Ch. 7

Question 1

What is a financial asset?

Answer 1

Legal claim to a future cash flow

Question 2

What is the pricing rule of financial assets?

Answer 2

Price should be determined by present value of the asset’s expected cash flow, which can be MORE or LESS certain

Question 3

What is the expected rate of return?

Answer 3

The forecast RofR from holding a security, expressed as %/yr

Question 4

What is the variance of the RofR?

Answer 4

Sum of weighted deviations from the expected return

Question 5

Define risk (on a security)?

Answer 5

Danger that the RofR on a security will be LESS than the investor expects when purchasing that security

Question 6

2 measures of association?

Answer 6

1) covariance

2) Correlation coefficent

Question 7

Define covariance ITO FMs?

Answer 7

Measures the extent to which 2 shares move up/down together

Question 8

What does it mean if the covariance between two shares, σ(AB) is:

a) Greater than zero?
b) Less than zero?

Answer 8

a) returns on A and B move in same direction

b) “” opposite direction (finish)

Question 9

What is specific risk?

Answer 9

Risk that is specific to a particular security (eg. a share)

Question 10

What is systematic risk?

Answer 10

Risk inherent in market fluctuations that cannot be diversified away

Question 11

What is naive diversification?

Answer 11

A strategy whereby an investor simply invests in a number of different assets in the hope that the variance of the expected return on the portfolio is lowered.

Question 12

What is efficient diversification?

Answer 12

Investing in a variety of securities and assets taking into account variance and covariance to achieve optimal risk-return portfolios

Question 13

When are gains to be made from portfolio diversification:

a) non-existent
b) at their maximum?

Answer 13

a) when there is perfect positive correlation between two stocks
b) when there is perfect negative correlation between two stocks

Question 14

What is an efficiency frontier?

Answer 14

A curve depicting risk-return portfolios where increased return is only possible by increasing risk

(a risk averse investor will want to select the weighted combination of shares that minimises risk for a given return!)

Question 15

What is the minimum variance portfolio?

Answer 15

A portfolio which minimises the risk of a combination of risky assets

Question 16

Draw the diagram showing the relationship between return and risk at different levels of correlation within the portfolio? Show the portfolio efficiency frontier on the diagram, and explain how it is decided where on this frontier an investor will be?

Answer 16

see notes P2S2

The optimal point on the PEF is where it is tangent to the indifference curve

Question 17

Draw systematic/unsystematic risk diagram?

Answer 17

Now P2S2

Question 18

What type of risk can diversification reduce?

Answer 18

Unsystematic risk only

Question 19

Explain what happens if you add ‘Tobin’s Risk Free Security’ to the Portfolio Diversification Framework? (considering 2 securities) Draw the diagram to show this.

Answer 19

Have a Risk-free security, return R, and a risky security x, return E(Rx). The risk-free security has 0 standard deviation and earns a certain return R. Since there is no correlation between a constant and a non-constant, the standard deviation (ie.) risk of the portfolio is equal to w(x).σ(x), and is therefore there is a linear relationship between the portfolio risk and the expected return on the portfolio, which gives the capital market line.

Question 20

What is the capital market line?

Answer 20

Straight line showing the linear relationship between the expected return on a portfolio and the risk of the portfolio, when the portfolio contains one riskless asset (eg. government bonds) and one risky asset:

E(Rp) = (1-w)R* + wE(Rx)

Question 21

What is the lesson from the capital market line? What 2 strong assumptions are made in this analysis?

Answer 21

Lesson: When there is a riskless asset there is a linear tradeoff between risk and return

Relies on the assumptions that:

1) the investor can borrow and lend at the risk-free rate
2) there are such things as ‘risk-free’ assets (arguably no asset is entirely risk free!)

Question 22

What is a market portfolio?

Answer 22

A portfolio made up of all the assets in the economy, with their weights equal to their relative market values

Question 23

Explain why the efficiency frontier is not the convex part of the line?

Answer 23

Because here curve goes back on itself tf lowering return and increasing risk - this is not what any investor would want!

Question 24

Explain, using a diagram, how the presence of a riskless security can increase the opportunities of an investor? How can his opportunities increase even further from this point?

Answer 24

See diagram
By holding a combination of the regular portfolio of risky assets and the riskless asset, the investor can attain any point ‘q’ on the diagram.

Furthermore, if they can borrow at the risk-free rate R* they can attain any point ‘q*’ on the diagram

Question 25

Why are the indifference curve in the portfolio analysis upward sloping?

Answer 25

Because investors are assumed to be risk-averse! (see diagram P3S1) (and bit below)

Question 26

Note:

Answer 26

To invest in line with the market portfolio, one must invest in each asset in the economy in line with its value weighting in the market portfolio

Question 27

What is the market price of risk given by?

Answer 27

The market price of risk is given by the slope of the capital market line (see numerical example slide 35)

Question 28

Explain the main limitations of portfolio theory? (3)

Answer 28

1) Difficult to apply when have many assets (N^2-N)/2 number of covariances to calculate
2) Difficult to measure indifference curves accurately
3) Relies on historic data on returns, standard deviations etc. to infer decisions on FUTURE investment (in reality many changes in the market and economy may change what actually happens, tf past not necessarily good predictor of the future!)