Equity markets 15 - Answer Indifference curves represent...

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Chapter 7 Capital Allocation Between the Risky Asset and the Risk-Free Asset Short Answer Questions 39. Discuss the differences between the asset allocation decision and the security selection decision. Answer: The asset allocation decision involves the choice of the proportion of the overall portfolio to be invested in broad general asset categories. In general, this decision should be the first step in the portfolio management process (after determining the investor's level of risk tolerance. The security selection decision describes the choice of which specific securities to hold within each broad asset classification group. As asset allocation and security selection are the two major components of portfolio formation, it is important that the student is able to distinguish between the two, and to understand the roles of each in portfolio management. Difficulty: Easy 40. Discuss the characteristics of indifference curves , and the theoretical value of these curves in the portfolio building process
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Unformatted text preview: Answer: Indifference curves represent the trade-off between two variables. In portfolio building, the choice is between risk and return. The investor is indifferent between all possible portfolios lying on one indifference curve. However, indifference curves are contour maps, with all curves parallel to each other. The curve plotting in the most northwest position is the curve offering the greatest utility to the investor. However, this most desirable curve may not be attainable in the market place. The point of tangency between an indifference curve (representing what is desirable) and the capital allocation line (representing what is possible). is the optimum portfolio for that investor. This question is designed to ascertain that the student understands the concepts of utility, what is desirable by the investor, what is possible in the market place, and how to optimize an investor's portfolio, theoretically. Difficulty: Moderate Bodie, Investments, Sixth Edition...
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