Portfolio Theory Flashcards
What is the analogue to the effiient frontier in standard micro problems?
The efficient frontier is like a technology constraint
What is mean-variance dominates
If return is greater and the variance is the same, or the variance is smaller and the mean are the same. Or if both are better
What is the efficient frontier?
The efficient frontier is the locus of all undominated portfolios in the mean-volatility space
What does perfect positive correlation look like in mean-standard deviation space?
A straight line between the two portfolios
What does perfect negative correlation look like in mean-standard deviation space?
A v-shape. Straight lines between assets and zero-variance portfolios
What is the minimum-variance frontier?
The set of portfolios that minimize variance for a given level of expected return
Why is the efficient frontier the straight line between (0,rf and the tangency portfolio?
Because every portfolio below is dominated by the portfolio on the line. Any portfolio above is infeasible
How do you solve for the minimum-variance frontier?
You minimize variance subject to a fixed level of return and weight summing to 1 (langrange or substitution)
What is the two-find seperation theorem?
All optimal portfolios consists of combinations of the risk-free asset and the tangency portfolio T
What is the shape of the minimum variance frontier?
It is a bullet shape. If std.dev is the x axis it is a hyperbola, if variance is the x axis it is a parabola
What is CAPM?
An equillibrium theory of asset prices. It takes Modern Portfolio Theory and sets demand equal to supply. But it des not model supply and takes it as given. There is no endogenous derivation of asset supply. It assumes supply will equal demand, and hence observed prices are equillibrium prices
What are the assumptions behind the CAPM?
1) Investors have mean variance preferences
2) Investors have a common time horizon and homogenous beliefs
3) Existence of risk-free rate
4) All endowments are traded
What is the Roll’s critique?
All assets are not traded (not human capital). And we cannot observe the market portfolio.
Why must all risky assets belong to T in equilibrium?
If an asset is not in T, then there is no demand for it. But if there is supply for it (e.g. it exists) and there is no demand, then we cannot be in equillibrium
What is the zero-beta capm?
A model similar to CAPM in which there is no risk-free asset.
However a risk-free portfolio can be created. There is a portfolio that has zero covariance with the market portfolio on the minimum variance frontier. This portfolio has zero beta. Can combine these to get zero-beta portfolio.
