Portfolio Theory Part 2

Question 1

Weight decline

Answer 1

as an assets weight decreases it implies you buy more of a high return asset

Question 2

Impact of Covariance

Answer 2

because there are more covariance terms (n(n-1)) in an equation, covariance is the biggest impact of E[return]

can build a low risk portfolio with risky assets IF covariances are low

This is the Markovitz concept

Question 3

Portfolio Building Concept

Answer 3

Not the best individual asset its how the assets all function together as a “team”

Minimize risk while maximizing return upside

Question 4

Diversification

Answer 4

Diversifying over several securities reduces portfolio variability because as some do well others may do better

Diversify with more unrelated stocks, think of how standard deviation responds to an increase in n

Question 5

Sharpe Ratio

Answer 5

Point of tangency between risk free asset and capital market line, that maximizes portfolio return and reduces risk

Question 6

Risk free asset

Answer 6

treasury securities held in combination with market portfolio

Question 7

Capital market line positioning

Answer 7

if an asset is above everyone would rush to buy it pushing UP PRICE & DOWN RETURNS

Question 8

Beta

Answer 8

quantification of market covariance / systematic risk

extent to which an asset moves with the market

high beta implies high covariance

Question 9

Unsystematic Risk

Answer 9

variability in stock price / stock return from particular factors in an industry

Can be diversified away

Also called idiosyncratic risk

Question 10

CAPM

Answer 10

Capital asset pricing model (equation)

Returns and risk premiums for any stock portfolio will be related to B

Implies high beta stocks are better in up years

Question 11

CAPM Line

Answer 11

x-axis: SD
y-axis return

contains risk free asset and portfolio