## Questions and Answers

What is the formula to calculate the coefficient of determination (Det.AB)?

Square of correlation coefficient

What is a portfolio, and what are its primary objectives?

A portfolio is a collection of investment vehicles assembled to meet one or more investment goals. Primary objectives include growth-oriented, income-oriented, and capital preserving portfolios.

What is an efficient portfolio, and what are its key characteristics?

An efficient portfolio is one that provides the highest return for a given level of risk. Investors will choose the investment with the highest potential return for a given level of risk or the one with the least risk for a given return.

What does a high coefficient of determination indicate about the returns of two assets?

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What are the main characteristics of any investment, and why are they important?

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Why is it desirable to combine assets with negative correlation in a portfolio?

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What is the ultimate objective for any investor, and how is it measured?

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What is a disadvantage of investing in different investments with high positive correlation?

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What is an advantage of international diversification?

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What is the relationship between risk and return, and how is it measured?

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What is a disadvantage of international diversification?

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What are the three primary objectives of a portfolio, and how do they differ?

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What is the main goal of portfolio theory?

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What is the key measure of an investor's success, and how is it evaluated?

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Why is it important to consider risk in investing?

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Why are precise quantitative measures necessary for comparing investment alternatives?

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What is the goal of finding the minimum variance portfolio?

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How can you minimize the portfolio variance according to the thought experiment?

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What is the condition for the minimum variance portfolio?

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Why is diversification key to optimal risk management?

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What is the goal of asset allocation?

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What is portfolio construction?

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What is the importance of covariances in portfolio selection?

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What is the relationship between the investment opportunity set and the number of assets?

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What is the relationship between the covariance of two assets and the variance of one of the assets?

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What is the property of the covariance matrix mentioned in the text?

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How is the expected return of a portfolio of three risky assets calculated?

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What is the formula for the variance of a portfolio of three risky assets?

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How is the return on an N asset portfolio calculated?

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What is the constraint on the weights of the assets in a portfolio?

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How is the expected return of a portfolio of many risky assets calculated?

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What is the formula for the variance of a portfolio of many risky assets?

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According to the Capital Asset Pricing Model (CAPM), what is the relationship between the expected risk premium on a security and the risk, beta?

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What is the formula for the Capital Asset Pricing Model (CAPM)?

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In the CAPM, what does the beta (ba) represent?

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What is the expected return on a stock with a beta of 1.3, if the risk-free rate is 4% and the market risk premium is 8.6%?

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Why is it beneficial to hold a combination of two assets with different parameters?

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How do you calculate the expected rate of return of an investment alternative?

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What is the purpose of calculating the variance and standard deviation of an investment?

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What happens to the risk of a portfolio when you combine two assets with different parameters?

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## Study Notes

### Chapter 4: Portfolio Analysis and Modern Portfolio Theory

#### 4.1 Introduction to Portfolio Analysis

- A portfolio is a collection of investment vehicles assembled to meet one or more investment goals.
- Types of portfolios: Growth-Oriented, Income-Oriented, and Capital Preserving portfolios.

#### 4.2 Portfolio Return and Risk Measures

- Investment return and risk are the main characteristics of any investment.
- Expected rate of return and variance or standard deviation provide information about the nature of the probability distribution associated with a single asset.
- Coefficient of determination (Det.AB) is calculated as the square of the correlation coefficient.

#### 4.3 Measuring Expected Return and Risk of a Portfolio

- Portfolio theory – mean variance analysis.
- Portfolio return and risk can be measured using expected return (E(rp)) and variance (∂²(rp)).
- Computing E(rp) and ∂²(rp) for a three-risky asset portfolio.

#### 4.4 Portfolio Risk-Return Analysis of Two Securities

- Correlation between series M, N, and P: correlation measures the strength of the linear relationship between two variables.
- Diversification reduces overall risk in a portfolio by combining assets with a negative (or low-positive) correlation.

#### 4.5 Portfolio Risk-Return Analysis of More Than Two Securities

- A portfolio of many risky assets: expected return (E(rp)) and variance (∂²(rp)) can be calculated using the weighted sum of individual securities.
- Minimizing portfolio variance by adjusting the weights of securities with different covariances.

#### 4.6 Diversification and Portfolio Risks

- International diversification offers a broader investment choice, potentially greater returns, and reduced portfolio risk.
- Advantages and disadvantages of international diversification.

#### 4.7 Portfolio Selection Models

- Asset allocation (portfolio selection) with many assets: finding the optimal allocation of funds to different asset classes.
- Capital asset pricing model (CAPM) describes the relationship between expected risk premium and beta (systematic risk).
- Example of CAPM: calculating expected return on a stock using beta and market risk premium.

#### Illustrations on Risk and Return Analysis

- Example 1: analyzing the advantage of holding a combination of two stocks (Y and Z) with different expected returns and variances.
- Example 2: determining expected rate of return, variance, and standard deviation for two investment alternatives (Y and Z).

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