8 Portfolio Management Theory, Portfolio Development, and Asset Allocation

Question 1

random walk hypothesis

Answer 1

any future price movement of a security will be based on any future information

future stock prices are random and do not follow any preestablished trend or path.

all the information up to the current time has been priced into a security

Question 2

portfolio theory

Answer 2

The optimal portfolio for an investor depends upon the investor’s ability to assume risk

The optimal portfolio has the lowest risk for a given level of return

The optimal portfolio offers the highest return for a given level of risk

Question 3

What is is the most appropriate and accurate indicator for determining a client’s risk tolerance level?

Answer 3

There is no single appropriate method for determining risk tolerance

Question 4

Identify the steps of the investment planning process

Answer 4

Determining the appropriate level of risk and return for the portfolio based on the investor’s risk tolerance and required return.

Determining the time horizon for the investment based on the client’s financial objective.

Determination of whether or not the client has the means to invest.

Formulation of an investment policy statement so the investment advisor is clear on which investment strategies to pursue on behalf of the client.

Question 5

What is necessary when calculating the measure of risk that is used in Markowitz’s efficient frontier?

Answer 5

Correlation between each asset class and every other asset class

The percentage of the portfolio invested in each asset class

Standard deviation for each asset class

The efficient frontier consists of efficient portfolio. An efficient portfolio has the highest return for a given level of risk. The risk measure is standard deviation; specifically, the standard deviation of a multi-asset portfolio. The other choices represent inputs needed to determine the standard deviation of a multi-asset portfolio. Beta is not used in the calculation.

Question 6

Characteristics of the investment policy statement

Answer 6

Provides a means for evaluating investment performance.

Gives guidance to the investment manager

A written document that sets forth the client’s objectives.

An investment policy statement is a written document that sets forth a client’s objectives and sets forth certain limitations for the investment manager. The investment policy statement gives guidance to the portfolio manager and provides a means for evaluating investment/portfolio performance.

Question 7

Modern Portfolio Theory

Answer 7

the optimal portfolio for an investor depends upon the investor’s ability to assume risk

the optimal portfolio offers the highest return for a given level of risk

the optimal portfolio has the lowest risk for a given level of return.

Question 8

In general, rising interest rates result in which of the following combinations

Answer 8

In general, rising interest rates result in falling stock and bond prices

Question 9

Implications of the weak form of the efficient market hypothesis (EMH)?

Answer 9

Stock prices fully reflect all historical price behavior.

Fundamental analysis may produce superior investment performance.

note: fundamental analysis is considered valuable under the weak form only.

Question 10

Market timing is an attempt to predict the overall direction of the securities market and to take advantage of changes in the prices of those securities.

Answer 10

Studies have shown that market timing techniques generally do not work.

Question 11

One implication of the efficient market hypothesis is that

Answer 11

although security markets are efficient, they are not necessarily equally efficient

Markets are efficient when many analysts follow a company, when information about a company is rapidly disseminated, and when no individual investor or analyst has information not readily available to any other investor or analyst. Some markets (e.g., foreign markets) may be less efficient, as may the markets for companies where few analysts follow a company, such as a small company that has few shares available for purchase by large institutional investors.

Question 12

Describe Capital Market Theory

Answer 12

the security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM)

the security market line (SML) depicts the trade-off between risk and expected return for all assets, whether individual securities, inefficient portfolios, or efficient portfolio

the market risk premium is the difference between the expected return for the equities market and the risk-free rate of return

Question 13

asset pricing models

Answer 13

The capital asset pricing model (CAPM) shows a linear relationship between risk and return.

The arbitrage pricing theory (APT) suggests that the relationship between a stock’s risk and return is not linear.

The capital asset pricing model (CAPM) suggests that the only factor that explains returns is a stock’s beta.

Question 14

arbitrage pricing theory (APT)

Answer 14

suggests that a stock’s price depends upon variables other than the market return and the volatility of returns of the stock.

Question 15

If information is generated randomly and information announcements are independent,

Answer 15

prices will change very quickly in response to the new random information.

Question 16

capital asset pricing model (CAPM)

Answer 16

The capital asset pricing model formula defines the security market line.
Superior performance opportunity exists if a fund’s position is above the security market line.

Question 17

efficient market hypothesis (EMH) and associated anomalies

Answer 17

An investor studying annual reports and analysts’ reports in his stock selection process believes that markets are weak-form efficient.
An investor who buys the securities of firms that are not followed by many analysts is trying to benefit from the neglected-firm effect.

Question 18

Monte Carlo simulation

Answer 18

Small changes in the projected rate of return will make dramatic differences in the outcome.

Monte Carlo analysis uses a random number generator to provide an output with specific probabilities of outcomes.
In a Monte Carlo simulation, each of the variables is also given a probability distribution to allow for real-world uncertainty.

Question 19

Strong form of the efficient market hypothesis suggests:

Answer 19

Inside information will not lead to superior investment results.

Studying financial statements will not lead to superior investment results.