Chapter 15: Introduction to the Portfolio Approach

Question 1

Expected Return of a Single Security Formula

Answer 1

Expected Cash Flow + Expected Capital Gain (or - Capital Loss) / Beginning Value

Question 2

Transaction period longer or shorter than a year.

Answer 2

Holding Period Return

Question 3

A rate of return that is expected. Helps to determine where funds should be invested

Answer 3

Ex-ante

Question 4

A rate of return that is based on actual historical returns. Compares actual results against both anticipated results and market benchmarks

Answer 4

Ex-post

Question 5

The rate that is essentially “risk free”, or zero risk. Yield is roughly determined by estimating the short term inflation rate and adding a real return, so all other securities must be greater than this to compensate for the added risk.

Answer 5

Risk free return

Question 6

The risk that inflation will reduce future purchasing power and real return

Answer 6

Inflation rate risk

Question 7

The risk that a company’s earnings will be reduced as a result of a labour strike, introduction of a new product to the market, or other factors.

Answer 7

Business Risk

Question 8

Risk of unfavourable changes in government policies. Raising taxes, raising or lowering interest rates, risks to foreign investment, etc.

Answer 8

Political Risk

Question 9

Risk that an investor will not be able to buy or sell the security at a fair price quickly enough because opportunities are limited

Answer 9

Liquidity Risk

Question 10

Risk that interest rates will adversely affect investment

Answer 10

Interest Rate Risk

Question 11

Risk of loss resulting from an unfavourable change in exchange rates

Answer 11

Foreign Investment Risk

Question 12

Risk that a company will be unable to make timely interest payments or repay the principal amount of a loan when it comes due

Answer 12

Default Risk

Question 13

Risk associated with investing in a capital market. Always present, cannot be reduced through diversification

Answer 13

Systematic Risk

Question 14

The risk of a specific security changing in price or going in a different direction. Can be reduced through diversification

Answer 14

Non-systematic/specific risk

Question 15

Measure of risk commonly applied to portfolios and individual securities within the portfolio. Gives the investor an indication of the risk associated with the portfolio.

Answer 15

Standard Deviation

Question 16

Links the risk of individual securities or a portfolio of securities to the market as a whole.
Measures the degree to which the securities tend to move up and down with the market.

Answer 16

Beta

Question 17

Expected Return of the Portfolio Formula

Answer 17

E(r) = (R1)(W1) + (R2)(W2)… (Rn)(Wn)

Question 18

A statistical measure of how the returns on two securities move together over time, and therefore, how a change to the value of one security can predict the change in value of another.

Answer 18

Correlation

Question 19

The additional movement and excess return on the portfolio. Equity portfolios often outperform the market have move more than expected from their beta.

Answer 19

Alpha

Question 20

Goal is to outperform a benchmark portfolio on a risk-adjusted basis. Use either a top-down or bottom-up analysis

Answer 20

Active Investment Manager

Question 21

Begins with a study of broad macroeconomic factors before narrowing the analysis to individual stocks

Answer 21

Top Down approach

Question 22

Begins with the focus on individual stocks, then builds portfolios of the best stocks in terms of forecasted risk-return characteristics

Answer 22

Bottom up approach

Question 23

Tend to replicate the performance of a specific market index without trying to beat it

Answer 23

Passive Investment

Question 24

Consistent with the view that securities markets are efficient, meaning that the price of a security at all times reflects all relevant information on expected return and risk.

Answer 24

Buy and Hold Strategy

Question 25

Involves buying and holding a portfolio of securities that matches the composition of a benchmark index

Answer 25

Indexing

Question 26

Focus on current and future earnings of individual companies, specifically EPS. Stocks in this type of portfolio usually have lower dividend yield, or provide no dividend at all, and managers may turn over the securities more often.

Answer 26

Growth Managers

Question 27

Focus is on stocks that are perceived to be trading for less than their true value. Turnover is typically low because these managers usually wait for a stock’s intrinsic value to be realized.

Answer 27

Value Managers

Question 28

High Price-to-earnings, high price-to-book value, high price-to-cashflow.

Answer 28

Growth Portfolio

Question 29

Low price-to-earnings ratio, low price-to-book value ratio, low price-to-cash flow ratio, high dividend yield.

Answer 29

Value Portfolio

Question 30

Applies to a top down approach, focusing on analyzing the prospects for the overall economy. Managers invest in the industry sectors expected to outperform. Primary focus is to identify the current phase of the economic cycle, the direction the economy is headed in, and the various sectors affected.

Answer 30

Sector Rotation

Question 31

Hold t-bills and short-term bonds with maturities less than five years. Portfolios holding these products are less volatile when interest rates rise because they have investments maturing that can be invested at higher rates

Answer 31

Short Term Managers

Question 32

Select higher quality corporate issues to improve the yield without taking on much additional risk. Generally, the lower quality of the bond, the higher the yield it must have.

Answer 32

Credit Quality

Question 33

High-yield bonds that are non-investment grade products.

Answer 33

Junk bonds

Question 34

Some managers feel they can add value by anticipating the direction of interest rates and structuring their portfolios accordingly.

Answer 34

Interest Rate Anticipators