week 7

Question 1

How do we calculate the expected return on a two asset portfolio?

Answer 1

R(bar)P = WaRa +WbRb

Where: 
R(bar)p = Expected return on Portfolio 
Ra = Return on Security A 
Rb = Return on Security B 
Wa = Share of Security A in portfolio 
Wb = Share of Security B in portfolio

Question 2

How do you calculate the standard deviation of a two asset portfolio?

Answer 2

σp = Square root of (W2Aσ 2A + w2B σ 2B + 2WaWb COV (RA,RB)

Where: 
σp = Portfolio Standard Deviation 
σA2= Variance of Investment A 
σB2 = Variance of Investment B 
COV(Ra,Rb) = Covariance of A and B

Question 3

How do we calculate the Covariance of A and B?

Answer 3

COV(Ra,Rb) = SIGMA (Ra - R (bar)a) (Rb - R(bar)b)pi

Where:
R(bar)a = Expected Return on A
R(bar)B = Expected Return on B

Question 4

How do we calculate the correlation coefficient?

Answer 4

P a,b = COV (Ra,Rb) / σa σb

Question 5

What is the correlation scale?

Answer 5

Ranges from -1.0 to +1.0.
The closer r is to +1 or -1, the more closely the two variables are related.
If r is close to 0, it means there is no relationship between the variables.

Question 6

What does the degree of risk reduction depend on?

Answer 6

the extent of statistical interdependence between the returns of the different investments

the number of securities over which to spread the risk

Question 7

What is the general rule in portfolio theory?

Answer 7

Portfolio returns are a weighted average of the expected returns on the individual investment . . .

BUT . . .

Portfolio standard deviation is less than the weighted average risk of the individual investments, except for perfectly positively correlated investments.

Question 8

what is the efficient frontier for portfolio analysis

Answer 8

set of optimal portfolio that offer the highest return for a defined level of risk or the lowest risk for a given level of expected return

Question 9

what is the indifference curve for portfolio analysis

Answer 9

describe investor demand for portfolio based on the trade-off between expected return and risk

its convex curve

upward sloping where it will meet the efficient frontier there is a match between supply and demand

Question 10

how are varying degrees of risk displayed in the indifference curve

Answer 10

documents

Question 11

How do you plot the points of a two asset model where both assets are perfectly correlated?

Answer 11

It is only possible to create along a straight line between the 2 assets

Question 12

how do you plot the points of a 2 asset model where both assets are uncorrelated

Answer 12

only possible to create a 2 asset portfolio with risk return along a line between either asset

Question 13

how do you plot points of a 2 asset model when both assets are correlated

Answer 13

only can create a 2 asset portfolio between the 1st 2 curves

diagram

Question 14

how do you plot the points of a 2 asset model where both assets are negatively correlated

Answer 14

possible create a 2 asset portfolio with much lower risk than eitheir asst

Question 15

how do you calculate the correlation coeffcient

Answer 15

cov(Ra,Rb)/(stnd_A*stnd_ B)

Question 16

how do you plot the points of a 2 asset model where both assets are perfectly negative

Answer 16

possible create a 2 asset portfolio with almost no risk

Question 17

what are the three varying degrees of risk aversion represented by indifference curve

Answer 17

moderate risk: this is a 45 degree line

low risk line: below 45 degree’s (becoming horizontal)

high risk: greater htan 45 degree (becoming vertical)

Question 18

why are indifference curve increasing

Answer 18

as risk increases, the investor is expected to be comepsated by a higher return

Question 19

what is the inefficient region

Answer 19

anything to the left of the efficient frontier look at notes, its usually shaded in grey or purple

Question 20

how can you know if there is diversifiable risk

Answer 20

look if it is the portfolio is above the asymtope if it is not then it is a un-diversifiable risk.
there will always be a degree of un-diversifiable risk present.

• so if you add 10-15 shares to your portfolio research show 90% of risk is diversified

Question 21

what would the un-diversifiable risk represent?

Answer 21

changes in tax and interest rate

Question 22

why does diversifiable risk decrease

Answer 22

you own more companies shares, these companies would be affected by random shocks –>lower return for that share. an individual decision would cancel out e.g. a manager making crappy decison.

Question 23

what is the benefit of international diversification?

Answer 23

International shares may provide a lower risk as a percentage of the risk on a single share

business cycles are different from country to country, so a decline in a country wouldn’t be great of a loss to you if you have countries doing well.