Portfolio Theory

    Cards (71)

    • What is the main focus of Lecture 1 in FI3004?
      Fundamentals of Portfolio Theory
    • 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
    • What does HPR stand for in investment return?
      Holding Period Return
    • How is expected return E(R) estimated by an investor?
      Based on subjective beliefs about the probability distribution of returns
    • What is the formula for expected return?
      Expected return is the weighted average of all predicted returns using probabilities as weights
    • What is the appropriate measure of risk in an investment?
      The variance of return
    • Why is standard deviation convenient in presenting risk?
      It allows for comparison of risk across assets/portfolios
    • What are the steps to compute expected return, variance, and standard deviation of return for stock A?
      1. Calculate expected return E(R_A)
      2. Compute variance Var(A)
      3. Determine standard deviation S.D(A)
    • What is the expected return E(R_A) for stock A?
      0.20 (20%)
    • How is variance calculated for stock A?
      By summing the squared differences between each return and the expected return, weighted by their probabilities
    • What does covariance measure in finance?
      The degree to which returns of two assets move together over time
    • How is correlation derived from covariance?
      By standardizing the covariance by the standard deviations of individual assets
    • What is the correlation between an asset and itself?
      1
    • What does it mean if two assets are uncorrelated?
      There is no relationship in the movement of their returns
    • 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)
    • 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:
      \[ E(R_P) = \sum (w_i * E(R_i)) \]
    • What are the components of portfolio return variance?
      • Variances of individual assets
      • Covariances between pairs of assets
    • How do you calculate the expected return of portfolio P if 75% is invested in A and 25% in B?
      By using the formula: \( E(R_P) = 0.75 * E(R_A) + 0.25 * E(R_B) \)
    • What is the expected return of portfolio P?
      22.8%
    • What is the significance of diversification in portfolio theory?
      Diversification reduces risk by combining assets with different correlations
    • What is the impact of negatively correlated assets on portfolio risk?
      • Risk (standard deviation) decreases more significantly
      • Complete elimination of risk is unlikely
    • Who developed the principles of Portfolio Theory?
      Harry Markowitz
    • What is the portfolio frontier?
      It represents the set of optimal portfolios that offer the highest expected return for a given level of risk
    • What happens to the expected return and risk if short-selling is allowed?
      It can increase expected return and alter the risk profile
    • 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
    • What is the expected return of a portfolio if $20 million is short-sold from stock A?
      33.2%
    • What is the relationship between asset weights and diversification effectiveness?
      The weights of assets and their correlation/covariance determine diversification effectiveness
    • 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
    • What is the expected return for a portfolio with weights 75% in A and 25% in B?
      1. 6%
    • What is the expected return for a portfolio with weights 60% in A and 40% in B?
      1. 8%
    • What is the expected return for a portfolio with weights 30% in A and 70% in B?
      1. 4%
    • 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
    • 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
    • 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
    • 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
    • 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)
    • What are the sources of systematic risk?
      Macroeconomic factors like political stability and interest rate policy
    • What are examples of unsystematic risk?
      Change in board of directors and firm bankruptcy
    • 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
    • What is the characteristic of a risk-free asset?
      Returns are known with certainty and total risk is zero
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