Risk, diversification, portfolio

Question 1

Consider APT model
What does alpha represent given APT assumptions?

Answer 1

Alpha is the expected return on asset i. It is a constant.

Question 2

Given the APT Model, what does f1 and f2 express?

Answer 2

f1 and f2 represent unexpected changes in identified market risk.

In APT model, the terms f1 and f2 refer to unexpected changes or shocks in specific market risks. These factors could be anything from changes in inflation to shifts in interest rates or GDP growth.

Question 3

Systematic risk (market risk)

Answer 3

Risk that affects all assets in the market (e.g., economic changes, interest rates). This cannot be diversified away.

Question 4

Unsystematic risk (DIVERSIBLE)

Answer 4

Risk that is specific to a single asset or firm (e.g., a company’s bankruptcy).

This risk can be reduced through diversification.

Question 5

Efficient Portfolios

Answer 5

An efficient portfolio provides the highest expected return for a given level of risk.

The portfolio’s risk (standard deviation) is minimized for its expected return.

Question 6

Efficient Market Hypothesis (EMH)

Answer 6

In an efficient market, all available information is already reflected in stock prices. Investors can only earn returns that correspond to the amount of risk they take on—no excess returns from arbitrage.