Portfolio Analysis and Modern Portfolio Theory
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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?

<p>That a high percentage of the variability in the returns of one asset can be explained by the returns of the other asset</p> Signup and view all the answers

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

<p>The main characteristics of any investment are investment return and risk. These are important because they help investors compare various alternatives of investments and make informed decisions.</p> Signup and view all the answers

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

<p>Because it reduces overall risk in a portfolio more effectively than combining uncorrelated or positively correlated assets</p> Signup and view all the answers

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

<p>The ultimate objective for any investor is to achieve a high rate of return. This is measured by the rate at which their funds have grown during the investment period.</p> Signup and view all the answers

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

<p>It will not provide sufficient diversification</p> Signup and view all the answers

What is an advantage of international diversification?

<p>It offers more diverse investment alternatives and potentially greater returns and reduced portfolio risk</p> Signup and view all the answers

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

<p>The expected rate of return and the variance or standard deviation provide investors with information about the nature of the probability distribution associated with a single asset.</p> Signup and view all the answers

What is a disadvantage of international diversification?

<p>It involves currency exchange and political risk, is less convenient to invest, and is more expensive due to transaction costs</p> Signup and view all the answers

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

<p>The three primary objectives of a portfolio are growth-oriented, income-oriented, and capital preserving. Growth-oriented portfolios aim for long-term price appreciation, income-oriented portfolios aim for current dividend and interest income, and capital preserving portfolios aim to earn marginal income without depleting capital.</p> Signup and view all the answers

What is the main goal of portfolio theory?

<p>To deal with uncertain outcomes in investing</p> Signup and view all the answers

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

<p>The key measure of an investor's success is the rate at which their funds have grown during the investment period. This is evaluated by measuring the rate of return on investment.</p> Signup and view all the answers

Why is it important to consider risk in investing?

<p>Because investing usually involves dealing with uncertain outcomes</p> Signup and view all the answers

Why are precise quantitative measures necessary for comparing investment alternatives?

<p>Precise quantitative measures are necessary for comparing various alternatives of investments to make informed decisions.</p> Signup and view all the answers

What is the goal of finding the minimum variance portfolio?

<p>To minimize the portfolio variance</p> Signup and view all the answers

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

<p>By adding a little weight to the security with a lower covariance and subtracting a little from the security with a higher covariance, and repeating the process until the variance cannot be lowered anymore</p> Signup and view all the answers

What is the condition for the minimum variance portfolio?

<p>All securities have the same covariance with the portfolio</p> Signup and view all the answers

Why is diversification key to optimal risk management?

<p>Because it allows for the minimization of portfolio variance</p> Signup and view all the answers

What is the goal of asset allocation?

<p>To divide funds into different asset classes</p> Signup and view all the answers

What is portfolio construction?

<p>A disciplined, personalized process</p> Signup and view all the answers

What is the importance of covariances in portfolio selection?

<p>Covariances are used to find the minimum variance portfolio</p> Signup and view all the answers

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

<p>The investment opportunity set looks different when there are many assets</p> Signup and view all the answers

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

<p>cov(rapple, rapple) = var(rapple)</p> Signup and view all the answers

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

<p>The covariance matrix is symmetric</p> Signup and view all the answers

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

<p>E(rp) = wa.E(ra) + ws.E(rs) + wh.E(rh)</p> Signup and view all the answers

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

<p>∂²(rp) = wa².∂²(ra) + ws² ∂²(rs) + w²h ∂²(rh) + 2waws cov(ra, rs) + 2wawh cov(ra, rh) + 2wswh cov(rs, rh)</p> Signup and view all the answers

How is the return on an N asset portfolio calculated?

<p>rp = w1r1 + w2r2 + · · · + wnrn</p> Signup and view all the answers

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

<p>The sum of the weights equals one</p> Signup and view all the answers

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

<p>E(rp) = w1E(r1) + w2E(r2) + · · · + wnE(rn) = ∑wiE(ri)</p> Signup and view all the answers

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

<p>∂²(rp) = w1².∂²(r1) + w2² ∂²(r2) +......+ w²n ∂²(rn) + 2w1w2 cov(r1, r2) + ...</p> Signup and view all the answers

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

<p>The CAPM describes the relationship between the expected risk premium on a security, E(Ri)-Rf, and the risk, beta.</p> Signup and view all the answers

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

<p>E(Ra) = Rf + ba[E(RM) – Rf]</p> Signup and view all the answers

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

<p>The beta (ba) represents the risk of an asset or a portfolio.</p> Signup and view all the answers

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%?

<p>15.18%</p> Signup and view all the answers

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

<p>Holding a combination of two assets with different parameters can reduce risk and increase expected return.</p> Signup and view all the answers

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

<p>You calculate the expected rate of return by multiplying each possible rate of return by its probability of occurrence and summing the products.</p> Signup and view all the answers

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

<p>The purpose is to measure the risk or uncertainty of an investment.</p> Signup and view all the answers

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

<p>The risk of the portfolio is reduced when you combine two assets with different parameters.</p> Signup and view all the answers

Flashcards

Portfolio

A collection of investments designed to achieve specific financial goals.

Portfolio Types

Different portfolio strategies including growth, income, and capital preservation.

Investment Return

Profit gained from an investment.

Investment Risk

Possible loss or lower return.

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Expected Return

Predicted average return of an investment.

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Variance

Measure of how dispersed investment returns are.

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Standard Deviation

Measure of investment return volatility.

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Correlation Coefficient

Measures the linear relationship between two assets.

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Coefficient of Determination

Square of the correlation coefficient – measures explained variance.

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Portfolio Return

Return from a collection of investments.

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Portfolio Risk

Potential loss from holding a collection of investments.

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Mean-Variance Analysis

Portfolio theory focusing on expected return and risk.

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Diversification

Reduces portfolio risk by spreading investments across different assets.

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International Diversification

Investing in assets from multiple countries.

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Asset Allocation

Distributing funds among different asset classes to manage risk.

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CAPM

Capital Asset Pricing Model – relates risk and expected return.

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Beta

Measure of a security's systematic risk in relation to the market.

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Systematic Risk

Risk inherent in the overall market.

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Market Risk Premium

Extra return investors expect for taking on market risk.

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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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Description

This quiz covers the concepts of portfolio analysis, modern portfolio theory, and portfolio risk-return analysis, including measuring expected return and risk, diversification, and portfolio selection models.

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