Lecture 2

Question 1

What is correlation

Answer 1

Correlation measures how returns move in relation to each other. It is between +1 (returns always move together) and -1 (returns always move in opposite way)

Question 2

Skewness

Answer 2

Skewness for a normal distribution is zero, and any symmetric data
should have a skewness near zero
• Negative values for the skewness indicate data that are skewed left
• Positive values for the skewness indicate data that are skewed right

Question 3

Positive and negative Kurtosis

Answer 3

• Positive excess kurtosis indicates a “peaked” distribution

- Negative excess kurtosis indicates a “flat” distribution

Question 4

Leptocurtic Distribution

Answer 4

Leptocurtic Distribution - K > 3
A distribution with wide tails and a tall narrow peak is called leptokurtic
Compared with a normal distribution, a larger fraction of the returns are at the
extremes rather than slightly above or below the mean of the distribution

Question 5

Platykurtic Distribution

Answer 5

Platykurtic Distribution - K

Question 6

Which returns are better Leptocurtic or Platykurtic

Answer 6

Leptocurtic

Question 7

Why Leptocurtic Returns?

Answer 7

• Low probability of extreme outcomes
• Regulatory process (e.g. managed exchange rate) dampens moderately
  deviant returns, forcing them closer to the mean than they would have been
  otherwise

Question 8

Simple diversification

Answer 8

• Invest an equal amount in each of N assets
  • Portfolio weight 1/N
• Select the assets randomly
• The portfolio is well-diversified if N is reasonably large and fully
  diversified if N → ∞

Question 9

More advanced diversification

Answer 9

• Pick assets and determine optimal weights using the variance
  covariance structure of the returns
  • Exploits the trade-off between risk and return by using a
  maximizing criterion – e.g. expected utility maximization

Question 10

Why Portfolio variance equals

the average covariance

Answer 10

• Gauges the systematic risk
  that affects all assets
• Unique risk (individual variances)
  diversified away

Question 11

Diversification

Answer 11

Strategy designed to reduce risk by spreading

the portfolio across many investments.

Question 12

Unique Risk

Answer 12

Risk factors affecting only that firm

- Also called “diversifiable risk”

Question 13

Market Risk

Answer 13

Economy-wide sources of risk that affect the
overall stock market
- Also called “systematic risk”
- Reason why stocks have a tendency to move together – common factor affecting all stocks

Question 14

What does correlation measure

Answer 14

Correlation measures how returns move in relation to each other