Finance 865 Exam 2

What happens to the minimum variance portfolio as the correlation between the assets change.

-Correlation has no effect on the expected return of a portfolio. However the volatility of the portfolio can change based on what the correlation is. The less correlation the less volatility in that portfolio. The expected return will not change but the volatility can.

• What does correlation mean?

-Correlation is a measure of how 2 asset returns move together. -If assets are perfectly negatively correlated, then 100% of variation can be reduced. Stocks always move oppositely -If assets are perfectly positively correlated, then no reduction in risk is possible. Stocks always move together. -Choosing assets with low correlation between each other helps reduce risk.

What is unsystematic risk (Firm Specific, Diversifiable)?

-Good or bad news about an individual company -When many stocks are combined in a large portfolio, the firm-specific risks for each stock will average out and be diversified.

• What is the tradeoff between risk and return?

-Higher risk requires a higher expected return. -Lower risk requires a lower expected return

Can you use Alpha to make money?

-Investor behavior must push prices so that non-zero alpha opportunities exist - Investors can improve the performance of our portfolio by selling stocks with negative alphas. -For an investor to earn a positive alpha and beat the market, some investors must hold portfolios with negative alphas.

What are the limitations of Alpha?

-It depends on the accuracy of your Beta estimate -A negative Alpha could result from manager incompetence or the impact of fees on the returns -A high Alpha could be a sign of an expert manager or just dumb luck -Can you really beat the market?

What is systematic risk (Market-Wide, Undiversifiable)?

-News that affects all stocks, such as news about the economy - will affect all firms and will not be diversified

What happens when you allow short selling?

-Short selling increases the expected return of your portfolio, but also its volatility, above those of the individual stocks. -a transaction in which you sell a stock today that you do not own, with the obligation to buy it back in the future. +Good strategy if you expect the stock price to decline in the future.

What is the Sharpe Ratio

-The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. -Measures the ratio of reward-to-risk provided by a portfolio -The portfolio with the highest Sharpe ratio is the portfolio where the line with the risk-free investment is tangent to the efficient frontier of risky investments. The portfolio that generates this tangent line is known as the tangent portfolio.

How could you estimate alpha from a regression?

-The alpha coefficient is the intercept of the regression of excess returns on Asset I relative to excess returns on the market

What is Alpha?

-To improve the performance of their portfolios, investors will compare the expected return of a security with its required return from the security market line. -Therefore the alpha indicates how an investment has performed after accounting for the risk involved

• What does covariance mean ?

-is the expected product of the deviations of two returns from their means. -Stocks move together their returns will be above or below average at the same time, covariance will be positive. -Stocks that move opposite directions one will be above average when the other is below, covariance will be negative. -The sign of covarariance is easy to interpret but the magnitude is not.

What is the Security Market Line?

-is the line along which all individual securities should lie when plotted according to their expected return and beta. -When the market portfolio is efficient, all stocks are on the security market line and have an alpha of zero.

What is the efficient frontier?

-is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return -Also show the best possible risk and return combinations that we can obtain by optimal diversification.

• What does standard deviation mean?

-measures the amount of dispersion around a variables mean, both above and below. -is used to measure risk. -The higher the standard deviation the higher the risk.

What is the Capital Market Line?

-which is the line from the risk-free investment through the market portfolio, represents the highest-expected return available for any level of Investment volatility.

Be able to calculate the expected return and standard deviation of a 2 asset portfolio as well as the minimum variance portfolio

1. Expected return -E(rp) = w1 r1 + w2r2 2. Standard Deviation - Make sure to square root the answer 3. MVP - Refer to powerpoint

Which of the following assets would be expected to have the lowest risk? Stock in one of the smallest sized companies in the S&P 500 Stock in one of the 100 largest companies in the S&P 500 A portfolio made up of only mid-cap US stocks. A portfolio made up of only large-cap US stocks like the S&P 500.

A portfolio made up of only large-cap US stocks like the S&P 500.

Which of the following statements is FALSE? Because investors are risk averse, they will demand a risk premium to hold unsystematic risk Over any given period, the risk of holding a stock is that the dividends plus the final stock price will be higher or lower than expected, which makes the realized return risky The risk premium for diversifiable risk is zero, so investors are not compensated for holding firm-specific risk Because investors can eliminate firm-specific risk "for free" by diversifying their portfolios, they will not require a reward or risk premium for holding it

Because investors are risk averse, they will demand a risk premium to hold unsystematic risk

How can you tell if you can improve the performance of your portfolio by adding another asset?

By calculating the portfolios expected return and standard deviation to see if adding another asset could improve the performance.

Almost all of the correlations between stocks are negative, illustrating the general tendency of stocks to move together

False

The closer the correlation is to 0, the more the returns tend to move together as a result of common risk.

False

The variance of a portfolio depends only on the variance of the individual stocks

False

Without trading, the portfolio weights will decrease for the stocks in the portfolio whose returns are above the overall portfolio return.

False

In the real world, what are alphas for most mutual funds?

Most alphas are negative.

Which of the following statements is FALSE? Expected return should rise proportionately with volatility. Investors would not choose to hold a portfolio that is more volatile unless they expected to earn a higher return. Smaller stocks have lower volatility than larger stocks. The largest stocks are typically more volatile than a portfolio of large stocks

Smaller stocks have lower volatility than larger stocks.

Because we normally use the standard deviation as a measure of risk, which of the following is TRUE? The riskiness of an asset will only decrease if positive returns occur. The riskiness of an asset will only increase if negative returns occur. The average annual return for a given asset is 5%. If next year this asset has a very good year and makes a 12% return, the riskiness of the asset will increase . All of these answers are TRUE

The average annual return for a given asset is 5%. If next year this asset has a very good year and makes a 12% return, the riskiness of the asset will increase

What trading anomalies show that alpha is not zero?

The average investor earns an alpha of zero before trading cost. Investors actual return on the average mutual fund is a negative alpha. Most fund managers appear to trade so much that the trading costs exceed profits.

Which of the following is NOT a diversifiable risk? The risk that oil prices rise, increasing production costs The risk of a product liability lawsuit The risk that the CEO is killed in a plane crash The risk of a key employee being hired away by a competitor

The risk that oil prices rise, increasing production costs

Which of the following is NOT a systematic risk? The risk that oil prices rise, increasing production costs The risk that the Federal Reserve raises interest rates The risk that the economy slows, reducing demand for your firm's products The risk that your new product will not receive regulatory approval

The risk that your new product will not receive regulatory approval

How do you find the efficient portfolio?

To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free investment.

The excess return is the difference between the average return on a security and the average return for

Treasury Bills

A stock's return is perfectly positively correlated with itself

True

The correlation between two stocks has the same sign as their covariance, so it has a similar interpretation

True

The expected return of a portfolio is equal to the weighted average expected return, but the volatility of a portfolio is less than the weighted average volatility.

True

The volatility declines as the number of stocks in a portfolio grows.

True

Which of the following statements is FALSE? While the sign of the correlation is easy to interpret, its magnitude is not While the sign of the correlation is easy to interpret, its magnitude is not Independent risks are uncorrelated When the covariance equals 0, the returns are uncorrelated To find the risk of a portfolio, we need to know more than the risk and return of the component stocks; we need to know the degree to which the stocks' returns move together

While the sign of the correlation is easy to interpret, its magnitude is not