Ch 7 & 8 - Risk return and stock markets, portfolio theory and CAPM Flashcards

1
Q

Generally in finance, risks are expressed in terms of _________-

A

Standard deviation

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2
Q

What does the standard deviation of a stock measure?

A

How far the actual return of the stock may vary from the expected return calculated

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3
Q

What is the mean variance rule?

A
  1. investment with higher return for the same level or risk

2. investment with lower risk for the same return

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4
Q

How do investors reduce risk and achieve a higher return?

A

By creating portfolios

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5
Q

What is a portfolio?

A

A collection of investment. It can include conventional assets and unconventional assets

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6
Q

What is the objective of creating portfoios?

A

To generate optimal returns- best return for the level f risk tolerance or the wealth available

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7
Q

What does the covariance of 2 stocks measure?

A

How the return of 2 stocks move together over time

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8
Q

What does the correlation measure?

A

The strength between 2 variables

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9
Q

What 3 variables is portfolio risk/ variance influenced by?

A
  1. risk of the individual assets
  2. wealth allocation
  3. covariance between the returns
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10
Q

What does Harry Markovitz’s modern portfolio theory state?

A

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

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11
Q

All points below the Mean Standard Deviation frontier is _____ but _____. This area is known as the ______

A

Feasible, inefficient, feasible region

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12
Q

All points above the MSD frontier are _______ and ________ but cannot be achieved due to ______

A

Desired, efficient, capital constraints

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13
Q

What does the MSD frontier illsutrate?

A

The different return and risk combinations that can be achieved using different investments in 2 risky assets

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14
Q

The curvature of the MSD frontier depends on _______

A

The correlation coefficient between the 2 assets

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15
Q

Ideally to reduce the risk investors must combine assets that have _____ or ______ correlation

A

Negative, 0

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16
Q

Since negative or 0 correlation is observed in reality, investors should combine assets that have _____ correlation

A

Low positive

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17
Q

The objective of diversification is to ________ and not to ______

A

Reduce risk , maximize returns

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18
Q

What is the global minimum variance portfolio?

A

The portfolio with the lowest variance/ risk

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19
Q

What does the efficient frontier illustrate?

A

The portfolios that maximize the return for a given level of risk. The portfolios lie to the right of the global min variance portfolio

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20
Q

The best portfolio for an investor is indicated through the tangency of the __________ and ________

A

Investor’s utility curve and the efficient frontier

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21
Q

The only security with no risk are _____

A

Gov securities such as treasury bills and bonds

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22
Q

What does the Capital Allocation Line illustrate?

A

The relationship between portfolio risk and return

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23
Q

The CAL for a portfolio made up of a risky and risk free asset is ______-

A

Linear

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24
Q

The CAL that becomes tangent to the efficient frontier is considered as the ________

A

Most optimal CAL or the Capital market line

25
Q

What is the tangency portfolio/ market porfolio?

A

All the risky assets in the market and is the most diversified portfolio in the market. But is only a theoretical portfolio

26
Q

What is the weightage of wealth placed on each asset when an investor creates a proxy based on the market portfolio?

A

The market capitalisation of each individual asset on the market portfolio

27
Q

What does the two fud separation theorem state?

A

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

28
Q

What does the CML illustrate?

A

Different portfolios and their respective risk and returns, that consist of an investment in the market portfolio and the risk free asset

29
Q

What are the 2 main asset pricing models in equity markets?

A

Capital asset pricing model

Arbitrage pricing theory model

30
Q

What are asset pricing models in equity markets used for?

A

Measure asset returns, degree of mispricing in assets and make investment decisions

31
Q

Total risk of equities can be decomposed into

A

Systematic risk and idiosyncratic risk

32
Q

What are systematic risks?

A

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

33
Q

What are idiosyncratic risks?

A

Risk factors that may influence the returns of stocks of a particular industry

34
Q

How can idiosyncratic risk be reduced?

A

By investing in different industries that do no correlated with one another

35
Q

What does the beta coefficient measure?

A

Beta is a measure of sensitivity. It measures how sensitive stock returns is to market risk(systematic risk) factors

36
Q

Beta of a market portfolio is always

A

1

37
Q

If beta of the stock > Market portfolio beta, these a considered to be _____ stocks

A

Aggressive

38
Q

If beta of the stock < Market portfolio beta, these a considered to be _____ stocks

A

Conservative

39
Q

As the number of assets in the portfolio increase, the total risk of the portfolio comes down due to the ______ effect

A

Diversification

40
Q

What does CAPM state?

A

In equilibrium, the expected returns of a risky asset is equal to the risk free rate plus a beta adjusted market risk premium

41
Q

What are some assumptions of CAPM?

A

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

42
Q

When an asset return lines on the securities market line (SML), they’re considered to be _______ and hence free of _________

A

Correctly priced, arbitrage

43
Q

When assets returns do not lie on the SML they’re considered to be _______ and hence investors can exploit the prices and make ______

A

Mispriced, arbitrage returns

44
Q

In the SML framework , the risk of portfolios is measured in terms of _____

A

Beta/ systematic risk since CAPM assumes that idiosyncratic risks can be completely diversified away

45
Q

Why is the validity of CAPM questionable?

A

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

46
Q

What are factor models?

A

Models used to calculate the expected return of stocks

47
Q

What are the 2 types of factor models?

A

Single factor models, multi factor models

48
Q

What are factors?

A

Macro economic variables that impact stock returns

49
Q

A simplified version of the single factor model is the _________-

A

Market model

50
Q

CAPM is a _______ factor model

A

Single

51
Q

What are some assumptions of the Arbitrage pricing theory?

A

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

52
Q

What is arbitrage?

A

Process of making riskless profits by exploiting the mispriced assets in the market

53
Q

What are the 2 ways of making arbitrage?

A

Buying/investing in underpriced assets

Short selling overpriced assets

54
Q

What is risk factor premium?

A

Return over and above the risk free rate that is generated by a factor

55
Q

What are 4 major portfolio performace measures?

A

Sharpe ratio, Treynor ratio, Jensen’s alpha and information ration

56
Q

What does the Sharpe ratio measure?

A

The excess return of a stock per unit of total risk

57
Q

What does the Treynor ratio measure?

A

Excess return of a stock per unit of systematic risk

58
Q

What does Jensen’s alpha measure?

A

Return over and above the CAPM expected return given an asset beta

59
Q

What does the information ratio measure?

A

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