Session 18 - Portfolio Concepts

Question 1

Mean-variance analysis

Answer 1

the use of expected returns, variances, and covariances of individual investments to analyze the risk-return tradeoff of combinations (i.e. portfolios) of these assets.

Question 2

Main Assumptions of Mean-Variance Analysis

Answer 2

1. All investors are risk-averse
2. Expected returns, variances, and covariances are known for all assets.
3. Investors create optimal portfolios solely on the parameters of expected return, variances, and covariances.
4. Investors face no taxes or transaction costs

Question 3

Sharpe Ratio

Answer 3

= R(x) - Rf / SD(x)

Question 4

Capital Allocation Line

Answer 4

= Rf + (Sharpe ratio)(SD of portfolio)

*use decimals for the terms in this equation

Question 5

Beta (systematic risk)

Answer 5

= (Correlation between the returns for stock i and the market portfolio)(SD of returns for i / SD of returns for market)

Question 6

Variance of a 2 Asset Portfolio

Answer 6

= (weight of x)²(SD of x)² + (weight of Y)²(SD of Y)² + 2(weight x)(weight Y)(covariance X,Y)

Question 7

Minimum Variance Portfolio

Answer 7

Has the smallest variances among all portfolios with identical expected return.

Question 8

Minimum Variance Frontier

Answer 8

A graph of the expected return/variance combinations for all minimum-variance portfolios

Question 9

The Efficient Frontier

Answer 9

(Markowitz) a plot of the expected return and risk combinations of all efficient portfolios, all of which lie along the upper portion of the minimum-variance frontier.

Question 10

Equally-Weighted Portfolio Risk

Answer 10

= (1/n)(average variance of all assets in the portfolio) + (n – 1)/n

Question 11

Capital Market Line

Answer 11

The capital allocation line in a world in which investors agree on the expected returns, standard deviations, and correlations of all assets. Assuming identical expectations, there will be only one capital allocation line, and it is called the capital market line.

Question 12

Security Market Line

Answer 12

The graph of the CAPM, representing the cross-sectional relationship between an asset’s expected return and its systematic risk. The intercept equals the risk-free rate and the slope equals the market risk premium.

Question 13

The Market Model - Expected Return

Answer 13

R(i) = intercept(i) + [Beta(i)*Market return]

Question 14

The Market Model - Asset Variance

Answer 14

= Beta(i)² x market variance + error variance (e.g. unsystematic risk)

Question 15

The Market Model - Asset Covariance

Answer 15

= (Beta of x)(Beta of y)(market variance)