103-7 Portfolio Management Theory

Question 1

Modern Portfolio Theory

Answer 1

Developed in 1952 by Harry Markowitz
Key point: many investments are required to effectively diversify a portfolio, and that # depends primarily on the correlation between the investments
Uses risk (as measured by SD) and expected return as the basis for determining appropriate combinations of assets, or portfolios

Question 2

Efficient Frontier

Answer 2

This curve represents that set of portfolios that has the maximum rate of return for every given level of risk
Every portfolio residing on the efficient frontier has either a higher rate of return for equal risk or lower risk for an equal rate of return than another portfolio below or underneath the frontier

Question 3

Indifference Curves

Answer 3

Represent the risk-reward trade-off that the investor is willing to make will cross the efficient frontier in two locations, lie tangent to the efficient frontier, or not intersect the efficient frontier at all

Question 4

Capital Market Line (CML)

Answer 4

Developed by William Sharpe
Sharpe said it was possible to identify a portfolio on the Markowitz efficient frontier that would be considered the market portfolio (M)
Uses standard deviation as the risk measure along the horizontal (X) axis

Question 5

Capital Asset Pricing Model (CAPM)

Answer 5

The end result of capital market theory
The CAPM allows the investor to determine an asset’s expected rate of return
2 components:
Stock risk premium: the inducement necessary to entice the individual to invest in a particular tock, whereas the market risk premium is the incentive required for the individual to invest in the securities market in general
Market risk premium: the incentive required for the individual to invest in the securities market in general
CAPM accounts for the impact of systematic risk and does not take into consideration unsystematic risk, which is assumed to have been diversified away

Question 6

Security Market Line (SML)

Answer 6

Quantifies the risk/return relationship for individual securities (this is the micro evaluation compared to the CML’s macro)
Depicts the relationship of risk and return for individual efficient portfolios and has the same formula as that for the CAPM
Unlike the CML, the SML uses beta as its risk measurement of the horizontal axis

Question 7

Arbitrage Pricing Theory (APT)

Answer 7

The CAPM explains the returns on stock as a result of only 1 factor: the volatility of a stock relative to the market as a whole (as measured by beta)
Other unanticipated factors are what the APT attempts to quantify
Proponents of APT assert that the expected returns on securities are based on a variety of unexpected or unanticipated factors

Question 8

Risk-Adjusted Return

Answer 8

A simple risk-adjusted rate of return calculation for a stock or mutual fund using beta is to divide the stock or mutual fund’s nominal rate of return by its beta coefficient

Question 9

Jensen’s Alpha

Answer 9

A measure of the risk adjusted value added by a portfolio manager
Alpha is measured as the portfolio’s actual or realized return in excess of (or deficient to) the expected return calculated by the capital asset pricing model (CAPM)

Question 10

Treynor Ratio

Answer 10

Uses beta in its denominator and, therefore, may be used only to compare the performance of diversified portfolios or stocks that constitute diversified portfolios
The higher the Treynor Ratio, the better the risk-adjusted performance of the asset

Question 11

Sharpe Ratio

Answer 11

Uses standard deviation in its denominator and, therefore, may be used to compare the performance of all portfolios
The Sharpe ratio is a relative performance measure, and the higher the ratio, the better the risk-adjusted performance

Question 12

Information Ratio

Answer 12

Measures the portfolio’s avg rate of return in excess of a comparison (benchmark) portfolio divided by the standard deviation of the excess return
Should be used only when alpha is positive (i.e., the portfolio manager has added value) and beta is meaningful

Question 13

Coefficient of Variation (CV)

Answer 13

A computation of the relative measure of total risk (as measured by standard deviation) per unit of expected return and is used to compare investments w/ varying rates of return and standard deviations
When using this ratio to compare two alternatives, the one w/ the lower CV is usually the preferable choice
Be careful not to confuse the coefficient of variation (CV) w/ covariance (COV). CV is a measure of relative risk per unit of expected return, whereas COV is a measure of how returns on assets move together. The former is used as a cross-check on an investment decision, whereas the latter is the basis for optimal portfolio diversification.

