Portfolio Theory Flashcards
What are the conviniert properties of normal return distribution?
In the short run it allows investors to limit their decision to only two variables as they aim for high expected return and low standard deviation.
How do different correlation coefficients influence the choice of constructing a portfolio of two assets?
If both stocks move in exact lockstep (p=+1) there are no gains at all from diversification.
If both stocks are perfectly negatively correlated (p=-1) the portfolio would have no risk.
If the correlation coefficient is somewhere in-between, it depends on the investors risk tolerance.
What are efficient portfolios according to Markowitz?
Portfolios that maximize the expected return for a given level of risk.
The graphical representation of the combination of all efficient portfolios is called the “efficient frontier”.
What is the tangency line portfolio?
The best portfolio is the one where the Sharpe Ratio is maximized:
= risk premium / standard deviation
which is also called the tangency line portfolio as it is the the tangent point of a drawn line between risk free interest rate and the efficiency frontier.
Since its unlikely that a singular investor has a monopoly of good ideas in a competitive market, the tangency line portfolio is also called market portfolio.
What is the Tobin Separation Theorem?
Introduces the concepts of borrowing and lending to the market portfolio and adpats the exposure to risk depending on the risk tolerance of the particular investor.
Risk-averse investors should lend some money and invest it in T-bills.
Risk-tolerant investors should borrow money and “over-invest” in the market portfolio to increase expected return (while obvioulsy taking on more risk).
What is the Capital Asset Pricing Model (CAPM)?
The CAPM predicts that in a competitive market the risk premium should increase in proportion to beta (the assets market risk) so that the expected returns of each portfolio should lie on the upward-sloping Security Market Line (SML).
Underperforming assets below the SML would always be sold by rational investors since they can always obtain an expected risk premium of B(rm-rf) by holding a mixture of the market portfolio and a risk-free loan.
What are some criticisms and limitations of the CAPM?
Criticsim
- While high-beta stocks perform better than low-beta stocks, the difference is historically not as great as CAPM predicts (weakened relationship)
- There are other firm specific risks which are not captured by beta (e.g. fear of bankruptcy)
Limitations based on not so accurate assumptions
- Borrowing rates are actually higher than lending rates rather than equal
- Information is not free as the model suggests
- Investors are not only concerned with the future as they should but also take into account the price at which they purchased the stocks (e.g. feel depressed when it is in the red)
What is the Arbitrage Pricing Theory (APT)?
Assumes that each stock’s return depends partly on “macroeconomic influences” (cannot be eliminated by diversification) and “noise” unique to the company (can be eliminated by diversification) as they have a different sensitivity (“factor loading”) with respect to these factors.
