Finance Portfolio Risk and Return

Portfolio Risk and Return

• An investor's optimal portfolio is determined by the indifference curve with the highest utility.
• Portfolios on the capital market line are constructed using a combination of the optimal risky portfolio and the risk-free asset.
• A fully diversified portfolio eliminates nonsystematic risk but not systematic risk.
• The security market line shows an asset's expected return based on the asset's systematic risk.
• The market model is used for determining the expected return of a security.

Portfolio Performance Measures

• The Sharpe ratio is a meaningful standalone metric for portfolio performance.
• The Treynor ratio and M-squared are not meaningful standalone metrics.

Capital Asset Pricing Model (CAPM)

• According to the CAPM, all investors are price takers because traders cannot influence the value of an asset.
• The CAPM assumes that investors have homogeneous expectations and are price takers.
• If an analyst determines a stock's expected return by another method and that return is higher than the stock's expected return as determined by the CAPM, then the analyst most likely should sell the stock since it is overvalued.

Calculating Expected Return

• Using the CAPM, if a security's expected return is 20%, its beta is 1.3, and the risk-free rate is 4%, then the market risk premium is closest to 12.3%.
• The market risk premium is the expected return of the market minus the risk-free rate.

Portfolio Risk

• The market portfolio's systematic variance is greater than its nonsystematic variance.
• If an asset has a beta that is equal to the average beta of all assets, then its risk level is equal to market risk.

CAPM Assumptions

• An assumption of CAPM is that investments are infinitely divisible.
• Another assumption of CAPM is that investors are rewarded only for systematic risk.

Portfolio Management

• A portfolio manager should add only funds with Jensen's alpha above −0.5% and an ex post Treynor ratio greater than 3%.
• The manager's most appropriate choice is Fund Y based on the given data.

This quiz assesses understanding of portfolio risk and return, including determining optimal portfolios and constructing portfolios on the capital market line. It covers topics such as investor preferences, risk-free assets, and global market indices.