Ch.6 Investments

What are the two broad sources of uncertainty in investments?

General economic conditions (Market Risk) and risk to a specific company.

What factors contribute to the market risk of an investment?

Inflation and interest rates.

What does the expected return on each fund represent?

It is a probability-weighted average of the outcomes.

How do stocks and bonds behave during recessions?

Bonds typically perform better than stocks in mild and severe recessions.

What is the significance of covariance in portfolio management?

Covariance measures how the returns on two securities move together, indicating diversification benefits.

What is the formula for calculating covariance?

COV = (X1 - X2)(Y1 - Y2), where X1 & Y1 are individual returns, and X2 & Y2 are expected returns.

What are the three rules of risky asset portfolios?

1. Portfolio return is the weighted average of returns on component securities. 2. Expected Portfolio return is similarly the weighted average of expected returns. 3. Variance of return on a two-risky-assets portfolio depends on correlation and individual asset variances.

What is the investment opportunity set?

The set of available portfolio risk-return combinations.

Where do investors typically want their portfolios located on the risk-return graph?

In the northwest part of the graph where there are higher expected returns for a given level of risk.

What does a higher Sharpe ratio indicate?

It indicates a greater expected return corresponding to any level of volatility.

What characterizes the efficient frontier in portfolio theory?

It is a graph representing portfolios that maximize expected return for each level of portfolio volatility.

What are the three methods to produce an efficient frontier?

1. Maximize expected return for a level of standard deviation. 2. Minimize standard deviation for a level of expected return. 3. Maximize Sharpe ratio for any standard deviation.

What are index models in finance?

Models that relate stock returns to broad market indices and firm-specific factors.

What does the Separation Property imply in portfolio choice?

It separates the tasks of determining the optimal risky portfolio and choosing the mix of this portfolio with a risk-free asset.

What does Beta represent in finance?

Beta is the sensitivity of a security's returns to market factors.

What is Alpha in investment terms?

Alpha is the stock's expected return beyond that induced by the market index.

What is residual risk?

The component of return variance that is independent of market factors.

What is the Security Characteristic Line (SCL)?

A plot of a security's predicted excess return from the excess return of the market.