Chapter 6 Portfolio Theory

What is the significance when the standard deviation of returns is zero?

Because the return on the risk free asset is the same in every state of nature , the return is always equal to its average (expected value) so the difference in the parentheses is always zero.

______________ also measures the amount of market (systematic) risk possessed by an individual asset.

Beta

______________ is the key measure of risk for large portfolio holders. It shows the marginal contribution of an individual asset to the overall risk of the market portfolio.

Beta

To understand a value-weighted portfolio, consider a market with two assets: the shares of ________________. and _______________.

Big Corp & Small Inc.

To lower the risk of your​ portfolio, you should add stocks​ that:

Have a low correlation with the stocks already in your portfolio.

What is the value-weighted portfolio?

In a value weighted portfolio, the portfolio weights are equal to the value of each asset relative to the total value of the assets in the portfolio.

What is risk-free asset?

An asset with no variation in its return and no risk of default. The best example is a U.S. government T-bill.

How do you evaluate its risk?

As you hold the market portfolio, you aren't concerned with the total risk of the stock because you can diversify away much of that risk in the portfolio.

Know the Portfolio Standard Deviation

*Look at the book*

What is beta?

- - The measure of systematic risk. Equal to the covariance of returns between the asset and the market portfolio divided by the variance of returns of the market. Measures the marginal change to the risk of the market portfolio from the changing quantity of a given asset. Also measures the amount of systematic risk in a given asset.

What does systematic risk include?

- Events such as wars, oil price shocks, surprise changes in monetary policy, and sovereign defaults. - They are events that affect all assets to some extent.

What is the exchange traded fund?

- Is simply a company (or trust) that holds a portfolio of assets. The companys shares (or the trust units) are listed on an exchange. - Investment companies, like mutual funds, that are legally classified as open-end companies or trusts. Most ETFs seek to achieve the same return as a particular market index, and so hold a basket of stocks that mimics the composition of the target index. There are a number of important differences between ETFs and indexed mutual funds. The ETF can be traded within the day, can be shorted, and can be purchased on margin.

Which of the following are correct statements about the​ risk-free asset?

- Its covariance with any other asset is zero. - Its variance of returns is zero. It has no default risk. - It generates the same return in every state of nature.

What is diversifiable risk?

- Risk associated with individual stock. - Risk that can be eliminated through diversification. Also called unsystematic risk or firm-specific risk.

What have learned?

- The market portfolio is value-weighted: the weights are the relative values of each asset in the portfolio. - According to Sharpe's model, all investors should optimally hold a portfolio with the same assets in the same proportions (and will earn the same return). - The market portfolio is the aggregation of the individual investor portfolios.

Sharpe's analysis showed that all investors hold two assets: (1)___________________________________________ from Markowitz's efficient set and (2) _________________________________

1). a common risky portfolio & 2). the risk-free asset.

When the correlation coefficient is equal to ____ , there's no bonus from diversification. & The ____________ standard deviation falls between the standard deviations of the individual securities.

1, portfolio

What is the stock market index?

A statistical indicator showing the relative value of a basket of stocks compared to their value in a base year. Indexes are created by a variety of entities (i.e., Standard and Poor's) using different baskets of stocks and different weighting schemes (i.e., value or price weighting). Indexes measure the ups and downs of the stock market.

________________ is the act of giving something variety. In the context of investing, diversification manages the risk of a portfolio by including a variety of assets.

Diversification

You can easily buy and sell __________ using an online brokerage account. Unlike mutual funds, __________ can be traded all through the day.

EFTs; EFTs

What did Markowitz call portfolios with the highest expected return?

Efficient set

As we diversify, what happens to risk?

Risk goes down.

What is Nondiversifiable risk?

Risk that cannot be eliminated through diversification. Also called systematic risk and market risk. Measured by beta.

What is unsystematic risk?

Risk that is not systemwide. This is risk that can be eliminated through diversification. Also called diversifiable risk or firm-specific risk.

What is systematic risk? (The term we mainly use)

Risk that is systemwide. Systematic risk cannot be eliminated through diversification. Also called nondiversifiable risk and market risk. Measured by beta.

What is William Sharpe add to Markowitz's efficient set?

Risk-free asset

What is the The most popular market proxy? the S&P 500 index and why? because it includes many of the largest companies in the country, so is highly correlated with the market portfolio.

S&P 500 index; because it includes many of the largest companies in the country, so is highly correlated with the market portfolio.

What is the significance The correlation of risk-free returns with the returns of any other asset is zero.

Since the standard deviation of returns for the risk-free asset is zero, the correlation is also zero. The covariance in te numerator is also zero, again because the return of the risk-free asset is always equal to its expected value in every state of nature.

What is the efficient set?

The set of all efficient portfolios across all levels of standard deviation. Harry Markowitz derived a formula for solving for the portfolio weights for each of the portfolios in the efficient set.

What is the new efficient set?

The set of portfolios formed by combining the risk-free asset and the market portfolio.

