Efficient divesification

What is the goal of efficient diversification in portfolio management?

To construct portfolios that provide the lowest possible risk for any given level of expected return.

What are the two sources of risk that affect stock returns?

General economic conditions and firm-specific factors.

How does diversification impact firm-specific risk?

Diversification can reduce firm-specific risk, also known as unique risk or nonsystematic risk.

What type of risk cannot be diversified away?

Market risk, also known as systematic risk or non-diversifiable risk.

What is risk pooling in the context of diversification?

Risk pooling refers to combining many independent sources of risk to reduce overall risk.

Define covariance in finance.

Covariance measures the tendency of asset returns to vary in tandem.

What does the correlation coefficient indicate?

The degree of covariance of two variables on a scale of -1 to 1.

How is the expected rate of return on a portfolio calculated?

It is the weighted average of the expected returns on the component securities.

What is the significance of the efficient frontier?

It represents the set of optimal portfolios that offer the highest expected return for a given level of risk.

What does the separation property imply in portfolio management?

It implies that portfolio choice can be separated into two tasks: determining the optimal risky portfolio and personal choice of the best mix of risky and risk-free assets.

In the context of the Treynor-Black Model, how is the weight of an added security determined?

The weight is determined by the variable w0_i adjusted by the security's beta.

What is the formula for the variance of the rate of return on a two-risky-assets portfolio?

σ²_P = (wB σB)² + (wS σS)² + 2(wB σB)(wS σS)ρBS.

What is meant by the mean-variance criterion?

Investors will prefer assets with higher mean returns and lower variance.

What is the role of the alpha and beta in the index model?

Alpha signifies the expected excess return when the market excess is zero, while beta measures a security's sensitivity to market movements.

What does a high R-squared value indicate in an index model?

It indicates that market factors dominate firm-specific factors in explaining stock returns.

How can one adjust a beta estimate for better predictive power?

By using a weighted average between the sample average and 1.

What does the optimal portfolio consist of when mixing risky assets with safe assets?

It is the best combination of risky assets that maximizes the Sharpe ratio.

What are T-bills in the context of an optimal risky portfolio?

T-bills are considered risk-free assets that can be added to create capital allocation lines (CALs) with portfolios.