# FINA 462 Exam 2

variance

equal to the weighted sum of the squares of the derivation from the expected or arithmetic average return

standard deviation

is the square root of the variance

variance and standard deviation are measures

of risk and the variability of returns

covariance

absolute measure of the tendency of two return series to move together overtime or different states of nature

(covariance) number means the truants tend to move in

opposite directions

(covariance)positive number means the truants tend to move in the

same directions

correlation coefficient

relative measure of the tendency of tow return series to co-vary together over time or different states of nature

the greatest diversification benefit is created by including asset classes in a portfolio whose returns are

negatively correlated

how many terms are in the matrix?

n*n or n^2

how many variance terms?

n

how many covariance terms?

n^2-n

how many unique covariance terms?

(n^2-n)/2

Do the variance terms or covariance terms increase in importance as securities are added to the portfolio?

covariance terms

What is market risk measured by?

Beta

Beta

measure of how sensitive a security's returns are to market returns

A portfolio is efficient if...

it offers the highest expected return for a given level of risk or the least amount of risk for a given expected return

a normal distribution can be described entirely using its first two moments:

mean and variance (mean-variance analysis)

market portfolio (consisting of all risky assets)

..if every investor prefers the same risky portfolio

Investment decision: Which risky Markowitz-Efficient portfolio do I invest in?

all investors choose portfolio M as their risky portfolio

Financing decision: how do i finance the acquisition of portfolio M?

each individual adjusts for their personal reeks preferences by borrowing or lending at the risk-free rate

Implications of CAPM

1. benefits of diversification
2. investors require extra return for riskier investments
3. benefits of indexing

single factor model

predicts a security's return is solely a function of its market risk

What type of model is CAPM?

single factor model

Arbitrage Pricing Theory is what type of model?

multi-factor model

The biggest disadvantage of APT-based models is..

that the throes itself does not specify the factors that affect returns

company cost of capital

the expected return on a portfolio of all the company's EXISTING securities

the opportunity cost of capital depends on...

the use to which that capital is put

Pure plays companies

public firms that specialized in ONE activity