Chap 8 Flashcards
What did Harry Markowitz draw attention to?
- the common practice of portfolio diversification
- showed how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move together.
When measured over a short interval, the past rates of return on any stock conform fairly closely to which probability distribution?
Normal Distribution
- If you were to measure returns over long intervals, the distribution would be skewed.
As you hold different combinations of two stocks, what changes?
Expected return and standard deviation change as you hold different combinations of two stocks
Remember to go through the graphs and understand what each of the lines/points represent - page 195, 196, 197, 199
:)
How do lending and borrowing extend the range of investment possibilities?
If you invest in portfolio S and lend or borrow at the risk-free interest rate, rf, you can achieve any point along the straight line from rf through S. This gives you the highest expected return for any level of risk.
How do lending and borrowing extend the range of investment possibilities?
If you invest in portfolio S and lend or borrow at the risk-free interest rate, rf, you can achieve any point along the straight line from rf through S. This gives you the highest expected return for any level of risk.
What is the sharpe ratio? How is it calculated?
It is the ratio of the risk premium to the standard deviation
= (r - rf) / std. dev.
How could you find the best efficient portfolio from the graph? (graph on page 197)
Start on the vertical axis at rf and draw the steepest line you can to the curved red line of efficient portfolios. That line will be tangent to the red line. The efficient portfolio at the tangency point is better than all the others.
Why do investors track sharpe ratios?
Investors track Sharpe ratios to measure the risk-adjusted performance of investment manag- ers.
What is market risk premium?
The differ- ence between the return on the market and the interest rate
= r - rf
What is the market risk premium on treasury bills?
0
What does the CAPM state?
In a competitive market, the expected risk premium varies in direct proportion to beta.
This means that each investment should lie on the sloping security market line connecting Treasury bills and the market portfolio.
- investors are solely concerned with the level and uncertainty of their future wealth
What is the relationship between beta and expected risk premium?
r - rf = beta(rm - rf)
What would a risk-averse / risk-tolerant investor when combining the efficient portfolio and lending/borrowing at the risk free rate?
A risk-averse investor will put part of his money in this efficient portfolio and part in the risk-free asset.
A risk-tolerant investor may put all her money in this portfolio or she may borrow and put in even more.
In the end, why does everyone hold the market portfolio?
Everybody has the same information and assessments of the expected returns, standard deviation and correlations.
If there is no superior information, each investor should hold the same portfolio as everybody else; in other words, everyone should hold the market portfolio.
What is Beta?
A stock’s sensitivity to changes in the value of the market portfolio is known as beta. Beta, therefore, measures the marginal contribution of a stock to the risk of the market portfolio.
What if a stock did not lie on the SML?
In equilibrium no stock can lie below the security market line.
Instead of buying a stock that does not lie on the SML, investors would either borrow or lend to
How could an investor always obtain an expected risk premium of [β(rm – rf)]?
by holding a mixture of the market portfolio and a risk-free loan. So in well- functioning markets nobody will hold a stock that offers an expected risk premium of less than β(rm – rf)
Why have common stocks given on average a higher return than treasury bills?
Few people quarrel with the idea that investors require some extra return for taking on risk
Are investors concerned with those risks that can’t be eliminated with diversification?
Yes, this is what the CAPM captures.
The CAPM states that every stock lies on ….
The security market line (SML)
Where are high beta/low beta portfolios plotted with respect to the SML?
High beta portfolios are plotted below the SML
Low beta portfolios are plotted above the SML
What assumptions are made in the CAPM?
- We assumed that investment in U.S. Treasury bills is risk-free
- That investors can borrow money at the same rate of interest at which they can lend. Generally borrowing rates are higher than lending rates.
What is one limit of the CAPM? (hint: with regards to the price they paid for the stock vs. the current price today)
The capital asset pricing model does not allow for the possibility that investors may take account of the price at which they purchased stock and feel elated when their investment is in the black and depressed when it is in the red.
What is the Arbitrage Pricing Theory?
Assuming that each stock’s return depends partly on pervasive macroeconomic influences or “factors” and partly on “noise”—events that are unique to that company.
What are the two sources of risk for any individual stock?
First is the risk that stems from the pervasive macroeconomic factors. This cannot be eliminated by diversification. Second is the risk arising from possible events that are specific to the company.
Which risk can be eliminated by diversification?
Diversification eliminates specific risk.
Therefore, the expected risk premium on a stock is affected by factor or macroeconomic risk; it is not affected by specific risk.
What is the formula for expected risk premium in ABT?
Expected risk premium = b1(rfactor 1 − rf) + b2(rfactor 2 − rf ) + · · ·
What are some similarities and differences between CAPM and ABT?
Similarity:
They both stress that expected return depends on the risk stemming from economywide influences and is not affected by specific risk
Difference:
In the CAPM, the market portfolio plays a huge role in determining the expected return, but in APT the market portfolio is not featured in the calculation
What is the Fama and French Three-Factor model?
Fama and French have identified 3 macroeconomic factors that will affect the expected return on any stock.
- the expected return is the risk free rate plus the factor sensitivities multiplied by the factor risk premiums
What are the three factors in the F&F 3 factor model?
- market factor, size factor, book-to-market factor
Which is the best-known model of risk and return?
The CAPM obvi
