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R02 > 04. Investment theory > Flashcards

04. Investment theory Flashcards

1
Q

What is Modern Portfolio Theory (MPT)?

A

An investment theory that allows investors to assemble an asset portfolio that maximizes expected return for a given level of risk.

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2
Q

What is a key assumption regarding investors’ risk profile in MPT, and what does that mean if they were offered a choice of two investments with the same return?

A
  • Investors are risk averse.
  • They would choose a less risky investment if they were offered the choice of two with the same return.
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3
Q

What does standard deviation measure?

A

It measures how widely the actual return on an investment varies around its average or expected return.

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4
Q

What does a large standard deviation signify?

A

Greater volatility & associated risk.

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5
Q

What are the calculations for 1, 2 and 3 standard deviations?

A
  • 68% of the time the returns expected to fall within 1 SD.
  • 95% of the time the returns expected to fall within 2 SDs.
  • 99% of the time the returns expected to fall within 3 SDs.
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6
Q

What is hedging?

A

A protection investment (bet) where if one falls in value, the other rises.

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7
Q

What can be used to achieve hedging?

A

Derivatives.

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8
Q

What is a futures contract?

A

An obligation for a seller to sell at a future date at a specified price.

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9
Q

What is a put option?

A

The right to sell at a specified price.

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10
Q

How does a put option differ to a futures contract?

A

The holder of a put option is not required to sell if they decide not to.

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11
Q

Name 2 ways the value of a portfolio of UK equities can be hedged.

A
  1. By selling FTSE 100 futures contracts.
  2. By buying FTSE 100 put options.
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12
Q

The effectiveness of diversification in a portfolio depend on the degree of ___ between assets in the portfolio.

A

correlation

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13
Q

What are the 3 types of correlation (e.g.between profits & share values of companies) and describe them?

A
  1. Positive correlation: move up and down together.
  2. Negative correlation: move in opposite directions.
  3. No correlation: not related to each other in any way.
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14
Q

The most effective diversification comes from combining investments that are ___ correlated.

A

negatively

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15
Q

Name 3 ways diversification can be achieved via the assets and companies held.

A
  1. Holding different asset classes within a portfolio.
  2. Choosing companies from different sectors.
  3. Including overseas companies.
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16
Q

What does the efficiency frontier plot?

A

The risk–reward profiles of various portfolios.

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17
Q

What 2 things can the efficiency frontier show? (best & lowest).

A
  1. The best return that can be expected for a given level of risk, or;
  2. The lowest level of risk needed to achieve a given expected return.
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18
Q

What are the 3 inputs to the efficiency frontier model?

A
  1. Return of each asset.
  2. Standard deviation of each assets’ return.
  3. Correlation between each pair of assets’ returns.
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19
Q

Name 5 limitations to using an efficiency frontier.

A
  1. It assumes standard deviation is the correct measure of risk & assumes assets have normally distributed returns.
  2. There may be other factors affecting investors’ preference to portfolios in addition to risk.
  3. Inputs for risk and correlation between assets often rely on historical data, which may not be stable.
  4. Transaction costs excluded.
  5. Assumes the underlying portfolios in each asset class are index funds with the same characteristics as the input data.
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20
Q

What is systematic risk measured by and what does it indicate?

A

Beta which indicates the volatility of a stock relative to the market.

21
Q

How can non-systematic risk be eliminated?

A

By holding a diversified portfolio.

22
Q

According to CAPM, a security with a beta of 1 is expected to ___.

A

move up and down exactly with the market.

23
Q

According to CAPM, a security with a beta of greater than 1 is expected to ___.

A

move more than the market (more volatile).

24
Q

According to CAPM, a security with a beta of less than 1 but more than 0 is expected to move ___.

What are these securities known as?

A
  • in same direction but less than the market (more stable).
  • “Defensive securities”.
25
Q

What does the CAPM calculate?

A

The theoretical expected return for a security.

26
Q

How do you calculate CAPM?

A

CAPM = Risky x Beta + Risk free

where Risky = Market return - Risk free

27
Q

Name 5 assumptions of the CAPM.

A
  • Investors are rational & risk averse and only make decisions on the basis of risk & return.
  • All investors have an identical holding period.
  • No taxes or transaction costs.
  • Information is free and available to all.
  • All investors can borrow & lend unlimited amounts of money at the RFR.
28
Q

Name 3 limitations of the CAPM.

A
  • What to use as the RFR.
  • What is the market portfolio.
  • Beta suitability.
29
Q

How do you calculate the standard deviation (SD) if you are only given the (bigger number) variance?

A

Square root of the SD.

30
Q

What do multi-factor models allow for?

A

Different sensitivities to different factors and the identification of each factor’s contribution to the security’s return.

31
Q

How did the Fama & French model expand the CAPM?

A

By adding factors for company size & value in addition to market risk factor.

32
Q

Fama and French identified 2 types of company securities that tended to do better than the market as a whole. What were they?

A
  1. Small cap stocks tended to outperform large cap stocks.
  2. Value stocks (those with a high book value to price ratio) tended to outperform growth stocks.
33
Q

What is Arbitrage pricing theory (APT)?

A

It is a pricing model that predicts a return using the relationship between an expected return and macroeconomic factors.

34
Q

What is arbitrage?

A

The practice of taking advantage of security mispricing to make a risk-free profit.

35
Q

What is efficient market hypothesis (EMH)?

A

The idea that in an open & efficient market, security prices fully reflect all available information and rapidly adjust to any new information so market prices are always the correct price.

36
Q

According to EMH, what is the only way an investor can obtain higher than average returns?

A

By purchasing riskier investments.

37
Q

What are the 3 forms of EMH?

A
  1. Weak-form efficiency.
  2. Semi-strong form efficiency.
  3. Strong-form efficiency.
38
Q

What is weak-form efficiency?

A

Security prices reflect all past price & trading volume information, and future prices cannot be predicted by analysing this type of historical data.

39
Q

What is semi-strong efficiency?

A

Security prices reflect all publicly available information so that excess returns can’t be earned by trading on that information.

40
Q

What is strong-form efficiency?

A

Security prices reflect all public & private information.

41
Q

What type of analysis is supposedly of no use under:

  • weak-form efficiency?
  • semi-strong form efficiency?
A
  • Technical analysis (charts).
  • Technical nor fundamental analysis (charts nor financial statements).
42
Q

What UK markets are considered to be the most efficient?

A

Government bond markets.

43
Q

Which stocks are considered to be more efficient, larger or smaller capitalised stocks?

A

Larger ones.

44
Q

If EMH is correct, does that support active or passive investing?

A

Passive. It makes sense to invest in tracker or index funds, which will mirror the overall performance of the market.

45
Q

What is behavioural finance and what does it attempt to account for?

A
  • An area of research that explores how emotional and psychological factors affect investment decisions.
  • It attempts to account for market anomalies and other market activity that is not explained by traditional finance models, such as MPT and the EMH.
46
Q

The key argument of behavioural finance is that ___ or ___ affect investors’ ability to act rationally.

A
  • psychological factors
  • behavioural biases
47
Q

What is prospect theory/loss aversion?

A

Individuals are much more distressed by prospective losses than they are made happy by equivalent gains. They play safer with gains and riskier with losses & hold onto losses longer.

48
Q

Name 3 effects of over-confidence on investors.

A
  1. Over-estimating their own skills & knowledge.
  2. Under-estimating risks likelihood of bad outcomes.
  3. Being more optimistic when the market goes up.

R02 (11 decks)

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