Unit 1: Part 1- Portfolio Theory

Question 1

What are dividends?

Answer 1

arise from simply holding shares when company is profitable

Question 2

What are capital Gains?

Answer 2

price of selling share - initial price of share bought (arise from increase in price of share)

Question 3

What is a monetary return?

Answer 3

Any monetary return is the dividend income plus any change in market value (capital gain/loss)

Question 4

What are asset returns?

Answer 4

Total return/ Initial Investment

Question 5

What is the variance?

Answer 5

Measures risk (volatility) & is the average squared difference/deviations between the actual return and the average return

Question 6

What are non-diversifiable risk?

Answer 6

Non diversifiable risks are risksthat cannot be eliminated by having a large portfolio of many assets. (systematic/market risks). They affect the larger economy rather than just one corporation etc.

Question 7

What are diversifiable risks?

Answer 7

Unsystematic risks (a.k.a. diversifiable) can be effectively eliminated through portfolio diversification. They only affect one corporation or one group etc.

Question 8

How do you choose between 2 investments with same level with return?

Answer 8

Choose one that has the lowest standard deviation as it will be least risky

Question 9

Why do we combine assets/investments in a portfolio?

Answer 9

Combining assets in a portfolio tends to result in a standard deviation of portfolio returns that is less than the weighted average of the risk of the standard deviation of the individual securities in the portfolio (to manage risks). Increasing assets in portfolio reduces risk.

Question 10

What does the extent of risk reduction in a portfolio depend on?

Answer 10

depends on the nature of the inter-dependence of the returns of the securities in the portfolio

Question 11

What does portfolio theory focus on?

Answer 11

Portfolio theory measures the inter-dependence between securities: covariance of security returns & associated correlation coefficient measure

Question 12

What is the covariance of 2 assets?

Answer 12

Covariance of 2 assets is the statistical measure of the tendency of 2 variables that co-vary (move) together. It is defined as the expected product of the deviations from the respective means of the 2 variables.

Question 13

What is the correlation coefficient?

Answer 13

The correlation coefficient is a measure of the linear interdependence of 2 variables. It falls on a scale of minus one to plus one

Question 14

What does it mean if the correlation coefficient is positive or negative?

Answer 14

If the correlation coefficient is positive, both securities move together in the same direction. If it is negative, they move in opposite directions. If coefficient correlation is 0, there is no relationship between the 2 variables

Question 15

What 3 components does the risk of a portfolio depend on?

Answer 15

the standard deviation/variance of the portfolio depends on the weightings, standard deviations and the correlation coefficient of the individual assets in the portfolio

Question 16

What is naiive diversification?

Answer 16

constructs portfolios by the random choice of assets without guidance from formal analysis

Question 17

What is the Markowitz portfolio theory?

Answer 17

Markowitz portfolio theory is the use of formal analysis to identify combinations of shares that minimises risk for a given level of expected return, or maximises expected return for a given level of risk