RWJ 11: Return and Risk: The Capital Asset Pricing Model (CAPM) Flashcards
For a portion of the feasible set, standard deviation actually decreases as we increase expected return (i.e. backward bending). How can increase in the portion of risky security lead to a reduction in the risk of portfolio?
Due to diversification effect. The returns on the two securities are negatively correlated to each other. One security tends to go up when the other goes down. Thus, an addition of a small amount of the other security acts as a hedge to a portfolio composed only of one security.
The portfolio variance formula
(X1SD1)^2+ 2X1X2corrSD1SD2 + (X2*SD2)^2
Formula for weighted average of SD
X1SD1+X2SD2
Compare the two formulas and illustrate the diversification effect.
Suppose, corr =1 , SD of a portfolio return = weighted average. As long as corr <1, it is smaller. The diversification effect applies as long as there is less than perfect correlation.
In general, the standard deviations of most of the individual securities in an index will be above the
standard deviation of the index itself, though a few of the securities could have lower standard deviations than that of the index. True of False?
True.
Opportunity set/feasible set VS efficient set/efficient frontier
feasible set: any point on the curve representing appropriate mix between the two securities
efficient set: from Minimum Variance to top of the curve
Each curve represents a different correlation. The lower the correlation, the more bend in the curve. True or False?
True
How to calculate variance and SD in a portfolio of many assets?
Use the box matrix.
XiXjcov(Ri,Rj)
In total, N terms of variance and N*(N-1) terms of covariance.
Hence, the variance of the return on a portfolio with many securities is more dependent on the covariances between the individual securities than on the variances of the individual securities.
Unsystematic risk are not correlated. True or False?
True
