Security Selection

Question 1

• The success of a portfolio selection rule depends on the quality of the input list
Problems of Markowitz approach

Answer 1

Three main problems

1. Markowitz tends too overweight stocks with high expected returns and low covariances
2. Number of parameters to estimate grows very fast
3. Portfolios might not ‘make sense’

Question 2

how to fix Markowitz

Answer 2

1. Add constraints (addresses 1 and 3)
   • No more than a certain amount of short-selling, no more than a certain amount in a given stock/industry, no more than a given overall turnover etc. etc.
2. Shrinkage (addresses 1)
   • Of mean
   • Of covariance matrix
3. Index Model Use factor models to obtain expected return(s) and covariance matrix (addresses 1 and 2) The simplification emerges because positive covariances among security
   returns arise from common economic forces that affect the fortunes of most firms
4. Bootstrap(what could have happened)

Question 3

Which of the following is not an assumption of the CAPM?

Answer 3

All investors have the same preference for risk.

Question 4

In a simple CAPM world which of the following statements is/are correct?

Answer 4

I) All investors will choose to hold the market and risk-free investment
II) Investors’ choice of risk-free vs risky investments depends on risk aversion
III) The market portfolio will be the tangency portfolio
IV) Alphas will be the only determinant of the cross section of expected returns(wrong)

Question 5

16. Which statement is false about Expected Returns

Answer 5

a. Expected Returns are higher when expected inflation increases
b. Expected Returns are higher when uncertainty increases
c. Expected Returns are higher for assets that pay off in a more distant future
d. Investors should care about real expected returns rather than nominal expected

Question 6

Which of the following is NOT an assumption of the APT?

Answer 6

a. There are a sufficient number of securities to form well-diversified portfolios.
b. All investors are rational mean-variance optimizers(wrong)
c. There are no persistent arbitrage opportunities
d. Returns can be described by a factor model