Question

Short questions and definitions. Briefly define the following objects or terms (at most 100one sentence) and provide examples if necessary:

1. (a) State the Sharpe ratio and explain its use.

2. (b) What is meant by an efficient portfolio? Explain.

3. (c) What does correlation measure? Provide an example of its use.

4. (d) Define asset beta and give an example of its use.

5. (e) Define agency conflict and give and an example.

Answer 1

(a)

Sharpe ratio

Sharpe ratio is the difference between expected return of portfolio and risk free rate divided by standard deviation of the portfolio.

Use

It is used to measure the performance of an investment compared to a risk-free asset, after adjusting for its risk. In other words it determines the excess of portfolio or average return to the risk free rate per one unit of volatility (standard deviation). It is used to evaluate past performance of portfolio when actual return are given.

(b)

Efficient portfolio

Efficient portfolio is the portfolio which gives the best possible expected return of portfolio at a given level of risk. In other words, it is a portfolio that offers the highest expected return for a given level of risk or a portfolio that provides minimum risk for a given expected return. It is also called as optimal portfolio.

(c)

Correlation

Correlation is used to measure the strength of a linear relationship between two variables. It describes the statistical relationship between two variables.

Example of use

For example, given two different securities from which we need to construct a optimal portfolio. Then the correlation will help us to provide the covariance of the two securities used to calculate the weight of each security in the optimal portfolio. Covariance = correlation * standard deviation of security1 * standard deviation of security2 so on.

(d)

Asset beta

Asset beta also known as unlevered beta is the beta of the company without considering the effect/impact of debt. It determines the volatility of a company without considering the financial leverage.

Example of use

It is mostly used in company valuation for professionals working in investment banking or equity research where they measure the company’s performance in relation to market and without considering debt.

(e)

Agency conflict

Agency conflict refers to conflict of interest between two parties. In corporate finance it refers to conflict of interest between a company's management and the company's stockholders. It occurs when company’s managers who act as agents intend to maximize their own wealth instead of looking for stockholder wealth.

Example

In 2001, energy giant Enron filed for bankruptcy. This was due to agency problem. The company's officers and board of directors were selling their Enron stock at higher prices due to false accounting reports that made the stock seem more valuable than it truly was. After the scandal was uncovered, thousands of stockholders lost millions of dollars as Enron share values plummeted.