(42) Portfolio Risk & Return: Part I Flashcards
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define holding period return.
Holding period return is used to measure an investment’s return over a specific period.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define arithmetic mean return.
Arithmetic mean return is the simple average of a series of periodic returns.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define geometric mean return.
Geometric mean return is a compound annual rate.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define money-weighted rate of return.
Money-weighted rate of return is the IRR calculated using periodic cash flows into and out of an account and is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define gross return and net return.
Gross return is total return after deducting commissions on trades and other costs necessary to generate the returns, but before deducting fees for the management and administration of the investment account. Net return is the return after management and administration fees have been deducted.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define pretax nominal return and after-tax nominal return.
Pretax nominal return is the numerical percentage return of an investment, without considering the effects of taxes and inflation. After-tax nominal return is the numerical return after the tax liability is deducted, without adjusting for inflation.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define real return.
Real return is the increase in an investor’s purchasing power, roughly equal to nominal return minus inflation.
LOS 42. a: Calculate and interpret major return measures and describe their appropriate uses. Define leveraged return.
Leveraged return is the gain or loss on an investment as a percentage of an investor’s cash investment.
LOS 42. b: Describe characteristics of the major asset classes that investors consider in forming portfolios. List common asset classes by level or risk. (High to low)
As predicted by theory, asset classes with the greatest average returns have also had the highest risk.
Some of the major asset classes that investors consider when building a diversified portfolio include:
- small-capitalization stocks
- large-capitalization stocks
- long-term corporate bonds
- long-term Treasury bonds
- Treasury bills
LOS 42. b: Describe characteristics of the major asset classes that investors consider in forming portfolios. In addition to risk and return, when analyzing investments, what do investors also take into consideration?
In addition to risk and return, when analyzing investments, investors also take into consideration:
- an investment’s liquidity
- as well as non-normal characteristics such as skewness and kurtosis.
LOS 42. c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data. Variance equation.
We can calculate the population variance, σ2, when we know the return Rt for period t, the total number T of periods, and the mean µ of a population’s distribution:
LOS 42. c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data. Sample variance equation.
In finance, we typically analyze only a sample of returns, so the sample variance applies instead:
LOS 42. c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data. Define covariance and equation.
Covariance measures the extent to which two variables move together over time. Positive covariance means the variables (e.g., rates of return on two stocks) tend to move together. Negative covariance means that the two variables tend to move in opposite directions. Covariance of zero means there is no linear relationship between the two variables.
LOS 42. c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data.
Correlation is a standardized measure of co-movement that is bounded by -1 and +1:
LOS 42. d: Explain risk aversion and its implications for portfolio selection. Define a risk-averse investor.
A risk-averse investor is one that dislikes risk. Given two investments that have equal expected returns, a risk-averse investor will choose the one with less risk. However, a risk-averse investor will hold risky assets if he feels that the extra risk he expects to earn is adequate compensation for the additional risk. Assets in the financial markets are priced according to the preferences of risk-averse investors.
LOS 42. e: Calculate and interpret portfolio standard deviation.
The standard deviation of returns for a portfolio with two risky assets is calculated as follows:
LOS 42. f: Describe the effect on a portfolio’s risk of investing in assets that are less than perfectly correlated.
The greatest portfolio risk will result when the asset returns are perfectly positively correlated. As the correlation decreases from +1 to -1, portfolio risk decreases. The lower the correlation of asset returns, the greater the risk reduction (diversification) benefit of combining assets in a portfolio.
LOS 42. g: Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio.
For each level of expected portfolio return, the portfolio that has the least risk is known as the minimum-variance portfolio. Taken together, these portfolios from a line called the minimum-variance frontier.
LOS 42. g: Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio.
On a risk versus return graph, the one risky portfolio that is farthest to the left (has the least risk) is known as the global minimum-variance portfolio.
LOS 42. g: Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio.
Those portfolios that have the greatest expected return for each level of risk make up the efficient frontier. The efficient frontier coincides with the top portion of the minimum variance frontier. Risk-averse investors would only choose a portfolio that lies on the efficient frontier.
LOS 42. h: Explain the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the capital allocation line.
An indifference curve plots combinations of risk and expected return that an investor finds equally acceptable. Indifference curves generally slope upward because risk-averse investors will only take on more risk if they are compensated with greater expected returns. A more risk-averse investor will have steeper indifference curves.
Flatter indifference curves (less risk aversion) result in an optimal portfolio with higher risk and higher expected return. An investor who is less risk averse will optimally choose a portfolio with more invested in the risky asset portfolio and less invested in the risk-free asset.
