Chapter 10 - Portfolio theory - principles and limitations

Question 1

effcient market hypothesis (EMH)

and the three forms

Answer 1

• in an open and effcient market, security prices fully reflect all available information and prices rapidly adjust to new information
• it is therfore not possible to outperform the market as movement is motivated by new information which is avilable to everybody at the same time
• weak - current prices reflect all past prices and trading info, future prices cannot be predicted anaylsing this
• semi strong - current prices reflect all publicly available info. prices adjust rapidly to new information - no excess returns can be earned tarding by that information. as above, also includes: finanacial statements, announcments and economic factors
• strong form - as above, but also includes private information - typically held by insiders such as officers, execs or their advisers

Question 2

the efficient frontier

limitations

Answer 2

• relationship between the expected return from a portfolio and the risk of the portfolio (risk measured by standard devaiation)
• maps various portfolios and shows the return that can be expected for given level of risk, or the lowest level of risk needed to achieve a given expected return

limitations

• assumes standard deviation is the correct measure of risk
• risk is not the only factor to consider, for example, tax and transaction costs
• corelation of risk relies on historical data

Question 3

modern portfolio theory (MPT)

Answer 3

• ways in which portfolios can be constructed to maximise returns and minimise risks
• important to consider how each investemnt in a portfolio changes in price relative to one another
• if two portfolios offered the same return but had oposing risk profiles, the least risky would be selected - rational

Question 4

capital asset pricing model (CAPM)

E(Ri) =

Answer 4

• theoretical expected return for a security. combination of the return on a risk free asset and compensation for holding a risky asset, i.e. a risk premium
• Rf + Bi (Rm - Rf)

Rf is the rate of return on a risk free asset

Rm is the expected return of the market portfolio

Question 5

diversification excluding correlation

Answer 5

• different asset classes. not all assets repsond in the same way to changes in the econmic cycle
  
  • equities are more likely to do well as the economy grows
  • fixed interest securities tend to outperform equities as recession looms
  • residential property values are closely related to peoples real earnings
• choosing companies from different sectors. diversification within sectors is limited, most shares move up or down in line with the sector
• including overseas comanies - countries may be at a different stage in the economic cycle

Question 6

systematic and non-systematic risk

Answer 6

• systematic - affects the market as a whole, cannot be avoided. sensitivity of stock is measured by it’s beta
  
  • interest rates, inflation or other economic factors
  • tax changes
  • terrorist attacks or wars
• non-systematic - unique to a particualr company. unexpected good or bad news. can be dampned by holding a diverse portfolio
  
  • new compeititor
  • technological breakthroughs (can be good or bad)
  • change in company credit rating

Question 7

ETF/ index funds

advantages / disadvantages

Answer 7

• collective investment schemes designed to track the performance of an index. can be structured as an OEIC or unit trust, but ETFs are now more popular. passive IM
• advantages
  
  • simple and easy to understand investment objective
  • returns in line with the index
  • low costs
  • lower portfolio turnover
  • no exposure to an active IM style
• disadvantages
  
  • possible tracking error
  • they follow markets down as well as up

Question 8

ETF/ index fund - indexation methodologies

physical

synthetic

Answer 8

• based on market capitalisation weighted indicies. equally weighted version of the same index are becoming popular
• physical replication - favoured and traditional method
  
  • full - each stock being tracked to be held in accordance with its index weighting. accurate, but expensive; only suitable for large portfolios
  • stratfied - sample of securities from each sector is held. may encourage a bias to select best perceived prospects. less expensive
  • optimisation - more comlpex. uses a computer modelling technique to find a sample of stocks that best mimic the broad charecteristics of the index. less expensive than full
• synthetic replication - FM entering into a swap (an OTC derivative) with a market counterparty to exchange returns on the index for a payment.
  
  • sampling is still used to identify the optimal range of securities to be included
  • costs are considerable lower, although counterparty risk is equally higher

Question 9

CAPM assumptions

Answer 9

• investors are rational and risk averse, making decesions on the basis of risk and return alone
• investors have an identical holding period
• no one individual can affect the market price
• there are no taxes, transaction costs and restrictions on short selling
• information is free and available to all investors
• invetsors can borrow and lend unlimited amounts of money at the risk-free rate
• the liquidty of an asset can be ignored

Question 10

behavioural finance

Answer 10

• explores how emotional and psychological factors affect investment decisions.
• it attempts to explain market anomalies and other market activity that are not explained by MPT and EMH, and offers alternative explanations of why security prices deviate from their fundamental values