Ch 7 & 8 - Risk return and stock markets, portfolio theory and CAPM Flashcards
Generally in finance, risks are expressed in terms of _________-
Standard deviation
What does the standard deviation of a stock measure?
How far the actual return of the stock may vary from the expected return calculated
What is the mean variance rule?
- investment with higher return for the same level or risk
2. investment with lower risk for the same return
How do investors reduce risk and achieve a higher return?
By creating portfolios
What is a portfolio?
A collection of investment. It can include conventional assets and unconventional assets
What is the objective of creating portfoios?
To generate optimal returns- best return for the level f risk tolerance or the wealth available
What does the covariance of 2 stocks measure?
How the return of 2 stocks move together over time
What does the correlation measure?
The strength between 2 variables
What 3 variables is portfolio risk/ variance influenced by?
- risk of the individual assets
- wealth allocation
- covariance between the returns
What does Harry Markovitz’s modern portfolio theory state?
In order to make the best returns for the investment made, investors need to take into account the way in which the assets returns move with one another
All points below the Mean Standard Deviation frontier is _____ but _____. This area is known as the ______
Feasible, inefficient, feasible region
All points above the MSD frontier are _______ and ________ but cannot be achieved due to ______
Desired, efficient, capital constraints
What does the MSD frontier illsutrate?
The different return and risk combinations that can be achieved using different investments in 2 risky assets
The curvature of the MSD frontier depends on _______
The correlation coefficient between the 2 assets
Ideally to reduce the risk investors must combine assets that have _____ or ______ correlation
Negative, 0
Since negative or 0 correlation is observed in reality, investors should combine assets that have _____ correlation
Low positive
The objective of diversification is to ________ and not to ______
Reduce risk , maximize returns
What is the global minimum variance portfolio?
The portfolio with the lowest variance/ risk
What does the efficient frontier illustrate?
The portfolios that maximize the return for a given level of risk. The portfolios lie to the right of the global min variance portfolio
The best portfolio for an investor is indicated through the tangency of the __________ and ________
Investor’s utility curve and the efficient frontier
The only security with no risk are _____
Gov securities such as treasury bills and bonds
What does the Capital Allocation Line illustrate?
The relationship between portfolio risk and return
The CAL for a portfolio made up of a risky and risk free asset is ______-
Linear
The CAL that becomes tangent to the efficient frontier is considered as the ________
Most optimal CAL or the Capital market line
What is the tangency portfolio/ market porfolio?
All the risky assets in the market and is the most diversified portfolio in the market. But is only a theoretical portfolio
What is the weightage of wealth placed on each asset when an investor creates a proxy based on the market portfolio?
The market capitalisation of each individual asset on the market portfolio
What does the two fud separation theorem state?
Investors can create optimal portfolios using an investment in a risk free asset and an investment in the market portfolio (most optimal risky asset portfolio) so that they can fine tune the risk of the overall portfolio
What does the CML illustrate?
Different portfolios and their respective risk and returns, that consist of an investment in the market portfolio and the risk free asset
What are the 2 main asset pricing models in equity markets?
Capital asset pricing model
Arbitrage pricing theory model
What are asset pricing models in equity markets used for?
Measure asset returns, degree of mispricing in assets and make investment decisions
Total risk of equities can be decomposed into
Systematic risk and idiosyncratic risk
What are systematic risks?
Macroeconomic risk factors that affect stocks in a market in varying degrees. The impact of these risks are measured through the beta coefficient. These risk factors cannot be completely eliminated away
What are idiosyncratic risks?
Risk factors that may influence the returns of stocks of a particular industry
How can idiosyncratic risk be reduced?
By investing in different industries that do no correlated with one another
What does the beta coefficient measure?
Beta is a measure of sensitivity. It measures how sensitive stock returns is to market risk(systematic risk) factors
Beta of a market portfolio is always
1
If beta of the stock > Market portfolio beta, these a considered to be _____ stocks
Aggressive
If beta of the stock < Market portfolio beta, these a considered to be _____ stocks
Conservative
As the number of assets in the portfolio increase, the total risk of the portfolio comes down due to the ______ effect
Diversification
What does CAPM state?
In equilibrium, the expected returns of a risky asset is equal to the risk free rate plus a beta adjusted market risk premium
What are some assumptions of CAPM?
Risk aversion
Unlimited borrowing and lending at the same risk free rate
Frictionless markets
Homogenous expectations
One period horizon
Infinitely diversifiable assets
Idiosyncratic risks can be completely diversified away
When an asset return lines on the securities market line (SML), they’re considered to be _______ and hence free of _________
Correctly priced, arbitrage
When assets returns do not lie on the SML they’re considered to be _______ and hence investors can exploit the prices and make ______
Mispriced, arbitrage returns
In the SML framework , the risk of portfolios is measured in terms of _____
Beta/ systematic risk since CAPM assumes that idiosyncratic risks can be completely diversified away
Why is the validity of CAPM questionable?
It’s a model of expectations
Requires a risk free rate to be used
Requires us to identify the return on the market portfolio
Evidence shows that beta has little to no influence over asset returns Size anomaly
Does not consider value premium
What are factor models?
Models used to calculate the expected return of stocks
What are the 2 types of factor models?
Single factor models, multi factor models
What are factors?
Macro economic variables that impact stock returns
A simplified version of the single factor model is the _________-
Market model
CAPM is a _______ factor model
Single
What are some assumptions of the Arbitrage pricing theory?
The returns of an asset can be expressed through a factor model
Capital markets are perfect, where transaction costs and taxes are 0
Perfect info symmetry in the market
There’s a large number of securities in the market. Hence investors hold diversified portfolios. Hence, they’re not exposed to idiosyncratic risks
There are not arbitrage opportunities in the market
What is arbitrage?
Process of making riskless profits by exploiting the mispriced assets in the market
What are the 2 ways of making arbitrage?
Buying/investing in underpriced assets
Short selling overpriced assets
What is risk factor premium?
Return over and above the risk free rate that is generated by a factor
What are 4 major portfolio performace measures?
Sharpe ratio, Treynor ratio, Jensen’s alpha and information ration
What does the Sharpe ratio measure?
The excess return of a stock per unit of total risk
What does the Treynor ratio measure?
Excess return of a stock per unit of systematic risk
What does Jensen’s alpha measure?
Return over and above the CAPM expected return given an asset beta
What does the information ratio measure?
The contribution of alpha (return over and above the CAPM) to the non systematic risk of the portfolio. That is, abnormal return per unit of idiosyncratic risk
