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Questions and Answers
What is the main reason for holding a diversified portfolio?
What is the main reason for holding a diversified portfolio?
What is the expected return (ERp) for a portfolio consisting of 50% in A and 50% in B with ERs of 10.5% and 12.9% respectively?
What is the expected return (ERp) for a portfolio consisting of 50% in A and 50% in B with ERs of 10.5% and 12.9% respectively?
Which factor does NOT affect the risk associated with holding a portfolio?
Which factor does NOT affect the risk associated with holding a portfolio?
How is the covariance between the returns of two assets A and B calculated?
How is the covariance between the returns of two assets A and B calculated?
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What is the effect of negative correlation between the returns of two investments on portfolio risk?
What is the effect of negative correlation between the returns of two investments on portfolio risk?
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What does the Efficient Frontier represent?
What does the Efficient Frontier represent?
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In a portfolio with a standard deviation of 14% for A and 4.32% for B, how does the variance of these assets affect the overall portfolio risk?
In a portfolio with a standard deviation of 14% for A and 4.32% for B, how does the variance of these assets affect the overall portfolio risk?
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Which of the following effectively describes portfolio diversification strategy?
Which of the following effectively describes portfolio diversification strategy?
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What is indicated by the Efficient Frontier in portfolio theory?
What is indicated by the Efficient Frontier in portfolio theory?
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Which of the following statements accurately describes the market portfolio (M)?
Which of the following statements accurately describes the market portfolio (M)?
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What defines the Capital Market Line (CML)?
What defines the Capital Market Line (CML)?
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Which assumption is NOT necessary for the investors described in the Capital Market Line model?
Which assumption is NOT necessary for the investors described in the Capital Market Line model?
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What is the primary reason for the presence of a risk-free investment outside of the Efficient Frontier?
What is the primary reason for the presence of a risk-free investment outside of the Efficient Frontier?
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What aspect does portfolio theory primarily focus on?
What aspect does portfolio theory primarily focus on?
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Which of the following limitations is associated with portfolio theory?
Which of the following limitations is associated with portfolio theory?
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To achieve the best risk-return combination, an investor should ideally invest in which portfolio?
To achieve the best risk-return combination, an investor should ideally invest in which portfolio?
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What does a higher Coefficient of Variation (CV) indicate about an investment?
What does a higher Coefficient of Variation (CV) indicate about an investment?
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Which formula accurately represents how to calculate the Coefficient of Variation (CV)?
Which formula accurately represents how to calculate the Coefficient of Variation (CV)?
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How is the expected rate of return for Stock B calculated?
How is the expected rate of return for Stock B calculated?
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Given the standard deviation of Stock A is 14 and Stock B is 4.32, what does this imply?
Given the standard deviation of Stock A is 14 and Stock B is 4.32, what does this imply?
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Which statement about investment risk is correct according to the provided data?
Which statement about investment risk is correct according to the provided data?
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What is the purpose of portfolio diversification for investors?
What is the purpose of portfolio diversification for investors?
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What does a standard deviation of 4.32 for Stock B suggest about its performance?
What does a standard deviation of 4.32 for Stock B suggest about its performance?
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If an investor is comparing investments based on the Coefficient of Variation, what characteristic are they focusing on?
If an investor is comparing investments based on the Coefficient of Variation, what characteristic are they focusing on?
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Study Notes
Portfolio Holding and Risk Reduction
- Holding a portfolio of investments diversifies risk and reduces exposure to risk.
- To determine the risk of a portfolio, understand the expected return and the correlation or covariance of returns among securities.
Portfolio Expected Return
- The formula for calculating portfolio expected return is: ERp = WA x ERA + WB x ERB where ERp is the portfolio expected return, WA is the weight of asset A, ERA is the expected return of asset A, WB is the weight of asset B, and ERB is the expected return of asset B.
Measuring Portfolio Risk
- Portfolio risk is influenced by the correlation or covariance of investment returns.
- Covariance (COV) measures the relationship between returns of different assets.
- A positive covariance indicates that returns move in the same direction, increasing portfolio risk.
- A negative covariance indicates that returns move in opposite directions, reducing portfolio risk.
- Portfolio standard deviation is calculated using a formula that considers the weights of individual assets and the covariance between them.
Efficient Frontier
- The Efficient Frontier represents the dominant portfolios in risk/return space.
- It comprises portfolios offering the highest return for a given level of risk or the lowest risk for a given level of return.
- The Coefficient of Variation (CV) is calculated as CV = Standard Deviation/Expected Return.
- CV helps compare investment risk when standard deviations are similar.
- A higher CV indicates a higher level of risk per unit of return earned.
Portfolio Selection and Diversification
- Investors typically hold multiple investments in a portfolio for diversification.
- The market portfolio (M) represents the weighted average of all assets in the market.
- The efficient frontier helps identify the optimal portfolio combinations with the highest return for a given level of risk or the lowest risk for a given level of return.
Risk-Free Rate and Capital Market Line (CML)
- Investments outside the efficient frontier, below and to the right, are considered risk-free investments.
- Risk-free investments, like government securities, offer a guaranteed return with no risk of capital loss.
- The CML graphically represents the range of best investment options in terms of risk and return.
- It depicts the trade-off between risk and return.
- A risk-averse investor may choose a risk-free investment, while a more risk-tolerant investor might opt for the market portfolio (M).
- The CML is based on the assumptions that investors are rational, have perfect information, and can invest freely without constraints.
Portfolio Theory Limitations
- Portfolio theory relies on certain assumptions that may limit its applicability in real-world scenarios.
- These assumptions include rational investors, perfect information, and frictionless markets.
- Real-world market conditions often deviate from these idealized assumptions.
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