CFP Investments - Portfolio Theory

Question 1

Definition of Standard Deviation

Answer 1

A measure of risk and variability of returns

Question 2

The higher the standard deviation, the

Answer 2

higher the riskiness of the investment

Question 3

+/- 1, 2, 3 standard deviation percentages

Answer 3

+-/ 1: 68%

+-/ 2: 95%

+-/ 3: 99%

Question 4

Coefficient of Variation is useful in determining

Answer 4

which investment has more relative risk when investments have different average returns

Question 5

Coefficient of Variation tell us the probability

Answer 5

of actually experiencing a return close to the average return

Question 6

The higher the coefficient of variation,

Answer 6

the more risky an investment per unit of return

Question 7

Formula for Coefficient of Variation

Answer 7

Standard Deviation/

Average Return

Question 8

Normal Distribution is appropriate if an investor is

Answer 8

considering a range of investment returns

Question 9

A Lognormal Distribution is appropriate if an investor is considering

Answer 9

a DOLLAR AMOUNT or PORTFOLIO VALUE at a point in time

Question 10

SKEWNESS refers to a normal distribution curve that is shifted

Answer 10

to the left of right of the MEAN RETURN

Ex: Commodity Returns

Left: Positive Skewness
Right: Negative Skewness

Question 11

Kurtosis refers to

Answer 11

the variation of returns

Little variation= distribution has a high peak (Treasuries)

Widely dispersed = low peak, negative Kurtosis

Question 12

Leptokurtic distributions mean what?

Answer 12

High peak, fat tails

Higher change of extreme events

Question 13

Platykurtic distributions mean what?

Answer 13

Low peak, thin tails

Low chance of extreme events

Question 14

Mean Variance Optimization means adding what kind of securities to your portfolio?

Answer 14

Process of adding RISKY securities BUT keeping the expected return the same.

Low variance as measured by standard deviation

Question 15

What is a Monte Carlo Simulation?

Answer 15

Spreadsheet simulation that gives a probabilistic distribution of events occurring

Question 16

Covariance is the measure of

Answer 16

2 securities combined and their interactive risk

How price movements between 2 securities are related to each other

Measure of RELATIVE RISK

Question 17

Correlation and Covariance are both

Answer 17

Relative measures

Question 18

Correlation Coefficent of 1

Answer 18

Denotes two assets are perfectly correlated

Question 19

Correlation Coefficient of 0

Answer 19

Denotes that assets are completely uncorrelated

Question 20

Correlation Coefficient of -1

Answer 20

Denotes perfectly negative correlation

Question 21

When combining asset classes, an investor begins to receive diversification benefits when correlation is

Answer 21

Less than 1

Question 22

Beta Coefficient is a measure of

Answer 22

an individual security’s volatility relative to that of the market

Measure of systematic/market risk

Question 23

Beta is best used to measure

Answer 23

the volatility of a diversified portfolio

the Beta of the market is 1

Question 24

A stock with a beta HIGHER THAN 1

Answer 24

Means the stock fluctuates more than the market and greater risk is associated

Question 25

A stock with a beta LOWER THAN 1

Answer 25

Indicates that the security fluctuates less relative to market movements

Question 26

If a fund has a return of 20% and the market has a return of 10%, the beta would be:

Answer 26

2 Security risk premium / Market risk premium

Question 27

Coefficient of DETERMINATIONS (R-Squared) is a measure of

Answer 27

How much return is due to the market OR What percentage of a security's return is due to the market

Question 28

Market (systematic) Risk

Answer 28

Return from the market Lowest level of risk one could expect in a fully diversified portfolio Non-diversifiable Economy-based risk

Question 29

Unsystematic Risk

Answer 29

Risks that are not shared with a wider market or industry (specific to a company/investment)

Question 30

Portfolio risk can be measured through

Answer 30

determination of the interactivity of the standard deviation and the covariance of securities in the portfolio

Question 31

Systematic Risks: P-R-I-M-E

Answer 31

Purchasing Power Risk Reinvestment Rate risk (bonds) Interest Rate Risk Market Risk Exchange Rate Risk

Question 32

Unsystematic Risks: A-B-C-D-E-F-G

Answer 32

Accounting risk Business risk Country risk Default risk Executive risk Financial risk Government/regulation risk

Question 33

Modern Portfolio Theory

Answer 33

The acceptance by an investor of a given level of risk while maximizing return objectives

Question 34

Modern Portfolio Theory: EFFICIENT FRONTIER

Answer 34

The curve which illustrates the best possible returns that could be expected from all possible portfolios

Question 35

Modern Portfolio Theory: INDIFFERENCE CURVES

Answer 35

Constructed using selections made based on this highest level of return given an acceptable level of risk

Question 36

Modern Portfolio Theory: EFFICIENT PORTFOLIO

Answer 36

Occurs when an investor's indifference curve is tangent to the efficient frontier

Question 37

Modern Portfolio Theory: OPTIMAL PORTFOLIO

Answer 37

the one selected from all efficient portfolios the point at which an investor's indifference curve is tangent to the efficient frontier, represents that investor's optimal portfolio

Question 38

Capital Market Line (CML)

Answer 38

the macro aspect of the Capital Asset Pricing Model (CAPM) a portfolio's return should be on the CML

Question 39

What measure of risk does the Capital Market Line (CML) use?

Answer 39

Standard deviation

Question 40

Capital Asset Pricing Model (CAPM) calculates

Answer 40

the relationship of risk and return of an individual security using BETA as it's measure of risk "Security Market Line" SML

Question 41

SML uses what as its measure of risk?

Answer 41

Beta

Question 42

What is the intersection on the y-axis of CML/SML

Answer 42

The risk-free rate of return

Question 43

Information Ratio

Answer 43

Relative risk-adjusted performance measure The higher, the better

Question 44

Treynor Index

Answer 44

NUMERATOR: the difference between the portfolio return and risk-free return DENOMINATOR: Beta of a portfolio RISK-ADJUSTED performance measure

Question 45

Sharpe Index

Answer 45

Provides a measure of portfolio performance using a risk-adjusted measure that standardizes returns for their variability NUMERATOR: the difference between the portfolio return and risk-free return DENOMINATOR: Standard deviation of a portfolio RISK-ADJUSTED performance measure Better for NON-diversified portfolios

Question 46

Jensen Model or Jensen's Alpha measures

Answer 46

a manager's performance relative to that of the market Can determine differences between realized or actual returns and required returns as specified by CAPM ABSOLUTE PERFORMANCE on a risk-adjusted basis positive Alpha is good negative is BAD

Question 47

A portfolio is considered diversified if its R-squared is greater than

Answer 47

0.70 Any less = not well diversified (use Sharpe Index as measure) REMEMBER! If correlation is 0.80, r-squared is 64%

Question 48

If the exam doesn't give you the R-squared, which performance measure should you use?

Answer 48

Sharpe Index

Question 49

Total Risk = Systematic = Unsystematic Risk Total risk is measured using ______ Systematic risk is measured using ______

Answer 49

Total Risk = Systematic = Unsystematic Risk Total risk is measured using STANDARD DEVIATION Systematic risk is measured using BETA

Question 50

The Beta of the Market is ____

Answer 50

1.0

Question 51

A stock that has a Beta of 1.5 is riskier or less risky than the market?

Answer 51

Riskier

Question 52

R-squared tells us what about Beta?

Answer 52

R-Squared will give us insight as to whether or not Beta is an appropriate measure of risk If R-Squared is greater than .7 then YES, it is a good measure to use to assess RISK