13- Portfolio Theory Flashcards
What are the 3 key characteristics of the efficient market hypothesis (EMH)?
-Information freely available to all
-Information correctly priced into security
-Rational investors
What are the 3 forms of the efficient market hypothesis?
-Weak form
-Semi-strong form
-Strong form
What are the 3 informations cumulatively reflected in share price through the EMH forms
-Historic share prices
-All publicly available info
-All private info
What is Technical analysis?
Analysis of historic prices and volumes and the use of graphs to identify repeatable patterns
What is Fundamental analysis?
The use of both quantitative and qualitative data about a company in an attempt to assess an intrinsic value.
What is stratified sampling for a tracker fund?
Buying the most influential shares in the benchmark from each sector
What is the formula for tracking error?
Tracking error = σ(Total portfolio return - total benchmark return)
What is the Holding Period Return (HPR) formula?
HPR = (Val1 - Val0)/Val0
What is the Money Weighted Rate of Return (MWRR)?
Equivalent to IRR of portfolio, designed to take account of cash inflows and outflows but can still be affected by timing and size of flows
What is the formula for MWRR?
PVinflow - PVoutflow = 0
What is the Time weighted rate of return (TWRR)?
This separates the returns into separate holding periods and calculates geometric mean over the period
What is the TWRR formula?
TWRR = (HP1end/HP1start x … x HPnend/HPnstart) - 1
What is the formula for Total Risk?
Total Risk = sqrt(VarMktrisk + VarSpecificRisk)
What is the difference between systematic and systemic risk?
Systematic risk is FX liquidity etc, systemic is entire market collapses
What is the beta formula?
Beta = Cov(Rm,Rx)/VarRm
How do you calculate portfolio beta?
Weighted average of the betas of each holding
What is Value at Risk (VaR)?
The maximum potential change in value of a portfolio of financial instruments with a given probability over a certain horizon
What is the Capital Asset Pricing Model (CAPM)?
The CAPM calculates the expected return from a security given its systematic risk
What are the 5 main CAPM assumptions?
-Risk free weight equal for all
-All investors have well diversified portfolios
-No tax or transactional costs
-Rational investors
-Investors have same risk/return expectations
What is the CAPM formula?
E(Rp) = Rf + βp(Rm-Rf)
What is the market risk premium formula?
Rm-Rf
What does arbitrage pricing theory do?
Attempts to derive a rate of return that will be used to price assets, by breaking the market into risk factors and creating a beta for each one
What 3 risk factors does arbitrage pricing theory take?
-Inflation
-Interest rates
-Liquidity
What is Jensen’s Alpha?
Difference between portfolio return and CAPM predicted return
Rp-Rcapm
What is the Sharpe ratio equation?
Sharpe ratio = (Rp-Rf)/σp
What is the Treynor ratio equation?
Treynor ratio = (Rp-Rf)/βp
What is the difference between the Sharpe and Treynor ratios?
Sharpe uses total risk as it assumes portfolio is not diversified, whereas Treynor does so it uses systematic (β)
What is the Information ratio formula?
Information ratio = (Rp-Rb)/σ(Rp-Rb)
What is Beta?
Expression of a portfolio’s sensitivity relative to its benchmark
How do you calculate portfolio duration?
Weighted average of the duration of each bond
What is relative duration?
Duration of bond (portfolio) / Duration of market
Dp/Dm
What is the CAPM formula for bonds?
E(Rp) = Rf + (Dp/Dm)(Rm-Rf)
What is a cash matched/dedicated portfolio?
Where the fund manager chooses bonds that generate cash flows of the same size and timing as the fund’s liabilities
What is Immunisation?
Matching the duration of its constituent bonds with the duration of its liabilities
What is a Bullet?
All bonds have a duration close to the duration of the liability
What is a Barbell?
The portfolio has a weighted average durations that matches the liability
What is a Liability Driven Investment (LDI)?
Investment strategy of a company or individual based on the cash flows needed to fund future liabilities
What is Policy switching in active bond management?
Switching between two different bonds to take advantage of market conditions
