Asset Allocation and Portfolio Diversification

Question 1

Active investing

Answer 1

• some investors are better than others
• believe markets are inefficient

Question 2

Strategic asset allocation

Answer 2

• usually once every few years
• considers range of outcomes for each portfolio mix and chooses best one

Question 3

Application of client life cycle analysis

Answer 3

• allocation can be closely related to age or place in life cycle
• typically as investors approach retirement, they become more risk adverse

Question 4

Client risk tolerance measurement

Answer 4

Applies to investment, insurance (deductible limit), and tax (techniques)
Issues
- client cannot express how risk tolerant they really are
- different tools can give different results
- age and wealth change, so does tolerance
- knowledge can change risk tolerance

Question 5

Risk tolerant characteristics

Answer 5

• high debt ratios
• small amounts of insurance
• change jobs/ locations
• makes quick decisions
• high level of wealth for age
• optimistic
• handles stress well
• experienced

Question 6

Risk adverse characteristics

Answer 6

• no debt
• high amounts of insurance
• stable employment
• deliberate
• low level of wealth for age
• pessimistic
• handles stress poorly
• inexperienced

Question 7

Strategies for assessing a clients risk tolerance

Answer 7

• use more than one approach
• ask a lot of questions

Question 8

Risk tolerance vs risk capacity

Answer 8

Risk tolerance
- risk investor is comfortable assuming
- uses questionnaires

Risk capacity
- risk investor must take to reach goals
- necessary rate of return

Question 9

Asset allocation rebalancing

Answer 9

• response to changes in economic environment or life cycle of client
  Eg.
• change in wealth, liquidity, legal, goals, taxes, needs

Question 10

Tactical asset allocation

Answer 10

• performed routinely as part of asset management
• changes in mixes are driven by predictions of future returns
• market timing approach

Question 11

Passive allocation strategies

Answer 11

• buy and hold
• immunization
• laddered bonds
• indexed portfolios
• barbell strategy
• dollar cost averaging

Question 12

Beta and volatility

Answer 12

Beta measures volatility of a stock to the overall market
- buy stock with low beta to control volatility

Question 13

Capital asset pricing model (CAPM)

Answer 13

• concerned with risk and expected return on risky assets
• macro: capital market line - specifies relationship between risk and return for a portfolio
• micro: security market line - relationship between risk and return for individual asset

Question 14

Arbitrage pricing theory (APT)

Answer 14

• pricing of securities in different markets cannot differ for any significant length of time
• not explained by relationship between risk and return
• unexpected inflation, change in industrial production, shift in risk premium, changes in structure of yields (all unexpected)
• of change is expected the vale is 0 and there is no affect

Question 15

Black-Scholes option valuation model

Answer 15

5 variables to value options of non-dividend paying stock
- price of underlying stock
- exercise price of option
- time remaining to expiration of option
- interest rate
- volatility of underlying stock

• increase in exercise price of call decreases calls value (indirect)
• increase in exercise price of put increases puts value (direct)
• all other variables have direct relationships

Question 16

Binomial option pricing

Answer 16

alternative to black scholes model
- assumes a stocks price can be two possible values at option expiration
- stock will either increase or decrease
- if theory is accurate, investor has riskless portfolio or perfect hedge