What type of risk affects all stocks to a greater or lesser extent and is due to large macroeconomic​ shocks?

Systematic​ (or nondiversifiable) risk.

It is guaranteed by the U.S. government, the ________________________ does not vary across states of nature (you always get 5%)

T-bill return

What is the capital asset pricing model (CAPM)?

The CAPM showed that investors who hold the market portfolio do not care about unsystematic risk. The CAPM yields a measure of systematic risk called beta and an equilibrium relationship between beta and expected returns.

What is diversification?

The act of giving something variety. In the context of investing, diversification manages the risk of a portfolio by including a variety of assets.

What is the marginal risk?

The increase in a portfolio's risk resulting from the addition of one more unit of a particular asset to the portfolio. With the market portfolio, marginal risk is measured by the beta of the asset.

What is the market portfolio?

The portfolio that includes every capital asset held in proportion to its market value relative to the market value of all assets in total

Where is the relevant risk?

The relevant risk is the marginal risk.

What is firm-specific risk?

The risk of holding one (or a few) firms in a portfolio. This is risk that can be eliminated through diversification. Also called diversifiable risk or unsystematic risk

What is market Risk?

The risk of holding the market portfolio. Market risk cannot be eliminated through diversification. Also called nondiversifiable risk or systematic risk.

The invariance of the return drives the following two facts about the risk-free asset: ___________________________________ ___________________________________

The standard deviation of returns is zero. & The correlation of risk-free returns with the returns of any other asset is zero.

What is naive diversification?

The strategy of investing equal amounts of money in a portfolio of randomly selected stocks. - is not the most effective approach to portfolio creation

True or​ False? Under​ Sharpe's model, investors only care about systematic risk.

True

The only truly risk-free asset is a ______ ___________ _____ ____________ ____________, since the return is known with certainty once the price is established.

U.S. government zero coupon bond

Sharpe called the set of all combinations of the two assets the ____________________________.

new efficient set

With less than perfect positive correlation, portfolio risk can be less than the least risky asset. That is the _______________ of diversification.

bonus

William Sharpe derived an equilibrium risk-return relationship for individual assets, which is now famous and is called the ___________________________________.

capital asset pricing model (CAPM)

If everyone holds a ___________________________________of risky assets, then that portfolio must contain every risky asset in the capital market.

common portfolio

We have learned that the effectiveness of diversification depends on the ______________ of the ____________.

correlation - returns.

isk can be divided into two parts: ______________ and ________________ risk.

diversifiable; nondiversifiable

we know that ____________________ reduces risk and that the reduction in risk depends on the correlation between the assets

diversification

True or False? A low-risk portfolio is constructed by selecting low-risk stocks.

false: - To build a low-risk portfolio we should collect stocks that are negatively correlated

Diversifiable risk is also called _____________ risk or_______________ risk.

firm-specific or unsystematic

What does unsystematic risks include?

include events such as strikes, input price shocks, loss of a major customer, or technological obsolescence. These events affect one firm or a few firms.

Your investment strategy is to hold a very large portfolio of stocks and make all of the portfolio weights equal. As you add more and more​ stocks, the standard deviation of your portfolio will​ _________.

include mainly systematic​ (or nondiversifiable) risk.

The only difference between ___________ are their ________________ weights for the two assets.

investors ; portfolio

how will the risk of the market portfolio change if you add one more share of this particular stock?

marginal risk is equal to the covariance between the returns on the asset and the market portfolio. We standardize the covariance by dividing it by the variance of returns on the market portfolio, and call the resulting measure beta.

Nondiversifiable risk is also called ______________ risk or _____________ risk.

market or systematic

Sharpe's ________________________ includes all risky assets—not just stocks.

market portfolio

The ______________________________ is very large and well diversified.

market portfolio ; Since it is in Markowitz's efficient set, it has no unsystematic (firm-specific) risk.

The common portfolio is called the ________________________________.

market portfolio.

The ______________________ is a value-weighted portfolio.

market portolio

Markowitz approached portfolio construction as an optimization problem: ___________ return and ___________ risk.

maximize and minimize

Markowitz's ______________ ________________ produces the portfolio weights for the best portfolio (highest expected return) at each level of standard deviation.

optimization routine

With perfect ____________ correlation, diversification can reduce risk, but the risk of the portfolio cannot fall below the level of the least risky asset.

positive

The security is only _______ _________ if there is no possibility of default. This is almost true for U.S. government bonds.

risk free

The most common proxy is a value-weighted ________________________________.

stock market index

The _________________________ is proportionate to beta. Stocks (and portfolios) with a large___________ have a large amount of systematic risk.

systematic portion ; beta

What does investors in the Sharpe's model care only about?

systematic risk.

ETF makes it easy for investors to __________________________ like the s&p 500 index.

trade market proxies

Because the weights of the market portfolio are the proportionate values, the market portfolio is a ______________________________________________.

value-weighted portfolio.