Portfolios Flashcards
What is a portfolio?
- Consists of a combination of investments in various financial instruments
- Can be composed of a risk-free security and risky portfolio
- Defined by:◦Invested securities
- Portfolio weight: fraction of capital invested in each security
What is a portfolio return?
The return on a portfolio rP during a period is the weighted average of returns on the securities, where weights are fractions of total capital invested in the securities:
What is a Buy-and-hold portfolio?
- Securities purchased, then left to grow in value as market determines.
What is a Rebalanced portfolio ?
- Weights altered through buying/selling securities to return to initially chosen weights
Why would portfolio weights change over time?
- Will change because of fluctuations of realized returns on securities
- To maintain weight, need to periodically rebalance portfolio through buying and selling securities
What is Diversification?
Reduction of risk without a corresponding reduction in the expected return
How can you tell if a portfolio is diversified?
When σ of the portfolio is lower than the weighted average.
how does the number of securities effect the risk?
More stocks, less impact of each stock, leading to risk reduction; however marginal benefit in risk reduction smaller as number of securities increases. In addition, one must consider costs of adding stocks (analysis, trading, management) and if marginal benefit less than costs, not worthwhile.
What is Unsystematic Risk
•Arises from firm and industry sources, e.g.: ◦Failure of a product
◦Death of a CEO
◦Work stoppage by employees
•Can be eliminated by forming portfolios
What is Systematic Risk?
•Arises out of the market or macroeconomic factors, e.g.: ◦Low GDP deflating market
◦Inflation
◦Unemployment
•Remains even after full diversification
What is total risk?
Total Risk
Total risk = systematic risk + unsystematic risk
= market risk + unique risk
= common risk + idiosyncratic risk
= undiversifiable risk + diversifiable risk
What can covariance tell us?
Covariance can tell us whether two variables are moving together or in opposition.
What is Correlation?
•Correlation ρ, pronounced rho, is a standardized measure of co-movement.
- ρ takes a value between −1 and 1.
•The sign of ρ indicates direction of co-movement.
•The magnitude of ρ indicates intensity of co-movement.
What is a portfolio combination line?
- Lines joining a series of points that represent different combinations of weights in portfolio.
- The exact shape of combination line depends on the correlation between the security returns.
- •Portfolio with zero risk (σ) is known as a perfect hedge (possible with ρ=±1).
•Straight line ( ρ=+1) will eventually have σ=0 if short-selling allowed.
Is a Perfect Hedge Possible in Reality?
A perfect hedge is not possible in reality as two stocks can never be perfectly positively correlated.
