mean-variance analysis
the optimal allocation of assets between risky and risk-free assets when the investor knows the expected return and standard deviation of those assets
1. all investors are risk averse; they prefer less risk to more for the same level of return
2. expected returns for all levels of assets are known
3. the variances and covariances of all asset returns are known
4. Investors need to know only the expected
Assumptions for mean-variance efficiency analysis
efficient portfolio
offers the highest level of return for a given level of risk as measured by standard deviation in modern portfolio theory
efficient frontier
a plot of the set of expected returns and standard deviations for all efficient portfolios
minimum variance frontier
set of all portfolios that represent the lowest level of risk that can be achieved for each possible level of return
Global Minimum Variance Portfolio
the portfolio with the lowest variance of all the portfolios, with the lowest level of risk to be achieved
lower; weighted average
Given two assets and just varying the correlation, we see the following:
-the lower the correlation, the __________ the standard deviation of the portfolio
-if the correlation is perfect, positive (p=1), the portfolios standard deviation is the __________
capital allocation line (CAL)
the optimal expected return and standard deviation combinations available from combining risky assets with a risk-free asset
the Sharpe ratio
What is the slope of the capital allocation line?
capital market line
represents the case in which all investors have the same expectations and, therefore, hold the same risky portfolio as the tangency portfolio
Capital Asset Pricing Model (CAPM)
describes the expected return to any asset as a linear function of its "beta
market risk premium
E[Rm] - Rf
beta
a measure of the asset's sensitivity to market movements; it is an elasticity measure
1. investors only need to know the expected returns, the variances, and the covariances of returns to determine which portfolios are optimal for them
2. Investors have identical views about risky asset's mean returns, variance of returns, and correlations
CAPM assumptions
security market line
The graphical depiction of the CAPM
Markowitz decision rule
provides several principals by which investors can determine how to allocate their assets
high
Do you want a sharpe ratio to be high or low?
beta
what is the slope of the CAPM?
weighted average of the beta
In portfolio analysis, that is portfolio risk for the stocks in the portfolio?
diversifiable risk/unsystematic risk/company-specific risk
the risk that goes away as we add assets
Non-Diversifiable Risk/market risk/systematic risk
risk that cannot be reduced by adding more assets
Modern Portfolio Theory (MPT)
the idea that we can reduce the risk of a portfolio by introducing assets whose returns are not highly correlated with one another