Chapter 2 - Portfolio Theory

Question 1

Standard Deviation

Answer 1

• Measures total risk of undiversified portfolios
  (Could ask, “What is riskiest asset?” Really, asking which asset has highest std. dev.)
• The higher the standard deviation, the higher the riskiness.
• Normal Distribution: 68% (1), 95% (2), 99% (3)
  CFP exam:
• calculate std dev
• use to determine probability of returns

Question 2

Coefficient of Variation

Answer 2

• Determines the probability of actually experiencing a return close to the average return.
• The higher the CV, the riskier an investment

Fomula: CV = Std Dev/Avg. Return

Question 3

Kurtosis

Answer 3

Variation of returns. If there is little variation (Treasuries), distribution will have high peak (positive Kurtosis).

• Leptokurtic: high peak & fat tails (higher chance of extreme events)
• Platykurtic: low peak and thin tails (lower chance of extreme events)

Question 4

Monte Carlo Simulation

Answer 4

A spreadsheet simulation that returns probability of events occurring based upon assumptions

Question 5

Covariance & Correlation (Coefficient)

Answer 5

Both:
- Measure movement of one security relative to that of another;
- relative measures

Covariance
Measures the relative risk of two securities
- How price movements between the two are related.
*COV formula provided

Correlation Coefficient
- Correlation ranges from -1 to +1.
+1: two assets are perfectly positively correlated to each other
0: the assets are completely uncorrelated
- Risk is reduced anytime correlation < 1.
Max Diversification Benefits are when correlation = -1

Question 6

Beta

Answer 6

• Measures volatility of a diversified portfolio
• An individual security’s volatility relative to that of the market.
• Measures systematic/market risk. (Std Dev measures total risk)
• Market Beta = 1 mirrors the market
• Beta > 1: stock fluctuates more than the market; greater risk
• Beta < 1: stock fluctuates less than the market; less risk
• Beta = 0 no systematic risk

*CFP Provided formula

Question 7

Coefficient of Determination or R-Squared (r^2)

Answer 7

Beta & Coeff of Determination VS
Std Dev & Coeff of Variation, Covariance, and Correlation Coeff

• % return due to the market. (r-squared = % of systematic risk)
• The higher % r-squared, the higher the % of systematic risk & smaller % of unsystematic risk
• Indicates how well diversified portfolio is & if Beta is appropriate to measure risk.

If r-squared > .70, then portfolio is diversified;
- Beta: Treynor & Jensen’s Alpha
(70% of the risk is systematic; 30% unsystematic)
If r-squared < .70, then portfolio is undiversified;
- Std. Dev: Sharpe

**Exam Tip: if not given r-squared, then choose Sharpe!

Question 8

Portfolio Risk

Answer 8

Utilizes the:
a) Std Dev (Coeff of Variation, Covariance, Correlation Coeff)
b) COV/Correlation Coeff
c) weight of the securities in a portfolio

*CFP Provided

Question 9

Systematic & Unsystematic Risk

Answer 9

• Systematic: lowest level of risk one could expect in a fully diversified portfolio. Inherent in the “system”. Non-diversifiable, market risk
  (as result of unknown element of securities).
• Unsystematic: exists in a specified firm or investment that can be eliminated through diversification. Diversifiable, unique, company-specific risk.

Question 10

Systematic Risks are PRIME

Answer 10

PRIME:
Purchase Power Risk: inflation decr amt of goods that can be purchased
Reinvestment Rate Risk: not being able to reinvest at same ROR (bonds)
Interest Rate Risk: inverse relationship of int rate and equities/bonds
Market Risk:
Exchange Rate Risk: change in rate impacts international securities

Question 11

Unsystematic Risks - ABCDEFG

Answer 11

Accounting Risk: risk that an audit firm is too closely tied to mgmt
Business Risk: inherent risk of industry in which they operate
Country Risk: doing business in a particular country
Default Risk: risk of company defaulting
Executive Risk: moral and ethical character of mgmt
Financial Risk: debt vs equity of firm, % of debt
Government Regulation Risk: risk of tariffs or restrictions being placed

Question 12

Efficient Frontier

Answer 12

The curve which illustrates the best possible returns that could be expected from all possible portfolios\
-Std Dev x-axis
- Expected return y-axis

Question 13

Indifference Curve

Answer 13

A curve based on the highest level of return given an acceptable level of risk. Represents how much return an investor needs to take on risk. Essentially, this tells how much return the investor requires in order to take on risk.
- If investor risk averse: significant return is required to take on a little risk. Hence, they will have a very steep indifference curve

Question 14

Efficient Portfolio

Answer 14

Occurs when an investor’s indifference curve is tangent to the Efficient Frontier

*studying graph rather than definitions probably more helpful

Question 15

Capital Market Line (CML)

Answer 15

• Macro aspect of the CAPM. Specifies relationship between risk & return in all possible portfolios.
• *Exam Tip: Measure of risk = Std. Dev.

*NOT need to know formula

Question 16

Capital Asset Pricing Model (CAPM) or Security Market Line (SML)

Answer 16

Calculates relationship between risk & return of an individual security.
- Measure of risk: Beta (diversified portfolio)
- *Exam Tip: asked to calculate Expected Return or Required ROR

*KNOW & practice Q’s w/formula

Question 17

Market Risk Premium

Answer 17

• How much an investor should be compensated to take on a market portfolio vs. a risk-free asset
• MRP = (rm - rf);
• rm = return of market
• rf = risk free rate of return

*MEMORIZE formula

Question 18

Portfolio Performance Measures

Answer 18

1) Information Ratio: *don’t study
2) Treynor Index: relative - needs to be compared to another Treynor ratio. Based on assumption of well-diversified portfolio, unsystematic risk is already close to zero. The higher the ratio, the better because that means more return provided for each unit of risk.
- Beta is used to measure risk (diversified)
- Measures return achieved relative to amt of systematic risk
- Does NOT measure portfolio performance vs. market’s performance
3) Sharpe Index: relative - needs to be compared to another Sharpe ratio. The higher the ratio, the better because that means more return provided for each unit of risk.
- Beta is used to measure risk (diversified)
- Measures risk premiums of the portfolio relative to the total amount of risk in the portfolio
**Exam Tip: if not given r-squared, then select Sharpe!
- Does NOT measure portfolio performance vs. market’s performance
4) Jensen Model or Jensen’s Alpha: significantly different from Treynor & Sharpe. It is a model of absolute performance
- Determines portfolio performance relative to market performance.
- Determines difference between realize, actual, and required returns
- Alpha: indicates level of portfolio’s performance
- Indications:
Positive (+) Alpha = Good; portfolio had more return than expected
Alpha = 0: portfolio return was equal to expected return
Negative (-) Alpha: Bad; portfolio had less return than expected

Question 19

Treynor vs Sharpe Index

Answer 19

• Treynor & Sharpe very similar. A higher ratio result is better because it means that more return is provided for each unit of risk.
• Both relative performance measures
• In poorly diversified portfolios, two portfolios are significantly different.
• In well diversified portfolios, results are identical