Portfolio Theory Flashcards
What are the two general approaches to the construction and management of a portfolio?
Top-down
Bottom-up
Typically, what does a portfolio do in terms of portfolio construction and management?
Use a blend of the elements from both the top-down and bottom-up methods
What is the top-down approach?
A manager looks at the major macrodrivers of asset returns (hence this approach is also referred to as a macro approach) and obtains a view (forecast) about these drivers in the form of a macroeconomic forecast.
What is the biggest determinant of portfolio management?
Expected interets rates
The greater the capital mobility, the…
…the less control there is over interest rates
What are some of the macro variables considered when obtaining a macroeconomic forecast?
Monetary policy, fiscal policy, tax policy, political developments, regulatory matters, exchange-rate movements, trade policy, demographic trends, and credit market conditions.
What is the bottom-up approach to portfolio construction and management?
Focuses on the micro analysis of individual asset issues, sectors, and specific industries. The primary research tools used in this form of investing is credit analysis, industry analysis, and relative value analysis.
How can portfolios be classified?
Active or passive
What is a passive portfolio?
Follows an index or market index such as the FTSE100 index in the UK
What is an active portfolio?
Is one that has a management team selecting assets which they think will outperform the market.
What type of portfolio tends to be more expensive and why is this?
Passive portfolios tend to be less expensive, as active portfolios tend to charge fairly high management fees.
What can portfolios be further subdivided into?
Ethical, green, emerging markets and a variety of other types of portfolio.
What is the most popular portfolio at the moment?
Ethical portfolios (ESG)
What is greenwashing?
Companies make themselves look more green than they are
How can the average return on three portfolios be calculated?
Calculate the mean
What can a two asset portfolio return be written as?
rp= w1r1 + w2r2
What measures the risk of a portfolio?
The variance
What is the formula for portfolio variance?
Look at slides
What will reducing the covariance do to risk?
Reduce the variance, therefore decrease the risk
What can variance be seen as ?
The standard deviation
How do you calculate the correlation between the return on two assets?
Look at slides
What can the risk of a two asset portfolio be written as?
Look at slides
When is there no benefit from diversification?
If the standard deviation is just the weighted average of the individual standard deviations.
What does perfect positive correlation mean for diversification?
There are no gains from diversification
What does perfect positive correlation not decrease?
The risk of the portfolio
When are the gains from portfolio diversification at a maximum?
When there is perfect negative correlation between assets in the portfolio
What is often the problem with a perfect negative correlation between two assets?
Hedged away all risk but decreased chances of a good rate of return
What does zero correlation do for portfolio diversification?
There are gains from portfolio diversification with zero correlation, but not as large as with perfect negative correlation.
How do you calculate the weighting of two risky assets in a minimum variance portfolio?
Look at slides
What does the minimum variance portfolio calculation tend to result in?
What can be questioned about this outcome?
Tend to end up with a large portion of one and a small of the other.
Is that really diversification?
What risks cannot be eliminated via diversification?
Systematic/market risk
What risk can diversification eliminate?
Unsystematic/firm-specific risk
Explain graphically what happens as the number of securities increases in terms of risk.
As the number of securities increase in a portfolio, unique risk falls and converges on market risk
What is the shape of the curve for portfolio risk against the number of securities?
Concave up, decreasing
Look at diagram on slides for the different expected returns and standard deviations
What are efficient portfolios?
Portfolios that maximize the expected return from an investment subject to a given level of risk
From among efficient portfolios, the one which risk averse investors prefer is called..
.. an optimal portfolio
What is the efficiency frontier?
This is the mean-standard deviation frontier, representing different weights of assets 1 and 2., where the correlation coefficient is zero.
What is the relevant part of the efficiency frontier?
Above the minimum variance portfolio, as it offers a return with a lower risk than the portfolios below.
Why is sometimes part of the line not apart of the efficiency frontier?
Because at the same risk they can get a higher return
What are the criticisms of portfolio theory?
- Behavioural finance
Where is the optimal portfolio with a risk-free portfolio?
The tangency point of the efficiency frontier with the capital market line
What can an efficient portfolio also be called?
Markowitz efficient portfolio
