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Basic financial terms and APT 2-factor models

I have some practice work to complete and I have no idea how to do it. This is in preparation for an exam later. I am doing the practice work in my chapters and need some help understanding. The questions are regarding basic financial terms and an APT 2-factor model.


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Define the following terms, using graphs or equations to illustrate your answers wherever feasible:

A. Portfolio; feasible set; efficient portfolio; efficient frontier

A portfolio is a group of financial assets, differing in possible risk and return, and is managed by an investor or a group of professionals. Generally, a higher return expected by a portfolio owner generates a higher risk as well, and vice versa. The mix of financial assets can range, and these can include stocks, bonds, mutual funds, and cash equivalents. Stocks are considered the most volatile of these options and thus generate the highest return/highest risk, with bonds being one of the safer options, which only generate a low return/low risk.

A feasible set of portfolios refers to the possible combinations of financial assets that an investor can have, according to his/her risk tolerance, investment goals, and resources. However, this does not necessarily mean that they are efficient.

An efficient portfolio refers to the set of feasible portfolios of financial assets that an investor can have for either i) the greatest return expected for a certain risk level, or ii) the lowest risk for a certain expected return.

An efficient frontier is composed of the set of efficient portfolios available to the investor, reliant on the portfolios giving the highest expected return for a specific risk level, and the portfolios giving the lowest risk for a targeted expected return. The y-axis represents the expected returns, while the x-axis represents the risks (standard deviations of returns). Diversification, thus composing one's portfolio of several financial assets rather than just one, is also a determinant factor. In contrast to portfolios with less diversification, which tend to be sub-optimal and below the curve, the efficient frontier curve outlines diversified portfolios that are optimal. This is depicted by the graph attached.

{See Graph 1}

As outlined in the example diagram provided by YoungResearch, the efficient frontier adequately demonstrates the impact of diversification, showing how it is a factor in determining the curve's optimal portfolios, determined by the amounts of risk (measured by standard deviation of annual returns) and return (average of annual returns). For example, a portfolio with only 100% stocks would generate a large return of 12.5%, though also a large risk of 17%. This is the opposite to a portfolio of 100% bonds, where the return ...

Solution Summary

A few basic definitions are highlighted and illustrated with the usage of graphs, diagrams, and pictures. Additionally, an APT 2-factor model problem is solved.