What are the two types of risk?
- Market risk which is systematic and non-diversifiable
- Firm-specific risk which is non-systematic and diversifiable
What are the two types of efficient diversification?
- Understanding portfolio risk with more than on asset
- Understanding how to obtain the optimal weights
When is there a diversification benefit and when not?
If the correlation of a portfolio is not perfectly correlated than there is a diversification benefit, with perfect correlation it is not
What does the opportunity set show?
It shows all combinations of the portfolio expected return and standard deviation that can be constructed from the two available assets
What are the different step in constructing a Markowitz Portfolio Optimization model?
- Identify the risk-return combinations of the available set of risky assets
- Identify the optimal portfolio of risky assets that result in the steepest CAL
- Choose an appropriate complete portfolio by mixing risk-free asset with optimal risky portfolio
How do we identify the risk-return combinations?
Make the minimum-variance frontier of risky assets and take all individual assets that lie to the right inside the frontier and than the efficient of risky assets are all portfolios lying on the frontier upward from the global-min variance portfolio
What are practical problems with the Markowitz model?
Computationally-intense
Possibly wrong results
Assumes the normal distribution
What are the solutions for the Markowitz problems?
- Heuristic approach
- Bayesian approach where we specify a prior distribution of expected returns and var-covariance matrix
- Bootstrapping approach, where we draw repeatedly a sample of return from assets empirical return distributions
What is the difference between risk pooling and sharing?
Adding uncorrelated risky project to the investors portfolio and allowing other investors to share in the risk of a portfolio of assets
