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What is the primary goal of an investor according to Markowitz’s solution?
What is the primary goal of an investor according to Markowitz’s solution?
According to the portfolio selection problem, all securities have certain outcomes.
According to the portfolio selection problem, all securities have certain outcomes.
False
Who proposed the modern portfolio theory in 1952?
Who proposed the modern portfolio theory in 1952?
Harry M. Markowitz
The approach proposed by Markowitz can be regarded as a __________ approach.
The approach proposed by Markowitz can be regarded as a __________ approach.
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Match the following concepts with their descriptions:
Match the following concepts with their descriptions:
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What must an investor recognize regarding security returns during the holding period?
What must an investor recognize regarding security returns during the holding period?
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Nonsatiation means that investors always prefer more to less wealth.
Nonsatiation means that investors always prefer more to less wealth.
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What is the basic challenge faced by investors as mentioned in the portfolio selection problem?
What is the basic challenge faced by investors as mentioned in the portfolio selection problem?
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What is the primary conflict faced by investors while attempting to maximize returns?
What is the primary conflict faced by investors while attempting to maximize returns?
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The Markowitz model provides a qualitative approach to balancing returns and risk.
The Markowitz model provides a qualitative approach to balancing returns and risk.
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What formula can be used to calculate the rate of return on a portfolio?
What formula can be used to calculate the rate of return on a portfolio?
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The initial wealth is denoted by _____ and the terminal wealth by _____.
The initial wealth is denoted by _____ and the terminal wealth by _____.
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Which of the following statements about random variables is true?
Which of the following statements about random variables is true?
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An investor can accurately predict the future rate of return for all portfolios.
An investor can accurately predict the future rate of return for all portfolios.
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What must an investor decide at time t=0?
What must an investor decide at time t=0?
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Match the following terms with their definitions:
Match the following terms with their definitions:
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According to Markowitz, investors should base their portfolio decisions on which two parameters?
According to Markowitz, investors should base their portfolio decisions on which two parameters?
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Investors are assumed to prefer lower levels of terminal wealth over higher levels.
Investors are assumed to prefer lower levels of terminal wealth over higher levels.
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What is the assumption that investors prefer portfolios with smaller standard deviations called?
What is the assumption that investors prefer portfolios with smaller standard deviations called?
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The two assumptions in the discussion of portfolio selection are ______ and ______.
The two assumptions in the discussion of portfolio selection are ______ and ______.
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What characterizes a 'fair gamble' for an investor?
What characterizes a 'fair gamble' for an investor?
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Utility is solely about financial gain and does not consider personal satisfaction.
Utility is solely about financial gain and does not consider personal satisfaction.
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How do investors maximize their utility according to the provided information?
How do investors maximize their utility according to the provided information?
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What does a correlation coefficient of +1 indicate?
What does a correlation coefficient of +1 indicate?
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A correlation coefficient of 0 signifies that the returns of two securities are perfectly correlated.
A correlation coefficient of 0 signifies that the returns of two securities are perfectly correlated.
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What is the formula for calculating the correlation coefficient?
What is the formula for calculating the correlation coefficient?
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When the covariance is zero, the correlation coefficient will also be __________.
When the covariance is zero, the correlation coefficient will also be __________.
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What is the range of values for the correlation coefficient?
What is the range of values for the correlation coefficient?
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With perfectly negatively correlated assets, one can create a portfolio with almost no risk.
With perfectly negatively correlated assets, one can create a portfolio with almost no risk.
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What statistical measure is closely related to covariance?
What statistical measure is closely related to covariance?
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A correlation coefficient of -1 indicates a __________ correlation.
A correlation coefficient of -1 indicates a __________ correlation.
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Which of the following best describes negative covariance?
Which of the following best describes negative covariance?
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What is the primary objective of the Markowitz portfolio selection problem?
What is the primary objective of the Markowitz portfolio selection problem?
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All investors have the same utility of wealth function.
All investors have the same utility of wealth function.
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What does 'diminishing marginal utility of wealth' mean?
What does 'diminishing marginal utility of wealth' mean?
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The __________ equivalent is the guaranteed amount of money that provides the same utility as a riskier option.
The __________ equivalent is the guaranteed amount of money that provides the same utility as a riskier option.
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Which investment option would a risk averse investor likely prefer?
Which investment option would a risk averse investor likely prefer?
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A rich investor values an extra unit of wealth more than a poor investor.
A rich investor values an extra unit of wealth more than a poor investor.
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What motivates risk averse investors to choose less risky investments?
What motivates risk averse investors to choose less risky investments?
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What does an indifference curve represent?
What does an indifference curve represent?
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An indifference curve can intersect with another indifference curve.
An indifference curve can intersect with another indifference curve.
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What does the slope of an indifference curve indicate about an investor's risk aversion?
What does the slope of an indifference curve indicate about an investor's risk aversion?
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All investors have an infinite number of indifference curves, resulting in an indifference curve _____ representing their preferences.
