Flashcards in Lecture 2 Deck (14)

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1

## What is correlation

### Correlation measures how returns move in relation to each other. It is between +1 (returns always move together) and -1 (returns always move in opposite way)

2

## Skewness

###
Skewness for a normal distribution is zero, and any symmetric data

should have a skewness near zero

• Negative values for the skewness indicate data that are skewed left

• Positive values for the skewness indicate data that are skewed right

3

## Positive and negative Kurtosis

###
- Positive excess kurtosis indicates a "peaked" distribution

- Negative excess kurtosis indicates a "flat" distribution

4

## Leptocurtic Distribution

###
Leptocurtic Distribution - K > 3

A distribution with wide tails and a tall narrow peak is called leptokurtic

Compared with a normal distribution, a larger fraction of the returns are at the

extremes rather than slightly above or below the mean of the distribution

5

## Platykurtic Distribution

### Platykurtic Distribution - K

6

## Which returns are better Leptocurtic or Platykurtic

### Leptocurtic

7

##
Why Leptocurtic Returns?

###
- Low probability of extreme outcomes

- Regulatory process (e.g. managed exchange rate) dampens moderately

deviant returns, forcing them closer to the mean than they would have been

otherwise

8

## Simple diversification

###
- Invest an equal amount in each of N assets

• Portfolio weight 1/N

- Select the assets randomly

- The portfolio is well-diversified if N is reasonably large and fully

diversified if N → ∞

9

## More advanced diversification

###
- Pick assets and determine optimal weights using the variance

covariance structure of the returns

• Exploits the trade-off between risk and return by using a

maximizing criterion – e.g. expected utility maximization

10

##
Why Portfolio variance equals

the average covariance

###
- Gauges the systematic risk

that affects all assets

- Unique risk (individual variances)

diversified away

11

## Diversification

###
Strategy designed to reduce risk by spreading

the portfolio across many investments.

12

## Unique Risk

###
Risk factors affecting only that firm

- Also called “diversifiable risk”

13

## Market Risk

###
Economy-wide sources of risk that affect the

overall stock market

- Also called “systematic risk”

- Reason why stocks have a tendency to move together – common factor affecting all stocks

14