week 5

Question 1

 Modern Portfolio Theory

Answer 1

o An investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk
o Emphasizing that risk is an inherent part of higher reward

Question 2

 Hedge Fund

Answer 2

o An asset that is uncorrelated or negatively correlated with another asset or portfolio on average is deemed attractive
 Protects against risk
o An alternative investment that is designed to protect investment portfolios from market uncertainty,
 Maximising profits whilst minimizing risk
o Shielding investment from market risk is attempted with alternative investments that try to mitigate loss and preserve capital
o Hedge funds are expensive, and the index’s have outperformed the hedge funds recently

Question 3

 Insurance

Answer 3

o Is gold equivalent to insurance, in terms of a store of value?
o Gold gives a negative value in normal times, but it pays off in a time of crisis
 Perfectly rational
 Same as insurance
o Haven return / investment = Sydney and Melbourne housing market?
 In large cities, Australia unlikely to crash etc

Question 4

 Sharpe Ratio

Answer 4

o Measure of return for a given level of risk
o Higher the value the better
o Rational, risk averse investors aim to maximise the Sharpe ratio of their portfolios

Question 5

 Diversification

Answer 5

o The standard deviation of your portfolio the same, but outcome has less variance
o Less risk
o Sharpe ratio will increase, you want stocks that are not correlated
o E.g. adding Microsoft stock to ford stock will reduce the risk of the portfolio
 Uncorrelated
 Factors affecting these two stocks are different
o Investors should prefer investments who’s returns are expected to co-vary less with their existing portfolio

Question 6

 Diversification continued

Answer 6

o Add assets whose performance is less than perfectly correlated with your portfolio
o The less correlated the performance of assets, the greater reduction in risk
o Can not diversify against the risk that affects everyone
 Systematic risk
o You can diversify away non-systematic risk
o E.g. investing in Australia, a portfolio of assets from all over the world has much lower systematic risk than a portfolio consisting of just Australian assets

Question 7

 Core insight into MPT

Answer 7

o To minimize risk for a given level of return, add assets whose returns are uncorrelated with the return to existing assets in your portfolio
o MPT is a general theory on how to construct a portfolio to minimize risk for a given level of expected return
o Risks that assets share in common (systematic risk) cannot be diversified away
 The greater the variety of assets in your portfolio across different dimensions
• Location, industry sector size
 The lower the portfolio’s systematic risk

Question 8

 Implications of MPT for investor demand for assets

Answer 8

o Total risk of an asset matters the most
o The extent to which the asset reduces your portfolio’s risk
o The relative risk of an asset is determined by how correlated its returns are with the returns of their portfolio

Question 9

 Hedge

Answer 9

o An asset that is uncorrelated or negatively correlated with another asset or portfolio on average

Question 10

 Safe Haven

Answer 10

o an asset that is uncorrelated or negatively correlated with another asset or portfolio in times of market stress or turmoil

Question 11

 Is MPT still relevant?

Answer 11

o Rational, wealth maximising, risk averse investors should care about the covariance of an investment with their existing portfolio
o Challenge is identifying the co-variance and whether the co-variance is stable or changes over the period you are invested
 World is unpredictable

Question 12

 Reports on the deaths of MPT

Answer 12

o MPT was real then the crisis would not have occurred
o Diversification will not hedge your portfolio against factors that affect the whole market
 Can not diversify away from systematic risk

Question 13

 Equity Premium Puzzle

Answer 13

o Real return to shares greater the variance than real return to nominally risk-free assets
o Investors demand greater expected return to hold shares
o Greater risk aversion implies investors demand greater expected return to hold shares
o Problem: the difference in required rate of return seems implausibly high
o Typical equity premium of around 6% in excess of the risk-free rate seems excessive
o Possible causes
 Unanticipated capital gains
 Survivorship bias
• Creates the appearance of abnormal returns in market efficiency studies