Chapter 6 - efficient diversification

Question 1

insurance principle

Answer 1

risk reduction by spreading exposure access to many independent risk sources

Question 2

Market risk (Systemic risk)

Answer 2

risk that remains even after diversification

Question 3

firm-specific risk, nonsystematic risk, diversifiable risk

Answer 3

Risk that can be eliminated by diversification

Question 4

covariance

Answer 4

• Probability-weighted average of the products
• Measures the average tendency of the asset returns to vary in tandem

Question 5

Cov(rS, rB) =

Answer 5

= ⍴SB x σS x σB

Question 6

correlation coefficient =

Answer 6

= ⍴SB = Cov(rS, rB) / σS x σB

Question 7

3 rules of two-risky-assets portfolios

Answer 7

• Rule 1/2: the expected RoR/RoR on a portfolio is the weighted average of the expected returns/returns on the component securities, with the portfolio proportions as weights
• Rule 3: the variance of the RoR on a two-risky-assets portfolio is:
  σ^2p = (wB x σB)^2 + (wS x σS)^2 + 2(wB x σB)(wS x σS)⍴BS

Question 8

Investment opportunity set

Answer 8

Set of available portfolio risk-return combinations

Question 9

mean-variance criterion

Answer 9

• Investors desire portfolios that lie to the “northwest” in the investment opportunity set
• There are benefits to diversification whenever asset returns are less than perfectly positively correlated

Question 10

optimal risky portfolio

Answer 10

• The best combination of risky assets to be mixed with safe assets when forming the complete portfolio
• Highest feasible Sharpe ratio
• Steepest CAL

Question 11

efficient frontier

Answer 11

Graph representing portfolios that maximizes expected return at each level of portfolio volatility

Question 12

separation property

Answer 12

• implies portfolio choice can be separated into two independent tasks:

(1) determination of the optimal risky portfolio, which is a purely technical problem

(2) the personal choice of the best mix of the risky portfolio and the risk-free asset

Question 13

index model

Answer 13

Model that relates stock returns to returns on both a broad market index and firm-specific factors

Question 14

Index model regression equation:

Answer 14

Ri(t) = ɑi + βi x (Rm(t) - Rf) + ei

Question 15

Alpha(ɑi)

Answer 15

expected RoR in excess of what would be predicted by an equilibrium model such as the CAPM

Question 16

Beta(βi)

Answer 16

The sensitivity of a security’s return to the return on the market index

Question 17

beta greater than 1

Answer 17

cyclical/aggressive stocks

Question 18

beta less than 1

Answer 18

Defensive stocks

Question 19

Slope of the CAL =

Answer 19

= excess return / variance

Question 20

e(i)

Answer 20

residual, firm-specific surprise in the security return

Question 21

Security characteristic line(SCL)

Answer 21

Plot of a security’s predicted excess return given the excess return of the market

Question 22

variance of the excess return of a stock:

Answer 22

variance(Ri) = variance(βiRm) + variance(ei)

Question 23

Algebraic representation of the single-index model regression line:

Answer 23

E(Rdisney|Rm) = ɑDisney + βdisney x Rm

Question 24

R^2 of the single-index model regression line:

Answer 24

R^2 = systemic(explained) variance / total variance

R^2 = (correlation coefficient)^2

Question 25

mean reversion

Answer 25

high betas securities tend to exhibit a lower beta in the future and vice versa

Question 26

Adjusted beta =

Answer 26

= ⅔ x (beta estimate) + ⅓ x 1

Question 27

information ratio

Answer 27

Ratio of alpha to the standard deviation of the residual

Question 28

active portfolio

Answer 28

The portfolio formed by optimally combining analyzed stocks

Question 29

Global minimum-variance portfolio

Answer 29

the risky portfolio with the lowest possible variance and a Sharpe ratio lower than that at the point of tangency

Question 30

time diversificaiton

Answer 30

A two-year investor puts her funds at risk for two years instead of one placing only half as much in the stock market each year as a one-year investor

Question 31

risk pooling

Answer 31

Pooling together many independent sources of risk