4 - Investment theory Flashcards
What is modern porfolio theory
Reflects the way in which portfolios can be constructed to maximise returns and minimise risk
What is essential to MPT
Investors are risk averse and would choose less risky investment
What is most common measure of risk
Volatility of returns
Standard deviation of returns
What is one SD
68%
What is 2 SD
95%
What is hedging
Protecting an existing investment position by taking another position in value if existing position falls in value
What can diversification not do
Remove market risk
What is the efficient frontier
Relationship between return expected from portfolio and risk of portfolio measured by SD
Risk-reward ratio
Limitations of using efficient frontier
SD is correct measure of risk and assets are normally distributed
Other factors than risk may be of play
Relies on historical data
No transaction cost
What is systematic or market risk
What is it measured by
Risk that markets will fluctuate - cannot be controlled
Measured by beta
What is non-systematic or investment specific risk
Relates to unexpected good or bad news in company - independent of political, economic factors
What is Capital Asset pricing model
E(RI) = Rf + Bi(RM-Rf)
E(RI) - Expected return on risk investment
RF - rate of return of risk free asset
Rm - ER on market portfolio
Bi - Sensitivity of investment movement
Rm - RF - market risk premium (excess return of market over risk free rate)
Bi (Rm - RF) Risk premium of risky investment
What are some assumptions of CAPM
Rational and risk averse
Identical holding periods
no transaction cost
many buyers and sellers
full information
Kind of like perfect competition
What is Multi factor model
Allows for different sensitivities to different factors and identification of each factors contribtuion to security return
What is an example of two factor model
Rf + BGDP (risk premium GDP) + BIR (risk premium IR) = minimum return + risk premium
