TOPIC 4 - CAPITAL ALLOCATION

Question 1

Speculation is:

Answer 1

undertaking of a risky investment for its risk premium.

Question 2

Risk premium has to be large enough to compensate a

Answer 2

risk-averse investor for the risk of the investment.

Question 3

a fair game is a risky prospect that has:

Answer 3

a zero risk premium.

an investment without a higher return for more risk accepted. Thus, an investor may take on higher risk without the possibility of higher return. Risk-averse investors tend to avoid these investments.

Question 4

will a fair game be undertaken by a risk averse investor?

Answer 4

NO

Question 5

investors’ preferences toward the expected return and volatility of a portfolio may be expressed by:

Answer 5

a utility function that’s higher for expected returns and lower for higher portfolio variances.

Question 6

More risk-averse investors will apply

Answer 6

greater penalties for risk.

Question 7

how to describe investors’ preferences for risk graphically?

Answer 7

indifference curves

Question 8

certainty equivalent value of a portfolio summarises what?

Answer 8

the desirability of a a risky portfolio to a risk-averse investor

Question 9

certainty equivalent rate of return is a value that,

Answer 9

if received with certainty would yield the same utility as the risky portfolio

The certainty equivalent is a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future. … The certainty equivalent represents the amount of guaranteed money an investor would accept now instead of taking a risk of getting more money at a future date.

Question 10

shifting funds from the risky portfolio to the risk-free asset is the simplest way to

Answer 10

reduce risk (other methods involve diversification of the risky portfolio and hedging)

Question 11

T-bills provide

Answer 11

a perfectly risk-free asset in nominal terms only

Question 12

why are t-bills considered the rf rate and not bonds?

Answer 12

bc the t-bills have pretty low SD of real returns vs other assets like long-term bonds and common stocks

Question 13

why do we refer to the assets traded in the money market as risk free generally?

Answer 13

bc these are all short term and pretty safe relative to most other risky assets

Question 14

an investor’s risky portfolio can be characterised by its reward to volatility which is:

Answer 14

Sharpe Ratio:

S = [E(rn) - rf] / SDp

Question 15

the Sharpe ratio is the slope of what

Answer 15

the Capital Allocation Line (CAL)

Question 16

what does the CAL show?

Answer 16

when graphed it goes from the rf asset through to the risky asset.

Shows all combos of the risk free asset on this line.

Question 17

ceterus paribus, an investor would prefer what in terms of the CAL:

Answer 17

a steeper sloping CAL bc that means higher expected return for any level of risk.

Question 18

If borrowing rate is greater than the lending rate, CAL then,

Answer 18

the CAL will be ‘kinked’ at the point of the risky asset.

Question 19

investor’s degree of risk aversion characterised by what

Answer 19

slope of his/her indifference curve.
Indifference curve shows at any level of expected return and risk, teh required risk premium for taking on one additional % of SD.

Question 20

more risk-averse investors have what type of indifference curve?

Answer 20

steeper –> they require a greater risk premium for taking on more risk

Question 21

a passive investment strategy disregards what?

Answer 21

security analysis, instead targets the rf asset and a broad portfolio of risky assets like the S&P 500 portfolio.

Question 22

Speculation=

Answer 22

assuming considerable investment risk to obtain commensurate gain

• occurs in spite of the risk involved bc 1 perceives a favourable risk-return trade-off

Question 23

gambling =

Answer 23

to be or wager on an uncertain outcome

risk is assuumed for enjoyment of the risk itself

Question 24

what’s the key dif btw speculation and gambling?

Answer 24

gambler doesn’t have commensurate gain

Question 25

to turn from gambling to speculation, you need

Answer 25

an adequate risk premium to compensate risk-averse investors for the risks they bear.
Risk aversion and speculation are consistent.

Question 26

risk-averse investors consider only:

Answer 26

risk-free or speculative prospects w. +ve risk premiums (reject fair games –> risk premium of 0 or worse)

Question 27

Utility function:

Answer 27

U= E(r) - 1/2A * Variance

A = index of investor’s risk aversion
Variance of returns
1/2 –> the scaling factor

Question 28

for low risk portfolios the higher the level of risk aversion, the

Answer 28

lower the measured utility score

Question 29

the higher the level of risk aversion for any given level ofSD

Answer 29

the lower the overall utility score

Question 30

certainty equivalent rate of return =

Answer 30

rate a risk-free investment would need to offer to provide the same utility as the risky portfolio

(aka the rate that if earned w certainty would provide a utility score = that of the portfolio in Q)

Question 31

a portfolio is only desirable where:

Answer 31

certainty equiv return > rf alternative

Question 32

risk averse investors consider risky portfolios only if

Answer 32

they provide compensation for risk via a risk premium.

A (index of risk aversion) >0

risk in the form of variance reduces utility

Question 33

risk neutral investors find level of risk

Answer 33

irrelevant and only consider expected return of risk prospects

A = 0

judge risk prospects solely by their expected rates of return.

Question 34

risk lovers <3 willing to accept

Answer 34

lower expected returns on prospects with higher amounts of risk

A <0

more variance equates to higher utility (not v conventional)

Question 35

will risk lovers always take a fair game?

Answer 35

YES!!
their upward adjustment of utility for risk gives the fair game a certainty equivalent that exceeds the alternative of the risk-free investment

Question 36

mean-variance criterion

Answer 36

portfolio A dominates portfolio B If:

E(ra) >/ E(Rb)

SDa < SDb

Question 37

Passive strategy avoids

Answer 37

any direct or indirect security analysis

Question 38

Capital Market Line (CML) results when

Answer 38

using the market index as the risky portfolio

Question 39

The capital market line (CML) represents

Answer 39

portfolios that optimally combine risk and return.

Question 40

CML is a special case of the CAL where

Answer 40

the risk portfolio is the market portfolio. Thus, the slope of the CML is the sharpe ratio of the market portfolio.

Question 41

The intercept point of CML and efficient frontier would result

Answer 41

in the most efficient portfolio called the tangency portfolio.

Question 42

An indifference curve shows a combination of

Answer 42

two goods that give a consumer equal satisfaction and utility thereby making the consumer indifferent.

Question 43

Along the indifference curve, the consumer has what sort of preference

Answer 43

an equal preference for the combinations of goods shown—i.e. is indifferent about any combination of goods on the curve.
Typically, indifference curves are shown convex to the origin, and no two indifference curves ever intersect.

Question 44

As income increases, what happens to an individual’s indifference curve ?

Answer 44

an individual will typically shift their consumption level because they can afford more commodities, with the result that they will end up on an indifference curve that is farther from the origin—hence better off.

Question 45

does a less risk averse investor have a shallower or steeper indifference curve?

Answer 45

shallower