Topic 3: Capital Allocation & Optimal Risky Portfolios

Question 1

What is the capital allocation choice used to control risk?

Answer 1

• Fraction of the portfolio invested in Treasury bills or other safe money market securities

Question 2

What investment is a risk free asset?

Answer 2

• T-bills (treasury bills)

Question 3

What investments are risky assets?

Answer 3

• consisting of two mutual funds, one invested in stocks and the other invested in long-term bonds

Question 4

What determines C?

Answer 4

• The investors risk aversion

Question 5

Greater levels of risk aversion lead to what?

Answer 5

• Lead to larger proportions of the risk free asset

Question 6

Lower levels of risk aversion lead to what?

Answer 6

• Lead to larger proportions of the risky asset

Question 7

What is a passive strategy?

Answer 7

• A passive strategy avoids any direct or indirect security analysis; it allocates funds between T bills and a fund of common stocks that mimics a broad market index, i.e. S&P 500, due to risk-return features and investor’s risk aversion

Question 8

What are the benefits of a passive strategy?

Answer 8

• Low administrative and transaction costs

- Free-rider benefit, since most assets are fairly priced

Question 9

What are the 2 sources of risk in a portfolio?

Answer 9

• Market risk (systematic risk,
  nondiversifiable risk)
• Unique risk (firm-specific risk, nonsystematic risk, or diversifiable risk)

Question 10

What does portfolio risk depend on?

Answer 10

• Portfolio risk depends on the correlation between the returns of the assets in the portfolio

Question 11

What does the covariance and the correlation coefficient measure?

Answer 11

• provide a measure of the way returns of two assets vary

Question 12

What is Naïve diversification?

Answer 12

• It uses equally

weighted portfolios of several securities

Question 13

What is efficient diversification?

Answer 13

• It constructs risky

portfolios to provide the lowest possible risk for any given level of expected return

Question 14

What happens to risk when the correlation between stocks are smaller?

Answer 14

• The smaller the correlation, the greater the risk reduction potential

Question 15

Are assets with lower or higher correlation prefered? and why?

Answer 15

• Since correlation coefficient doesn’t affect expected return, with other things equal, we always prefer to add assets with lower correlation with our existing position

Question 16

Markowitz Portfolio Theory

What is the first step to find the complete portfolio?

Answer 16

• determine the risk-return opportunities available to investors, which is summarized by minimum-variance frontier. Only the efficient frontier of risky assets (the part that lies above the global minimum-variance portfolio) is useful

Question 17

Markowitz Portfolio Theory

What is the second step to find the complete portfolio?

Answer 17

• draw a CAL starting from risk-free asset and tangent to the efficient frontier. The tangent portfolio P is the optimal risky portfolio with the highest reward-to-variability ratio

Question 18

Markowitz Portfolio Theory

What is the third step to find the complete portfolio?

Answer 18

• we choose the complete portfolio (mix between the optimal risky portfolio–P, and the risk free asset) according to individual investor’s degree of risk aversion

Question 19

What does the separation property tell us?

Answer 19

• tells us that the portfolio choice problem may be separated into two independent tasks

Question 20

What are the two independent tasks formed by separation property?

Answer 20

• Determination of the optimal risky portfolio is purely technical
• Allocation of the complete portfolio to T-bills versus the risky portfolio depends on personal preference