MPT

Question 1

4 MPT features

Answer 1

the way in which portfolios can be constructed to
maximise returns and minimise risks.

we cannot simply consider the potential risks and returns of an individual investment; relative to other

investors are risk averse and would choose a less risky investment if they were offered the choice of two with the same return.

a diversified portfolio of imperfectly correlated asset classes
can provide high returns with the least amount of volatility.

Question 2

SD features 3

Answer 2

measures volatility

and therefore risk

can have same expected return but wider SD

Question 3

SD rule of thumb

Answer 3

return can be expected to fall within one standard deviation of the average return roughly 68% of the time

and within two standard deviations roughly 95%

bell curve

Question 4

4 ways to diversify

Answer 4

correlation
overseas
sector
asset class

Question 5

Define EF 3

Answer 5

the relationship between the expected
return

and the risk of the portfolio as measured by the
standard deviation.

shows the best
return that can be expected for a given level of risk, or the lowest level of risk needed to
achieve a given expected return.

Question 6

3 ef inputs

Answer 6

• return of each asset;
• standard deviation of each asset’s returns; and
• correlation between each pair of assets’ returns.

Question 7

5 limitations of EF

Answer 7

• SD correct measure of risk and assumes assets have
  normally distributed returns.
• based solely on their attitude to
  risk, as investors may be concerned about other factors
• Inputs for risk and correlation between assets often rely on historical data - Correlations usually rise in a financial crisis, meaning that less risk will actually be
  diversified away
• The model does not include transaction costs when changing portfolio
• It assumes that the underlying portfolios in each asset class are index funds with the
  same characteristics as the input data.