Chapter 4 – the merits and limitations of the main investment theories Flashcards
What does standard deviation measure?
Standard deviation measures how widely the answer of return on investment varies around the mean or expected return. The greater the standard deviation, the greater the volatility and associated risk.
What does beta measure?
Beta measures the sensitivity of a security to a market
What type of risk can be eliminated by holding a diverse portfolio?
Nonsystematic or investment specific risk
Why, in theory, should investment managers construct portfolios to lie on the efficient frontier?
The efficient frontier represents the set of portfolios that have the best risk reward trade-off, so for any level of risk the portfolio on the frontier with that level of risk will give the best return for the investor
What is usually used as representing a risk-free Assets in the capital asset pricing model equation?
91 day Treasury bills as there is virtually no default risk and, because of the short life, interest and inflation risks are minimal. Another risk free rate that is less commonly used is the long gilt yield
How does arbitrage pricing theory differ from capital asset pricing model?
Arbitrage pricing theory is based on the belief that there is more than one type of risk of influence as security returns, the different securities have different sensitivities to each risk. Capital asset pricing model argues that returns are based on the systematic risk to which the security is exposed, rather than total risk.
What are the three forms of efficient market hypothesis and what information do they consider?
- Weak form efficiency. This states that the current security price is fully refract all past price and trading volume information and future prices cannot be predicted by analysing this type of historic data.
- Semi strong deficiency. This states that security prices adjust to all publicly available information very rapidly and in an unbiased way, so that excess returns cannot be earned by trading that’s information.
- Strong form efficiency. This states that security prices reflect all the information that any investor can acquire.
How does behavioural finance explain market anomalies?
Behavioural finance highlights inefficiency is caused by the irrational way in which investors react to new information, which causes market trends inspect of bubbles.
Formula for the capital asset pricing model equation
This formula gives you the expected return on a risky investment
= Rf + Bi(Rm - Rf)
Rf - rate of return on risk free asset
Rm - expected return of market portfolio
Bi - measure of sensitivity of investments To movements in the overall market
(Rm - Rf) - market risk premium, The access return of the market over the risk free rate
Bi(Rm - Rf) - Risk premium of the risky investment
The formula of the two factor model
This also gives the expected return like the CAPM equation
=Rf + Bgdp + Bir
Risk free return plus risk premium based on the security sensitivity to all anticipated changes in GDP plus risk premium based on the securities sensitivity to an anticipated changes in interest rates
If the returns from a market are normally distributed and the average return is 10% a year, with an SD of 10% approximately what percentage of returns will be negative?
Approximately 68% of returns will fall between 0% and 20% (I.e. 10%+-10%). Therefore, since a normal distribution is symmetric, 16% of returns will be above 20% and 16% will be below 0%, I.e. 16% of returns will be negative
Does the EMH support active stock selection or passive investing (E.g index funds)?
EMH indicates that active stock selection would not put perform the market as the market adapts to environment, so supports passive index investing
What is the expected return for southern research if it has a beta of 1.4, if the expected return on a treasury bill is 3.5% and the. Expected return on the market portfolio is 8%?
3.5 + 1.4(8-3.5)
