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