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Cards (71)
What is the main focus of Lecture 1 in FI3004?
Fundamentals of
Portfolio Theory
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What are the learning objectives of the lecture?
Familiarity with risks and returns
Understanding
risk reduction
through diversification
Interpreting the
Capital Market Line
Preparing for
capital asset pricing models
and their implications
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What does HPR stand for in investment return?
Holding Period Return
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How is expected return E(R) estimated by an investor?
Based on subjective beliefs about the
probability distribution
of returns
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What is the formula for expected return?
Expected return
is the
weighted average
of all predicted returns using
probabilities
as weights
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What is the appropriate measure of risk in an investment?
The
variance of return
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Why is standard deviation convenient in presenting risk?
It allows for comparison of risk across
assets
/
portfolios
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What are the steps to compute expected return, variance, and standard deviation of return for stock A?
Calculate
expected return
E(R_A)
Compute
variance
Var(A)
Determine
standard deviation
S.D(A)
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What is the expected return E(R_A) for stock A?
0.20 (
20%
)
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How is variance calculated for stock A?
By summing the squared differences between each return and the
expected return
, weighted by their
probabilities
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What does covariance measure in finance?
The
degree
to which
returns
of
two
assets
move
together
over
time
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How is correlation derived from covariance?
By standardizing the covariance by the
standard deviations
of individual assets
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What is the correlation between an asset and itself?
1
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What does it mean if two assets are uncorrelated?
There is no relationship in the movement of their
returns
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Given the correlation between stock A and B is -0.35, how do you calculate the covariance?
Using the formula:
Cov(A,B)
=
Correlation(A,B)
*
S.D(A)
*
S.D(B)
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What is the formula for a portfolio's expected return?
Expected return of portfolio P is the
weighted average
of expected returns of individual assets:
\[
E(R_P)
= \
sum
(w_i *
E(R_i)
) \]
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What are the components of portfolio return variance?
Variances
of individual assets
Covariances
between pairs of assets
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How do you calculate the expected return of portfolio P if 75% is invested in A and 25% in B?
By using the formula: \(
E(R_P)
= 0.75 *
E(R_A)
+ 0.25 *
E(R_B)
\)
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What is the expected return of portfolio P?
22.8%
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What is the significance of diversification in portfolio theory?
Diversification reduces risk by combining assets with different
correlations
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What is the impact of negatively correlated assets on portfolio risk?
Risk
(
standard deviation
) decreases more significantly
Complete elimination of risk is unlikely
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Who developed the principles of Portfolio Theory?
Harry Markowitz
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What is the portfolio frontier?
It represents the set of
optimal portfolios
that offer the highest
expected return
for a given level of
risk
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What happens to the expected return and risk if short-selling is allowed?
It can increase expected return and alter the
risk profile
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What is the effect of short-selling on portfolio weights?
Short-selling allows for negative weights in assets
It can lead to higher
expected returns
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What is the expected return of a portfolio if $20 million is short-sold from stock A?
33.2%
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What is the relationship between asset weights and diversification effectiveness?
The weights of assets and their
correlation
/
covariance
determine diversification effectiveness
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What are the key components of the portfolio frontier?
Optimal portfolios
with highest expected return for given risk
Impact of
asset correlation
on risk reduction
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What is the expected return for a portfolio with weights 75% in A and 25% in B?
6%
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What is the expected return for a portfolio with weights 60% in A and 40% in B?
8%
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What is the expected return for a portfolio with weights 30% in A and 70% in B?
4%
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What does the portfolio frontier represent in portfolio theory?
A set of all
mean-variance efficient
portfolios of risky assets
Portfolios on the frontier dominate those below it
Rational
risk-averse
investors choose portfolios on the frontier
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What is the optimal portfolio selection strategy on the portfolio frontier?
Maximize
returns at any given level of risk or minimize risk at any given level of
expected return
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How does adding more risky assets to a portfolio affect its standard deviation?
The standard deviation is influenced by the
covariance
terms as the number of assets increases
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What happens to the importance of individual asset risk in a well-diversified portfolio?
The risk associated with each asset becomes minimal
The overall portfolio risk is dominated by
covariance
terms
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What is the limit of diversification in a portfolio?
Unique risk can be diversified away (
unsystematic risk
)
Market risk cannot be diversified away (systematic risk)
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What are the sources of systematic risk?
Macroeconomic
factors like political stability and
interest rate policy
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What are examples of unsystematic risk?
Change in
board of directors
and
firm bankruptcy
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What is the Capital Market Line (CML)?
Represents the risk-return trade-off for efficient portfolios
Tangent to the
efficient frontier
Combines risky assets with
risk-free assets
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What is the characteristic of a risk-free asset?
Returns are known with
certainty
and total risk is
zero
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