S1 - portfolio theory

Question 1

what are realised returns

Answer 1

realised returns - based on actual prices that have been observed, so we are looking back in time
Average annual return
Arithmetic mean

Question 2

what are expected returns

Answer 2

based on expectations regarding future prices, so we are looking forward in time
Weighted average of the possible returns, where weights correspond to probabilities
E[R] = sum P x R

Question 3

what is risk and how is it measured

Answer 3

likelihood of loss
Symmetric measure of dispersion is variance or standard deviation
Variance measures spread
Variance = sum P (R - (sumR))^2
SQRoot Variance = SD

Question 4

what is firm specific risk

Answer 4

affects only that firm and its close competitors
Idiosyncratic risk
Unique risk
Unsystematic risk
Diversifiable risk

Question 5

what is systematic risk

Answer 5

due to market wide effects
Common risk
Non diversifiable risk
Market risk

Question 6

how to manage risk

Answer 6

Diversification
Strategy designed to reduce risk by spreading the portfolio across many investments

Question 7

what is the expected return on a portfolio

Answer 7

(x1,R1) + (x2,R2) = fraction of portion in asset, rate of return

Question 8

what is covariance and correlation coefficient in portfolio risk

Answer 8

Covariance
relationship between returns of more than one asset
Correlation coefficient
standardised form of the covariance
Use standard deviations

Question 9

what are the values of P in correlation coefficient

Answer 9

1 = perfect positive correlation
0 = no correlation
-1 - perfect negative

Question 10

what are outcomes of expected return on the portfolio

Answer 10

Portfolio risk depends on the covariance of the returns
As correlation decreases, volatility of the portfolio falls
Maximum benefit from forming a portfolio occurs when p = -1

Question 11

what is individual risk in portfolios

Answer 11

diversification leads to a reduction in risk if the securities are not perfectly positively correlated
Individual risk is not important - leading to the central idea of portfolio theory
Extent of risk reduction depends upon the correlation between the securities

Question 12

what is the Markowitz portfolio theory

Answer 12

goal is maximise return for any level of risk
Risk can be reduced by creating a diversified portfolio of unrelated securities
Graphical representation of all the possible mixtures of risk assets for an optimal level of return
Mean variance efficient portfolio - set of all risky portfolios having minimum risk for a given level of expected return
Select portfolio from efficiency frontier

Question 13

what is the capital market line

Answer 13

shows the trade off between risk and return for a portfolio of the risk free and the market portfolio in the capital asset pricing model

Question 14

what is the tangency portfolio

Answer 14

tangency point is the optimal portfolio of risky assets, known as the market portfolio
optimal portfolio consists of a risk free asset and an optimal risky asset portfolio
Optimal risky asset portfolio is M at the point where the CML is tangent to the efficient frontier
Optimal = slope of the CML is the highest which means we achieve the highest returns per unit of risk

Question 15

what is the Sharpe ratio

Answer 15

CMLs slope is that of the Sharpe ratio, indicating the best expected return per unit of risk
Will be superior to any portfolio on the efficient frontier
= risk premium / standard deviation
Point of tangency represents a portfolio of 100% of the risky asset

Question 16

what is separation theorem

Answer 16

each investor should put money into two benchmark investments
Risk free asset (borrowing or lending)
Portfolio M
The exact combination will depend upon the preferences for risk