Portfolio theory (w3) Flashcards
What is the difference between market risk and firm-specific risk?
Market risk = systematic, non-diversifiable, market wide
Firm specific = diversifiable, non-systematic
How is the portfolio risk calculated?
Portfolio risk = portfolio SD
Portfolio variance = w^2* var(A) + w^2 * var(B) + 2ww*Cov(A,B)
Portfolio SD = sqrt of variance
Cov (A, B) = covariance of the RETURNS
How is the covariance of the returns calculated?
Covariance of the returns = p * SD(A) * SD(B)
where p = correlation coefficient
What do different values of p determine?
If p = 1, stocks have a perfect positive correlation
If p = 0, stocks are not correlated
If p =-1, stocks have a perfect negative correlation
How to determine the weight of each asset in a portfolio if the securities have p = -1?
weight of A = risk of B / summed risk of A & B
weight of A = SD(B) / [ SD(A) + SD(B) ]
How to determine the risk of a portfolio when securities have p = 1
Portfolio risk = w(A) * SD(A) + w(B) * SD(B)
How to determine the risk of a portfolio when securities have p = 1
Portfolio risk = w(A) * SD(A) + w(B) * SD(B)
What is minimum-variance portfolio?
A portfolio where due to diversification, its risk is smaller than that of individual components
Only achievable if correlation is smaller than 0 (or, sometimes possible if p = 0)
How to choose a portfolio from all mean-variance portfolios available?
The portfolios will have CAL passing through them. The aim is to find the portfolio with the steepest CAL = highest Sharpe ratio
–> Higher CAL = higher Sharpe = higher return for the unit of risk
Due to the shape of the opportunity set created by a portfolio of diversible assets, the highest CAL = tagent to the opportunity set
How to find the portfolio with the highest CAL?
Due to the shape of the opportunity set created by a portfolio of diversible assets, the highest CAL = tagent to the opportunity set
We search for max of IOS, therefore, to find the portfolio with the highest sharpe ratio, the investment opportunity set must be differentiated
What is the difference between the optimal risky portfolio and optimal complete portfolio?
Optimal risky portfolio = portfolio on an investment opportunity set, with CAL tangent to it
–> Does not consider for individual preference and risk aversion
Optimal complete portfolio = a combination of an optimal risky portfolio and risk free asset, found along the CAL
–> Tangent to an investor’s indifference curve
What is the difference between efficient frontier and minimum variance frontier?
Efficient frontier = feasable portfolios with the greatest return for a given level of risk
–> above global minimum variance portfolio
Minimum variance frontier = investment opportunity sets achieved through manipulation of weights of various assets
–> inclusive of efficient frontier
The return-risk relationship is not linear
What is the equation for single-factor security model?
ri = E(ri) + B(F) + e
ri = return on security
B = sensitivity
F = surprise in macroeconomic factor
e = firm specific disturbance
E(r) = a: security return when factor (market) excess return = 0
How is risk defined in the single-index model?
Risk = B^2 * variance of the market + variance of the security
Risk = B^2 * var(F) + var(e)
How is covariance of securities calculated under the single index model?
Covariance (A,B) = B(A) * B(B) * var(F)
var(F) = var(m) in CAPM
