Chapter 13 - Portfolio Theory

Question 1

Performance Measurement

Answer 1

1. Holding period return: difference between end and start values
2. Money Weighted rate of return (MWRR): Equivalent of IRR. Takes into account inflows and outflows - but not timing and size of flows. Therefore, can overstate/understate returns.
3. TWR - Gives equal weighing to the return in each period - hence enables comparisons of funds that have inflow and outflow at different times

Question 2

Risk and Reward

Answer 2

1. Systematic AKA market Risk: Economic, political and global events that impact the market (hard to predict)
2. Unsystematic (micro - can be eliminated by diversification)
   - business
   - industry
   - management
   - financial (debt financing)

Total risk= systematic + Unsystematic risk

Question 3

Measuring Risk

Answer 3

1. Standard deviation (volatility/distance between the mean). Measures TOTAL risk. High Sd=riskier.

Adv-based on every item of the distribution. Dis-volatility not complete measure of risk, measures both upside and downside risk. Is upside risk bad??

2. Beta Coefficient: can measure the volatility of an individual stock vs the market - slope of stock return(Y-axis) and market return (X axis) graph
3. Drawdown risk: measures worst case risk

Question 4

Pricing Models

Answer 4

1. Capital asset pricing (CAPM): Calculates expected returns given systematic risk
   Can use with expected and actual returns data
   Assumptions:
   -no tax or transactional costs
   - investors have same expectations and want maximum return with minimum risk. They have diversified portfolios
   - risk free rate equal for all
2. Arbitrage pricing theory

Question 5

Performance Measures

Answer 5

1. Jensen’s Alpha: Actual return of portfolio - expected returns (CAPM)
2. Sharpe Ratio: uses total risk (portfolio standard deviation) as assumes portfolio is not diversified
3. Treynor ratio: uses systematic risk only (beta of portfolio) as assumes portfolio is diversified
4. Information ratio: measures risk taken to gain alpha/excess returns

Question 6

Bond Portfolios

Answer 6

Passive
Cash matched/dedicated portfolios: bonds generate cash flows of same time and size of liabilities (CDI)
Immunization: match duration of bonds with duration of liabilities
Bullet - ALL bonds have close duration to liabilities
Barbell - weighted average durations match liabilities

Active
Policy switch: different bonds switch
Anomaly switch: similar bonds switch
- Riding yield curve
LDI- looks at:
Plan surplus, surplus volatility and surplus tracking error (shortfall)

Question 7

Questions????

Answer 7

1. Time weighted rate of return - if high than market return fund has been managed well???