Question 14

Efficient Market Hypothesis (EMH)

Answer 14

Suggests that investors are unable to outperform the market on a consistent basis
Fundamental assumption: current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information
Hypothesis is the basis for the buy and hold strategy

Question 15

Weak Form of EMH

Answer 15

Holds that current stock prices have already incorporated all historical market data and that historical price trends are, therefore, of no value in predicting future price changes

Question 16

Semistrong Form

Answer 16

Holds that current stock prices not only reflect all historical price data but also reflect data from analyzing financial statements, industry, or current economic outlook

Question 17

Strong Form

Answer 17

Holds that current stock prices reflect all public and private information
Insider info already included

Question 18

Anomalies

Answer 18

Unexpected market results or trends that tend to contradict the EMH

Question 19

Price-to-Earnings (P/E) Ratio Effect

Answer 19

Suggests that higher returns may be attainable w/ portfolios comprising securities w/ low P/E ratios
Fundamental premise of value investing

Question 20

Small or neglected firm effect

Answer 20

Relates to the # of security analysts who follow smaller companies
When fewer analysts follow a stock, the security may not be as efficiently priced and may result in undervalued stocks

Question 21

January Effect

Answer 21

Suggests that stocks have a tendency to decline during the month of December and move up significantly in early January
Likely the result of tax selling and buying

Question 22

Value Line Enigma

Answer 22

Relates to stocks that are rated 1 on Value Line’s scale of 1-5 ratings (with 1 being the highest rating and a recommended buy)

Question 23

Down Jones Industrial Average (DJIA)

Answer 23

Higher priced stocks within this index have more influence on the overall movement of this index than lower priced stocks
This is a price-weighted index (e.g. $50 stock has 5 times the impact of a $10 stock)
The correlation between the DJIA and the S&P is greater than 95%

Question 24

Market Capitalization Weighted Index

Answer 24

A stock w/ a market capitalization value of $25 million will have 10 times the impact of a stock w/ a market capitalization value of a $2.5 million company

Question 25

S&P 500 Index

Answer 25

Market capitalization weighted index

Comprises 500 different stocks from the NYSE and the Nasdaq and includes only large companies

Question 26

Russell 2000 Index

Answer 26

Used to benchmark small capitalization companies

This index is a market capitalization weighted index

Question 27

MSCI EAFE Index

Answer 27

Morgan Stanley Capital International Europe, Australasia, and Far East
Created as a measure of the international securities markets
This is the most well-known measure of international markets

Question 28

Wilshire 5000 Index

Answer 28

Consists of over 5,000 U.S.-based companies and is often used as a measure of the overall market within the United States

Question 29

J.P. Morgan Indices

Answer 29

Track emerging markets, government debt, and corporate assets classes

Question 30

Primary Market

Answer 30

Purpose is to facilitate the initial sale of securities issued to the public

Question 31

Initial Public Offering (IPO)

Answer 31

To do this, first, the owners engage an investment banking firm to underwrite the stock offering; that is, to purchase all the public shares at a pre-established price and then resell them to the public (presumably at a significant profit)
The proposed stock sale is publicized in the financial press with ads commonly known as tombstones because they are in heavy print w/ a notable black border

Question 32

Firm Commitment basis

Answer 32

The underwriter will purchase any shares that remain unsold

Question 33

Best Efforts basis

Answer 33

The underwriter will make every effort to sell all the shares, but the company does not receive any money for unsold shares

Question 34

Dilution

Answer 34

When a company has already issued shares but wants to raise additional capital through the sale of more stock
A company typically issues new shares only if its capital structure of debt and equity needs rebalancing to comply with debt covenants

Question 35

Secondary Market

Answer 35

Purpose is to provide investors with a method of buying and selling previously issued securities

Question 36

Market Order

Answer 36

The most popular and has the highest priority, is subject to the fluctuations and timeliness of the market

Question 37

Limit Order

Answer 37

Used to sell or buy at a specific price, one that is better, than the market price at the time the order is placed. The price acts as a ceiling for purchases and a floor for sales

Question 38

Stop Order

Answer 38

Used to protect investors from large losses. If the market price reaches a certain point, the stop order will turn into a market order.

Question 39

Stop Limit Order

Answer 39

Similar to a stop order except that it turns into a limit order when triggered

Question 40

Good-til-canceled (GTC) order

Answer 40

An order to buy or sell a security at a specific price or limit price that lasts until the order is completed or cancelled