Week 2- Portfolio Theory Flashcards
What are the two types of risk?
Systematic risk and unsystematic risk
What is the difference between speculation and gambling
Speculation occurs in spite of risk due to the perception of a favourable risk-return trade off, whereas in gambling risk is assumed for the enjoyment of risk itself. Effectively the central difference is the lack of βcommensurate gainβ
What is the utility function we assume that investors assign to their competing portfolios?
π = πΈ(π) β 1/2π΄π^2
In the utility function: π = πΈ(π) β 1/2π΄π^2, what does everything stand for?
- π = Utility value
- πΈ(π) = Expected return
- π΄ = Index of the investorβs risk aversion
- π2 = Variance of returns
- Β½ = Scaling factor
What are the 3 kinds of investors? How does their A index demonstrate this?
- Risk Averse (A>0)
- Risk Neutral (A=0)
- Risk Loving (A<0)
How do risk averse individuals view risk?
Risk-averse investors consider risky portfolios only if they provide
compensation for risk via a risk premium.
How do risk neutral individuals view risk?
Risk-neutral investors find the level of risk irrelevant and consider
only the expected return of risk prospects.
How do risk loving individuals view risk?
Risk lovers are willing to accept lower expected returns on
prospects with higher amounts of risk.
How do we find the risk-free rate?
Risk-free Rate = Expected Return - Risk Premium
What is the portfolio return?
A simple weighted average of the proportion invested in each stock
What does the risk of a portfolio depend on?
- The risk of the individual stocks in the portfolio; and
- T he correlations between the stocks.
So how do we work out the return of a portfolio, say of in a portfolio with an 80:20 split between stocks A and B, stock A with 5.96% return and stock B with 9.10% return?
portfolioAB= (0.8 Γ 5.96) + (0.2 Γ 9.1) = 6.59%
For a portfolio with 2 Stocks, A and B, what is the covariance of Stocks A and B? How about the covariance between Stocks B and A?
ππ΄B = ππ΄Bππ΄πB
πBπ΄ = πBπ΄πBππ΄
Note that these are identical
Additionally, if there are multiple events with different probabilities, these all need adding up
What is the covariance a product of?
Covariance can be expressed as the product of the correlation coefficient ππ΄B and the two standard deviations π.
What is the purpose of diversification?
Diversification is the process of combining securities in a portfolio with the aim of reducing total risk, but without sacrificing the portfolio return.
What is key for why diversification works?
Diversification works because stock prices do not move in perfectly in phase with one another.
As some stock prices are moving upwardly others are moving in the
opposite direction.
What happens to unsystematic risk as the number of investments in a portfolio increases?
It decreases, this is called portfolio diversification of risk
What is the difference between systematic and unsystematic risk?
Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk tied to the broader market, such as changes in business cycles or govt policy.
What are other names for systematic and unsystematic risk?
Market and Unique risk
What does total risk =?
Total Risk = Systematic (market) Risk + Unsystematic (unique) Risk
What must the correlation coefficient ππ΄B stay between?
-1 < ππ΄B < 1
Can unsystematic risk be diversified away if ππ΄B = +1?
No unsystematic risk can be diversified away in this situation (however this rarely happens)
Can unsystematic risk be diversified away if ππ΄B = -1?
In this situation, all unsystematic risk will be diversified away
Can unsystematic risk be diversified away if ππ΄B = 0?
In this situation there is no correlation between the returns of the 2 securities.
