Lecture 9: Portfolio risk & return, diversification, expected value, variance, standard deviation

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15 Terms

1
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What is the formula to measure portfolio risk?

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2
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What is covariance?

Capture how much 2 securities move together

<p>Capture how much 2 securities move together</p>
3
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What is the extreme case where correlation = -1?

Securities a and b move in opposite directions

  • 1 moves up, other moves down proportionally

  • risk reduction

<p>Securities a and b move in opposite directions</p><ul><li><p>1 moves up, other moves down proportionally</p></li><li><p>risk reduction</p></li></ul><p></p>
4
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What is the extreme case where correlation = 1?

The 2 securities move in sync

  • 1 moves up, other moves up

  • no diversification/risk reduction benefit

5
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What is the normal case where the correlation = 0.35?

Buy 2 random stocks → some co-movement

  • a little diversification

  • some risk reduction, not a lot (don’t put all eggs in 1 basket)

<p>Buy 2 random stocks → some co-movement</p><ul><li><p>a little diversification</p></li><li><p>some risk reduction, not a lot (don’t put all eggs in 1 basket)</p></li></ul><p></p>
6
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What is the modern portfolio theory of the efficient frontier?

Minimize standard deviation for a given expected return

  • by changing portfolio weights & finding the respective E[R] → gives you the curve

  • any point on the curve is better than a single point off the curve (better reward for same level of risk)

<p>Minimize standard deviation for a given expected return</p><ul><li><p>by changing portfolio weights &amp; finding the respective E[R] → gives you the curve</p></li><li><p>any point on the curve is better than a single point off the curve (better reward for same level of risk)</p></li></ul><p></p>
7
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What are the limits of diversification?

  • Systematic (market) risk: more securities you get, more co-variances you get → can’t get rid of co-variances

  • Unsystematic risk: risk specific to each firm which can be eliminated through diversification

<ul><li><p>Systematic (market) risk: more securities you get, more co-variances you get → can’t get rid of co-variances</p></li><li><p>Unsystematic risk: risk specific to each firm which can be eliminated through diversification</p></li></ul><p></p>
8
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What is international diversification?

There are more benefits to investing outside of Canada → more diversification, higher E[R], lower risk

9
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What are the benefits of combining a risky portfolio and a risk-free asset?

Ability to invest in risk-free asset will ensure a positive return, which will give you leverage to start at A and eventually invest more towards B

  • M is efficient → highest E[R] relative to risk

  • points on graph depends on your risk preference

<p>Ability to invest in risk-free asset will ensure a positive return, which will give you leverage to start at A and eventually invest more towards B</p><ul><li><p>M is efficient → highest E[R] relative to risk</p></li><li><p>points on graph depends on your risk preference</p></li></ul><p></p>
10
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What is Beta?

A systematic risk measure → need for market portfolio

  • standard deviation is still a good measure of risk, but Beta is good for a single security

<p>A systematic risk measure → need for market portfolio</p><ul><li><p>standard deviation is still a good measure of risk, but Beta is good for a single security</p></li></ul><p></p>
11
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What is the portfolio beta?

  • Diversification reduces unique risk, but not market risk

Calculates the beta of a portfolio as the weighted average of securities individual betas

<ul><li><p>Diversification reduces unique risk, but not market risk</p></li></ul><p>Calculates the beta of a portfolio as the weighted average of securities individual betas</p>
12
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What is the security market line?

Line that shows all combinations of security & portfolio

  • line is an equilibrium → the securities adjust

<p>Line that shows all combinations of security &amp; portfolio</p><ul><li><p>line is an equilibrium → the securities adjust</p></li></ul><p></p>
13
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What is the capital asset pricing model?

Forecasts the expected returns of individual stocks

<p>Forecasts the expected returns of individual stocks</p>
14
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What does it mean when the expected result using the capital asset pricing model is less than the risk free rate?

This means when the market goes down, this company goes up

  • Hedge → a company booms when everyone else suffers (acts as insurance)

  • cost of this insurance is getting less than risk free rate

<p>This means when the market goes down, this company goes up</p><ul><li><p>Hedge → a company booms when everyone else suffers (acts as insurance)</p></li><li><p>cost of this insurance is getting less than risk free rate</p></li></ul><p></p>
15
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What are some concerns of the capital asset pricing model?

  • Real estate & human capital is not included

  • Momentum → strategy where assume stocks that performed well previously will perform will in the future