minimum variance frontier
Efficient frontier
Line of portfolios that have greatest return for each level of risk
Global minimum-variance portfolio
Portfolio on efficient frontier that has the least risk
Capital allocation line
Line of possible portfolio risk and return combinations - the best CAL is the one that touches on indifference curve
