Question

1. a) Define the following:

1. Capital Allocation to Risky assets
2. Complete Portfolio
3. Sharpe Ratio
4. Mean – Variance Analysis
5. Passive Strategy

b) What features of the money markets securities distinguish them from other fixed-income

     securities?

Answer 1

a. Define the following

i. Capital Allocation to Risky assets - Allocation of the portfolio to a risky asset along with risk free asset is capital allocation to Risky asset. Risky asset are equities, Real estate etc. If this portfolio consists of a risky asset with a proportion of y, then the proportion of the risk-free asset must be 1 – y.  

ii. Complete Portfolio - In constructing portfolios, investors often combine risky assets with risk-free assets (such as government bonds) to reduce risks. A complete portfolio is defined as a combination of a risky asset portfolio, with return R_p, and the risk-free asset, with return R_f.

iii. Sharpe Ratio - The ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits associated with risk-taking activities. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

iv. Mean – Variance Analysis - Mean-variance analysis is the process of weighing risk, expressed as variance, against expected return. Investors use mean-variance analysis to make decisions about which financial instruments to invest in, based on how much risk they are willing to take on in exchange for different levels of reward. Mean-variance analysis allows investors to find the biggest reward at a given level of risk or the least risk at a given level of return.

v. Passive Strategy - Passive investing is an investment strategy to maximize returns by minimizing buying and selling. Index investing in one common passive investing strategy whereby investors purchase a representative benchmark, such as the S&P 500 index, and hold it over a long time horizon. It is also defined as the strategy in which investor replicate and track the index.

b) What features of the money markets securities distinguish them from other fixed-income securities?

Ans.

Money Market Securities are more liquid than other Fixed income securities

They have maturity less than a year whereas others will generally have more than a year. Also, since maturity period is less than 1 year and and are more liquid, risk is low for money market securities.