Topic 3: Capital Allocation & Optimal Risky Portfolios Flashcards Preview

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Flashcards in Topic 3: Capital Allocation & Optimal Risky Portfolios Deck (20)
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1

What is the capital allocation choice used to control risk?

- Fraction of the portfolio invested in Treasury bills or other safe money market securities

2

What investment is a risk free asset?

- T-bills (treasury bills)

3

What investments are risky assets?

- consisting of two mutual funds, one invested in stocks and the other invested in long-term bonds

4

What determines C?

- The investors risk aversion

5

Greater levels of risk aversion lead to what?

- Lead to larger proportions of the risk free asset

6

Lower levels of risk aversion lead to what?

- Lead to larger proportions of the risky asset

7

What is a passive strategy?

- A passive strategy avoids any direct or indirect security analysis; it allocates funds between T bills and a fund of common stocks that mimics a broad market index, i.e. S&P 500, due to risk-return features and investor’s risk aversion

8

What are the benefits of a passive strategy?

- Low administrative and transaction costs

- Free-rider benefit, since most assets are fairly priced

9

What are the 2 sources of risk in a portfolio?

- Market risk (systematic risk,
nondiversifiable risk)

- Unique risk (firm-specific risk, nonsystematic risk, or diversifiable risk)

10

What does portfolio risk depend on?

- Portfolio risk depends on the correlation between the returns of the assets in the portfolio

11

What does the covariance and the correlation coefficient measure?

- provide a measure of the way returns of two assets vary

12

What is Naïve diversification?

- It uses equally
weighted portfolios of several securities

13

What is efficient diversification?

- It constructs risky
portfolios to provide the lowest possible risk for any given level of expected return

14

What happens to risk when the correlation between stocks are smaller?

- The smaller the correlation, the greater the risk reduction potential

15

Are assets with lower or higher correlation prefered? and why?

- Since correlation coefficient doesn’t affect expected return, with other things equal, we always prefer to add assets with lower correlation with our existing position

16

Markowitz Portfolio Theory
What is the first step to find the complete portfolio?

- determine the risk-return opportunities available to investors, which is summarized by minimum-variance frontier. Only the efficient frontier of risky assets (the part that lies above the global minimum-variance portfolio) is useful

17

Markowitz Portfolio Theory
What is the second step to find the complete portfolio?

- draw a CAL starting from risk-free asset and tangent to the efficient frontier. The tangent portfolio P is the optimal risky portfolio with the highest reward-to-variability ratio

18

Markowitz Portfolio Theory
What is the third step to find the complete portfolio?

- we choose the complete portfolio (mix between the optimal risky portfolio--P, and the risk free asset) according to individual investor’s degree of risk aversion

19

What does the separation property tell us?

- tells us that the portfolio choice problem may be separated into two independent tasks

20

What are the two independent tasks formed by separation property?

- Determination of the optimal risky portfolio is purely technical

- Allocation of the complete portfolio to T-bills versus the risky portfolio depends on personal preference