Ch. 7 Reading

Potential ( ) ( ) of returns requires us to pay attention to risk measures that focus on worst-case losses such as value at risk (VaR) ( ) ( ) or (ES).

- Non-Normality - Expected Shortfall

Which part of the investment decision depends on an investor's attitudes toward risk?

Capital Allocation

Depends on an investor's risk preferences Requires covariances as inputs Is an optimization problem All investors with identical input lists will hold an identical one Solution is a portfolio with the highest possible Sharpe Ratio Solution includes the risk free asset

- Complete Portfolio - Risky Portfolio - Both - Risky Portfolio - Both - Complete Portfolio

Which statements are true of the optimal risky two-asset portfolio? Define the variables as in the text. Recall that E(RD) is the expected excess return of D and E(rD) is its expected return.

- It is given by the formula wD = E(RD)σ2E−E(RE)Cov(RD,RE)/E(RD)σ2E+E(RE)σ2D−[E(RD)+E(RE)]Cov(RD,RE) - It solves the Sharpe ratio maximization problem

Which statements about the expected return of a two-asset portfolio are correct? Define the expected return of asset D as E(rD), the weight on asset D as wD, the expected return of asset E as E(rE), and the weight on asset E as wE.

- It is given by the formula wD E(rD) + wE E(rE). - It is the weighted average of the component security expected returns with the investment proportions as weights.

Which statements about the variance of a two-asset portfolio are correct? Define the variance of asset D as σD2, the weight on asset D as wD, the variance of asset E as σE2, the weight on asset Eas wE., and the covariance of the asset returns as Cov(rD,rE). [Recall that a variance is the covariance of an asset with itself.]

- It is the weighted sum of covariances, where each weight is the product of the portfolio proportions of the pair of assets in the covariance term. - It is given by the formula w;0; + w;o + 2 wD wE Cov(rD,rE)

Which parts of the investment decision form the optimal risky portfolio?

- Security Selection - Asset Allocation

Which statements are true about portfolios, capital allocation lines (CALs), and Sharpe ratios?

- Steeper CALs provide higher excess returns for any level of risk. - The higher the Sharpe ratio, the steeper the capital allocation line.

Which statements about diversification of two-asset portfolios are true?

- The benefit of diversification is that the standard deviation of a portfolio is lower than the weighted average standard deviation. - Portfolios of less than perfectly correlated assets always offer some degree of diversification benefit.

Which statements are true of the efficient frontier as depicted in the figure?

- The optimal risky portfolio is the one on it with the highest Sharpe ratio. - It is the part of the minimum-variance frontier that lies above the global minimum-variance portfolio.

Examples of a type of constraint aimed at ruling out investments in industries or constraints considered ethically or politically undesirable are:

- environmental - social - governance-focused

The standard deviation of a two-asset portfolio is less than the weighted average of the individual security standard deviations if the correlation of the two assets is

- equal to zero - less than zero - equal to negative one - less than one

The risk that ______ extensive diversification is called _____ risk.

- remains even after; market - can be eliminated by; unique

portfolio opportunity set for p = -1 for p = 1

- shows all combinations of portfolio expected return and standard deviation that can be constructed from the two available assets - The portfolio opportunity set reveals the maximum advantage from diversification the portfolio opportunity set reveals the maximum advantage from diversification - The correlation between the two funds is perfectly positive. the correlation between the two funds is perfectly positive.

Viewing the investment decision as a top-down process, order the steps of portfolio formation.

1. Capital Allocation 2. Asset Allocation 3. Security Selection

Order the steps for finding the optimal complete portfolio

1.) Specify the return characteristics of all securities 2.) Calculate the optimal risky portfolio P 3.) Determine the properties of portfolio P 4.) Calculate the fraction of the complete portfolio allocated to portfolio P and to the risk-free asset 5.) Calculate the share of the complete portfolio invested in each asset

Spreading a portfolio over many investments to avoid excessive exposure to any one source of risk is the definition of

Diversification

True or false: The input list is comprised of a set of expected rates of return and a standard deviation matrix.

False

True or false: The minimum-variance portfolio has a standard deviation larger than that of either of the individual component assets.

False

The set of parameters such as expected returns, variances, and covariances necessary to determine the optimal risky portfolio is referred to as the ( ) ( )

Input List

The expected return-standard deviation pairs of all portfolios that can be constructed from a given set of assets is referred to as the ( ) ( ) set.

Portfolio Opportunity

Constraints that restrict investment strategies or vehicles ______ the Sharpe ratio of that portfolio.

Reduce

Which of the following is an example of risk sharing?

Selling portions of a risky portfolio to outside investors

The idea that portfolio choice can be separated into two independent tasks--first, determination of the optimal risky portfolio and second the choice of the optimal complete portfolio--is referred to as the ___________, Correct Unavailable property.

Seperation

The idea that portfolio choice can be separated into two independent tasks--first, determination of the optimal risky portfolio and second the choice of the optimal complete portfolio--is referred to as the ( )

Seperation Property

The reward-to-volatility measure was firs used extensively by William __ thus giving the ratio its name.

Sharpe

The portfolio's risk premium in excess of the risk-free rate, divided by the standard deviation, is referred to as its

Sharpe Ratio

Which of the following is NOT involved with establishing the risky portfolio (asset allocation)?

Specify the return characteristics of all securities (expected returns, variances, covariances)

Extensive diversification can be expected to ______ firm-specific risk.

Substantially Reduce

Sharpe Ratio

That ratio of the risk premium to the standard deviation of the excess returns is known as the reward-to-volatility or the _ ratio.

The graph representing a set of portfolios that maximize expected return at each level of portfolio risk is called the ( ) ( ) of risky assets.

efficient frontier

The portfolio of risky assets with lowest risk is referred to as the ( )- ( ) portfolio.

minimum variance

The primary assumption in the portfolio optimization techniques is that asset returns have a(n) _____ distribution.

normal

Risk sharing is a complement to risk

pooling

Spreading your exposures across multiple uncorrelated risky ventures or by investing in many risk assets is referred to as risk

pooling

When many investors each take a portion of portfolio of a given size it is referred to as risk

sharing

In the case of perfect correlation, all risk is

systemic

As portfolios become more diversified, the impact of a new security on portfolio risk is primarily driven by

the covariance of the security with the portfolio components