CFP Investments - Portfolio Theory Flashcards
Definition of Standard Deviation
A measure of risk and variability of returns
The higher the standard deviation, the
higher the riskiness of the investment
+/- 1, 2, 3 standard deviation percentages
+-/ 1: 68%
+-/ 2: 95%
+-/ 3: 99%
Coefficient of Variation is useful in determining
which investment has more relative risk when investments have different average returns
Coefficient of Variation tell us the probability
of actually experiencing a return close to the average return
The higher the coefficient of variation,
the more risky an investment per unit of return
Formula for Coefficient of Variation
Standard Deviation/
Average Return
Normal Distribution is appropriate if an investor is
considering a range of investment returns
A Lognormal Distribution is appropriate if an investor is considering
a DOLLAR AMOUNT or PORTFOLIO VALUE at a point in time
SKEWNESS refers to a normal distribution curve that is shifted
to the left of right of the MEAN RETURN
Ex: Commodity Returns
Left: Positive Skewness
Right: Negative Skewness
Kurtosis refers to
the variation of returns
Little variation= distribution has a high peak (Treasuries)
Widely dispersed = low peak, negative Kurtosis
Leptokurtic distributions mean what?
High peak, fat tails
Higher change of extreme events
Platykurtic distributions mean what?
Low peak, thin tails
Low chance of extreme events
Mean Variance Optimization means adding what kind of securities to your portfolio?
Process of adding RISKY securities BUT keeping the expected return the same.
Low variance as measured by standard deviation
What is a Monte Carlo Simulation?
Spreadsheet simulation that gives a probabilistic distribution of events occurring
Covariance is the measure of
2 securities combined and their interactive risk
How price movements between 2 securities are related to each other
Measure of RELATIVE RISK
Correlation and Covariance are both
Relative measures
Correlation Coefficent of 1
Denotes two assets are perfectly correlated
Correlation Coefficient of 0
Denotes that assets are completely uncorrelated
Correlation Coefficient of -1
Denotes perfectly negative correlation
When combining asset classes, an investor begins to receive diversification benefits when correlation is
Less than 1
Beta Coefficient is a measure of
an individual security’s volatility relative to that of the market
Measure of systematic/market risk
Beta is best used to measure
the volatility of a diversified portfolio
the Beta of the market is 1
A stock with a beta HIGHER THAN 1
Means the stock fluctuates more than the market and greater risk is associated
A stock with a beta LOWER THAN 1
Indicates that the security fluctuates less relative to market movements
If a fund has a return of 20% and the market has a return of 10%, the beta would be:
2
Security risk premium / Market risk premium
Coefficient of DETERMINATIONS (R-Squared) is a measure of
How much return is due to the market
OR
What percentage of a security’s return is due to the market
Market (systematic) Risk
Return from the market
Lowest level of risk one could expect in a fully diversified portfolio
Non-diversifiable
Economy-based risk
Unsystematic Risk
Risks that are not shared with a wider market or industry (specific to a company/investment)
Portfolio risk can be measured through
determination of the interactivity of the standard deviation and the covariance of securities in the portfolio
Systematic Risks: P-R-I-M-E
Purchasing Power Risk
Reinvestment Rate risk (bonds)
Interest Rate Risk
Market Risk
Exchange Rate Risk
Unsystematic Risks: A-B-C-D-E-F-G
Accounting risk
Business risk
Country risk
Default risk
Executive risk
Financial risk
Government/regulation risk
Modern Portfolio Theory
The acceptance by an investor of a given level of risk while maximizing return objectives
Modern Portfolio Theory: EFFICIENT FRONTIER
The curve which illustrates the best possible returns that could be expected from all possible portfolios
Modern Portfolio Theory: INDIFFERENCE CURVES
Constructed using selections made based on this highest level of return given an acceptable level of risk
Modern Portfolio Theory: EFFICIENT PORTFOLIO
Occurs when an investor’s indifference curve is tangent to the efficient frontier
Modern Portfolio Theory: OPTIMAL PORTFOLIO
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
Capital Market Line (CML)
the macro aspect of the Capital Asset Pricing Model (CAPM)
a portfolio’s return should be on the CML
What measure of risk does the Capital Market Line (CML) use?
Standard deviation
Capital Asset Pricing Model (CAPM) calculates
the relationship of risk and return of an individual security using BETA as it’s measure of risk
“Security Market Line” SML
SML uses what as its measure of risk?
Beta
What is the intersection on the y-axis of CML/SML
The risk-free rate of return
Information Ratio
Relative risk-adjusted performance measure
The higher, the better
Treynor Index
NUMERATOR: the difference between the portfolio return and risk-free return
DENOMINATOR: Beta of a portfolio
RISK-ADJUSTED performance measure
Sharpe Index
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
Jensen Model or Jensen’s Alpha measures
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
A portfolio is considered diversified if its R-squared is greater than
0.70
Any less = not well diversified (use Sharpe Index as measure)
REMEMBER! If correlation is 0.80, r-squared is 64%
If the exam doesn’t give you the R-squared, which performance measure should you use?
Sharpe Index
Total Risk = Systematic = Unsystematic Risk
Total risk is measured using ______
Systematic risk is measured using ______
Total Risk = Systematic = Unsystematic Risk
Total risk is measured using STANDARD DEVIATION
Systematic risk is measured using BETA
The Beta of the Market is ____
1.0
A stock that has a Beta of 1.5 is riskier or less risky than the market?
Riskier
R-squared tells us what about Beta?
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
