Portfolio Theory Flashcards
What is a portfolio?
A collection of securities with different risks and returns associated.
What is the realised return?
A geometric average of past returns.
What are the three characteristics of portfolios?
First: Expected Return
Second: Variance
Third: Covariance
What is the expected return?
Expected return is the best guess for the return that will be achieved the next period.
What are the methodologies we can use to find the expected return?
Distribution of Returns and Sample of Past Returns
What is the formula for the expected return when we use the methodology of distribution of returns?
E(ri) = ∑piri
What is the excel formula we should use to find the expected return (using distribution of returns)?
=sumproduct()
When can we use the mean return to find the expected return?
When observations are independent and identical distributed, the Law of Large Numbers states that the mean return converges in probability to the true expected return,
What is the excel formula we should use to find the expected return (using a sample of past returns)?
=average
What is the variance of the return?
The best guess for the measurement error. It tells us how much should an investor expect to fail prediction. It is the measure of risk.
What are the methodologies we can use to find the variance?
Distribution of Returns and Sample of Past Returns
What is the formula to find the variance using the distribution of returns?
∑ pi [ri - E(ri)]^2
True or false: The variance of the mean return is the true variance.
False
What is the volatitility?
The risk, it’s the standard deviation
In excel, what formula should we use to find the variance?
=var.s()
In excel, what formula should we use to find the standard deviation?
=stdev.s()
What does the covariance measure?
The relationship between two random variables.
What does it mean when a covariance is positive?
On expectation, the returns of the two securities move in the same direction.
What does it mean when a covariance is negative?
On expectation, the returns of the two securities move in opposite directions.
What does it mean when a covariance is zero?
We suspect the securities are independent.
Why do we compute the coefficient of correlation?
Because we can only interpret the sign of the covariance.
What is the interval of values the coefficient of correlation can take?
Between-1 to 1
How do you calculate the coefficient of correlation?
COV/σaσb
What does it mean if the coefficient of correlation is 1?
The two securities move by the same amount in % points in the same direction.