Term
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Definition
| The uncertainty of future outcomes |
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Term
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Definition
| By the probability of an adverse outcome (40% you will receive a return less than stated return) - Standard Deviation |
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Term
| Advantages of Standard Deviation |
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Definition
1. This measure is somewhat intuitive
2. It is a correct and widely recognized risk measure
3. It has been used in most of the theoretical asset pricing models |
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Term
| How to calculate the expected return of an individual asset |
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Definition
| It is equal to the sum of the potential returns multiplied with the corresponding probability of the returns |
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Term
| How to calculate the expected return of a portfolio |
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Definition
| It is equal to the weighted average of the expected rates of return for the individual investments in the portfolio |
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Term
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Definition
| a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri), where Pi is the probability of the possible rate of return, Ri |
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Term
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Definition
| A measure of the degree to which two variables “move together” relative to their individual mean values over time |
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Term
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Definition
| Covij = E{[Ri - E(Ri)] [Rj- E(Rj)]} |
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Term
| How do you obtain the correlation coefficient? |
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Definition
| By standardizing (dividing) the covariance by the product of the individual standard deviations |
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Term
| What is the range of possible correlation coefficients? |
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Definition
- Range from +1 to -1.
- +1 = perfect positive correlation. The two assets move together in a positively and completely linear manner.
- –1 = perfect negative correlation. The returns for two assets move together in a completely linear manner, but in opposite directions. |
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Term
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Definition
| A strategy designed to reduce risk by spreading the portfolio across many investments - works because prices of different stocks do not move exactly together. |
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Term
| When does diversification work best? |
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Definition
| When the returns are negatively correlated, ie when they move in opposite directions so that the net effect cancels out and you make an average profit under different circumstances |
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Term
| Why does unique risk arise? |
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Definition
| Because many of the dangers that surround an individual company are peculiar to the company and perhaps its direct competitors |
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Term
| From what does market risk stem? |
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Definition
| From economy-wide perils that threaten all businesses. Market risk explains why stocks tend to move together, so that even well-diversified portfolios are exposed to market movements |
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Term
| What is the only type of risk that matters for a diversified portfolio? |
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Definition
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Term
| In a portfolio, what happens to the variance and covariance terms? |
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Definition
| The variance terms are effectively diversified away, but the covariance terms are not |
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Term
| What have studies confirmed in regard to international portfolios? |
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Definition
| well-structured international diversification does indeed reduce the risk of a portfolio and increase the return on portfolios of comparable risk |
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Term
| What are long-term rates of return generally attributable to? |
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Definition
| Long-term returns are primarily about a country’s economic performance and long-term economic performance varies across countries |
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Term
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Definition
| it is possible to find another portfolio that is better in terms of both expected return and volatility. |
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Term
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Definition
| There is no way to reduce the volatility of the portfolio without lowering its expected return. |
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Term
| Expected rate of return on a diversified portfolio |
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Definition
| A weighted average of the expected returns on the securities in the portfolio |
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Term
| Variance of a portfolio with 2 risky assets |
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Definition
| o^2 = (wBoB)^2 + (wSoS)^2 + 2(wBoB)(wSoS)p - where p is the correlation coefficient |
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Term
| What does the efficient frontier represent? |
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Definition
| That set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return - portfolios of investments rather than individual securities except the assets with the highest return and the asset with the lowest risk |
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Term
| What does the investor's utility curve specify? |
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Definition
| The trade-offs he is willing to make between expected return and risk |
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Term
| How does the slope of the efficient curve change as you move upward? |
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Definition
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Term
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Definition
| The portfolio that has the highest utility for a given investor |
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Term
| How can an investor who is seeking higher returns interact with risk-free assets? |
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Definition
| Decide to borrow money to invest even more in the stock market. |
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Term
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Definition
| The portfolio that generates the steepest possible line when combined with the risk-free investment |
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Term
| What is the function of the Sharpe Ratio? |
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Definition
| Measures the ratio of reward-to-volatility provided by a portfolio |
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Term
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Definition
| Sharpe = (Porfolio excess return / Portfolio volatility) = (Ep - Rf) / SDp |
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Term
| How is the Sharpe Ratio used? |
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Definition
| The portfolio with the highest Sharpe ratio is the portfolio where the line with the risk-free investment is tangent to the efficient frontier of risky investments |
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Term
| What provides the best possible risk and return trade-off for an investor? |
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Definition
| Combinations of the risk-free asset and the tangent portfolio - The tangent ratio is efficient and all efficient portfolios are combinations of the risk-free asset and the tangent portfolios |
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Term
| What will an investor's preference determine in regards to the tangent portolio and risk free investment? |
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Definition
| How much to invest in the tangent portfolio versus the risk-free investment - ¨ Both types of investors will choose to hold the same portfolio of risky assets, the tangent portfolio, which is the efficient portfolio |
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Term
| Function of the Capital Asset Pricing Model |
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Definition
| Allows us to identify the efficient portfolio of risky assets without having any knowledge of the expected return of each security |
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Term
| Instead of expected return, what does the CAPM use to identify the efficient portfolio? |
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Definition
| Uses the optimal choices investors make to identify the efficient portfolio as the market portfolio, the portfolio of all stocks and securities in the market |
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Term
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Definition
1. Investors can buy and sell all securities at competitive market prices (without incurring taxes or transactions costs) and can borrow and lend at the risk-free interest rate.
2. Investors hold only efficient portfolios of traded securities—portfolios that yield the maximum expected return for a given level of volatility.
3. Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities |
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Term
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Definition
| All investors have the same estimates concerning future investments and returns |
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Term
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Definition
| When the tangent line goes through the market portfolio |
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Term
| According to CAPM, where should all individually plotted securities fall? |
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Definition
| On the Security Market Line |
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