Portfolio Theory Flashcards
what are the two ,Ian categories of investment assets?
Real assets and financial assets.
What are conventional investments?
Traditional assets like stocks, bonds, and cash.
What are alternative investments?
Non-traditional assets like private equity, hedge funds, real estate, and commodities.
What two factors do we use to form investment expectations?
Rates of return and risk.
How does investor preference influence investment decisions?
It determines the allocation between risky and risk-free assets.
What additional factor must be considered when investing in multiple risky assets?
The dependence (correlation) among individual risky assets.
What is the basic formula for a single-period rate of return?
(P_1 - P_0 + D) / P_0, where P_0 is the initial price, P_1 is the ending price, and D is dividends.
Why do we use expected return rather than actual return?
Because future returns are uncertain, so we consider multiple scenarios.
What does variance measure in investing?
The dispersion of returns around the expected return.
How is standard deviation related to variance?
Standard deviation is the square root of variance, representing risk in the same units as return.
Why do we estimate means and variances from historical data?
Because true means and variances are unobservable in advance.
What is the definition of risk premium?
The extra return required to hold a risky asset instead of a risk-free one.
How is risk premium calculated?
RP = E(R) - R_f , where E(R) is the expected return of the risky asset, and R_f is the risk-free rate.
Why must the risk premium be positive?
Because investors require compensation for taking on additional risk.
What does the Sharpe Ratio measure?
The trade-off between return and risk, calculated as:
SR = Risk Premium / Standard Deviation
Why is the Sharpe Ratio widely used?
It evaluates investment performance by adjusting for risk.
What is a key limitation of the Sharpe Ratio?
t assumes investment decisions are based only on expected return and standard deviation, ignoring skewness and kurtosis.
What happens if excess returns are not normally distributed?
Standard deviation is no longer a complete measure of risk.
What is skewness in return distributions?
A measure of asymmetry—negative skew means more extreme negative returns.
What is kurtosis in return distributions?
A measure of extreme values—positive kurtosis means a higher likelihood of large deviations.
How did stock returns behave in the second half of the 20th century?
They had the highest average returns.
How are firm capitalizations distributed?
They are highly skewed, with many small firms and a few large firms.
How do small-cap stocks compare to large-cap stocks in terms of returns?
Historically, small stocks have had higher average realized returns.