All investors have an infinite number of indifference curves, resulting in an indifference curve _____ representing their preferences.
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Match the risk aversion level with the description:
Match the risk aversion level with the description:
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What assumption causes indifference curves to be positively sloped and convex?
What assumption causes indifference curves to be positively sloped and convex?
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All investors are assumed to have identical degrees of risk aversion.
All investors are assumed to have identical degrees of risk aversion.
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What should an investor do to select the optimal portfolio from their indifference curve map?
What should an investor do to select the optimal portfolio from their indifference curve map?
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Study Notes
Investment Theory (Part I)
- Investment Management course, ACF 313, Department of Accountancy, Faculty of Business Studies Finance, Wayamba University of Sri Lanka, Kuliyapitiya.
- Successful completion of this topic enables students to understand the portfolio selection problem.
- Students will understand why investors aim to maximize expected return (ER) and minimize uncertainty.
- Crucial topics include Markowitz's solution, Nonsatiation, Risk Aversion, utility, and investor behavior.
- Most investments carry uncertainty and risk.
- Investors must determine the most suitable risky securities to invest in.
- A portfolio comprises multiple securities.
- Portfolio selection is similar to finding the optimal portfolio from various possible investment portfolios.
- Harry Markowitz (1952) provided a solution to this portfolio selection problem, marking a significant point in modern portfolio theory.
- The Markowitz approach assumes an investor with a specific amount to invest currently, held for a duration known as the holding period.
- At the end of the holding period, the investor sells purchased securities.
- The investment proceeds can be used for consumption or reinvestment.
- The Markowitz model is a single-period approach.
- Security returns during the holding period are typically unknown.
- Investors estimate expected returns and aim to minimize uncertainty in future returns.
- The investor attempts to maximize expected returns while minimizing risk.
- The model seeks a balance between these competing objectives.
- Initial wealth and terminal wealth calculations are crucial in portfolio theory.
- Terminal wealth (at end of period) = Initial Wealth × (1 + return).
- Portfolio return (rp) calculation: (End-of-period portfolio value – Beginning-of-period portfolio value) / Beginning-of-period portfolio value.
- The investor must determine which portfolio is most suitable.
- Investors must determine projected returns, and the standard deviation of the expected return for each portfolio.
- Investor behavior assumes preferences for higher levels of terminal wealth.
- Risk-averse investors choose portfolios with lower standard deviations.
- A fair gamble has an expected return of zero.
- Utility represents the satisfaction or enjoyment derived from economic activities like work, consumption, and investment.
- People are assumed rational, maximizing their utility.
- Utility of wealth function describes the link between utility and wealth.
- Investors typically prefer more wealth to less wealth.
- Marginal utility of wealth (MUW), the additional utility from each additional unit of wealth, usually decreases as wealth increases (diminishing marginal utility).
- Wealthier investors generally place a lower value on additional wealth compared to poorer investors.
- Certainty Equivalent is the guaranteed amount of money that makes an investor as happy as a riskier investment with the same expected result.
- Risk premium is the expected increase in terminal wealth compared to a certain investment, accounting for the risk.
- Risk-averse investors accept lower expected terminal wealth in exchange for lower risks.
- Indifference curves display different combinations of expected terminal wealth and risk leading to the same level of utility.
- Higher indifference curves represent a higher level of utility.
- Investors choose the portfolio on the highest indifference curve and on the efficient frontier.
- The degree of risk aversion affects the slope of indifference curves; more risk aversion leads to steeper slopes.
- Expected return of a portfolio is calculated as a weighted average of the expected returns of individual assets within the portfolio.
- Formula: E(Rp) = w₁E(R₁) + w₂E(R₂) + ... + wₙE(Rₙ)
- Portfolio risk (standard deviation) isn't simply a weighted average of the individual securities' standard deviations.
- Diversification reduces risk. The risk from covariance risk is minimized with higher diversification.
- Standard deviation calculation formula:
[ \sigma_{p}^{2} = \sum_{i=1}^{n} \sum_{j=1}^{n} w_{i} w_{j} \sigma_{i} \sigma_{j} \rho_{i j} ] Where: N = Number of securities in the portfolio wi = weights of the ith security σi = standard deviation of returns for the ith security ρij= correlation of returns of security i and j
- Covariance measures how much two securities' returns move together. Correlation coefficient of returns (r) is covariance divided by the product of the standard deviations:
[r_{i j} =\frac{Cov(R_{i}, R_{j})}{\sigma_{i} \sigma_{j}}]
- Correlation values lie between -1 and +1. (+1 = perfect positive correlation, -1=perfect negative correlation) , 0= no correlation.
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Description
This quiz explores key concepts in Investment Management, focusing on portfolio selection and the theories posed by Harry Markowitz. Understand how investors balance expected returns against risks while considering risk aversion and utility. Engage with essential topics that form the foundation of modern portfolio theory.
