Ch 4 Flashcards
What is Modern Portfolio Theory?
Investors are risk-averse, and would choose to maximise returns based on minimal risk
What is the most commonly used measure of risks?
Volatility of returns/standard deviation
What does standard deviation measure?
How widely the actual return on an investment varies around its expected return
If an investment returns stay close to its expected return, what is this considered to be?
Low risk and low standard deviation
If an investment returns fluctuate widely to its expected return, what is this considered to be?
High risk, higher standard deviation of returns
What does a greater standard deviation signify?
More volatile/more risky investment
What is standard deviation designated by?
Greek letter - sigma
How is standard deviation calculated?
Differences between the average or mean return and actual returns, based on past experience
What are the two ways you can reduce risk on a portfolio?
- Hedging
- Diversification
What is hedging?
Protecting an investment position by taking another position that will increase in value if the existing position falls in value
How can diversification reduce risk?
- combining different asset classes/securities reduces the overall risk to less than average risk of the individual securities
- combining negatively correlated assets
What is a positive correlation?
+1
Profits/values move up and down together
What is no correlation?
0
Not related in any way
What is a negative correlation?
-1
Move in opposite directions
How can diversification be additionally achieved (as well as negative correlations)?
- Holding different asset classes
- Choosing companies from different sectors
- Including overseas companies
What is the efficient frontier model?
Plots the risk-reward profiles of various portfolios and shows the best return that can be expected for a given level of risk, or the lowest level of risk needed to achieve a given expected return
What inputs are needed for the efficient frontier model?
- Return of each asset
- Standard deviation of each asset’s returns
- Correlation between each pair of asset’s returns
What does the efficient frontier represent?
Each portfolio lying on the efficient frontier, offers the highest expected return relative all other portfolios of comparable risk
What are some limitations of using the efficient frontier?
- Assumes standard deviation is correct measure of risk
- Difficult to say which portfolio investors would require based purely on risk
- Inputs for risk/correlation based on historical data
- Does not include transaction costs
- Assumes that underlying portfolios in each asset class are index funds with the same characteristics as input
What is systematic risk?
Systematic/market risk affects the markets as a whole and cannot be avoided
What is non-systematic risk?
Non systematic/investment risk is unique to a particular company and related to unexpected pieces of good or bad news
How can you hedge against a portfolio of UK equities?
- Selling FTSE 100 futures contracts
- Buying FTSE 100 put options
How can non-systematic risk be diversified against?
Can be eliminated by holding a diversified portfolio
What does CAPM say?
It is the sensitivity of the security to the market that is the appropriate measure of risk
What is the sensitivity to the market expressed by?
Beta
What does it mean if a security has a beta = 1?
Move up and down exactly with the market
What does it mean if a security has a beta > 1?
Exaggerates market movement and is more volatile than the market.
If the market goes up, the security will go up more. If the market goes down, the security will go down more.
What does it mean if a security has a beta < 1?
More stable than the market, and will move less than the market but in same direction
What is the CAPM equation?
E(Ri) = Rf + Bi(Rm - Rf)
Expected return = (Rate of return on a risk-free asset) + Sensitivity to market(expected return on market portfolio - return on a risk free asset)
What factors are required for CAPM equation to calculate expected return on risky investment?
- Beta (sensitivity to market)
- Rate of return on risk free asset (ie treasury bill)
- Expected return on the market portfolio
What are the assumptions for the CAPM?
- Investors are rational and risk averse
- All investors have identical holding period
- Market comprises many buyers/many sellers, no one individual affects market price
- No taxes/transaction costs
- Information is free and avail to all
- All investors can borrow and lend unlimited amounts of money at risk-free rate
- Quantity of risky securities is fixed and fully marketable (liquidity can be ignored)
What are the limitations of the CAPM?
- What to use as the risk-free rate? (usually use treasury bill)
- What is the market portfolio? (usually use market index ie FTSE all-share/100)
- The suitability of beta (must be stable/predictable)
What do multi-factor models attempt to describe?
Security returns as a function of a limited number of factors. Allows for different sensitivities to different factors and the identification of each factor’s contribution to the return of the security.
What two ideas do all multi-factor models share?
1) Investors require extra return for taking risk
2) They appear to be predominately concerned with the risk that cannot be eliminated by diversification
How did the Fama and French model expand CAPM?
Adding factors such as company size and value
What did Fama and French find?
1) Small cap stocks tend to outperform large cap stocks
2) Value stocks (high book value to price ratio) tend to outperform growth stocks
What are the two basic ideas that all multi-factor models share?
- Investors require extra returns for taking more risk
- Predominately concerned with the risk that cannot be eliminated by diversification (systematic)
What is Arbitrage Pricing Theory based on?
The idea that a security’s returns can be predicted using the relationship between the security and a number of common risk factors, where sensitivity to changes in each factor is represented by a factor-specific beta
What is the expected return on a security determined by, according to APT?
By adding the risk-free rate to figures representing the risk premium for each of the risk factors
How does APT and CAPM differ?
APT assumes each investor holds an unique portfolio with its own particular degree of exposure to the fundamental risks that affects its returns
What are the four important factors that influence security returns?
- Unanticipated inflation
- Changes in the expected level of industrial production
- Changes in the default risk premium on bonds
- Unanticipated changes in the return of long-term government bonds over Treasury Bills (shifts in the yield curve)
What is the idea of the Efficient Market Hypothesis?
Security prices fully reflect all available information, therefore market prices are always the correct price and reflect the best estimate of their true value
What is Weak Form Efficiency? (EMH)
Prices reflect all past prices and trading volume information
Prices cannot be predicted by analysing historical data
What is Semi-Weak Form Efficiency? (EMH)
Prices reflect all publicly available information (inc company’s financial statements, company announcements etc)
What is Strong Form Efficiency? (EMH)
Prices reflect all information including public and private information
How efficient a Government bonds? (EMH)
Extremely efficient
If a market is less efficient, how can more knowledgable investors perform?
More knowledgeable investors can outperform those with less information
How efficient are large cap stocks and small cap stocks?
Large cap stocks are efficient
Small cap stocks are less efficient
How efficient is Venture Capital?
Less efficient
If EMH is correct, what kind of funds does this support?
Index/tracker funds
What is Prospect Theory/Loss Aversion?
- People do not always behave rationally
- Investors place larger weights on losses than gains
- Often play safe when protecting gains but take riskier decisions to protect losses (loss aversion) which makes people hold onto losses in the hope they will be recouped
What is Regret in finance?
People may be less willing to sell a losing investment because it is showing a loss, and so hold on to stocks too long in the hope that they will make a profit, or sell too soon in case profits turn to losses
What can Overconfidence cause?
Overestimate the reliability of their knowledge, underestimate risks and exaggerate their ability to control events, which can lead to excessive trading volumes and speculative bubbles
