Chapter Nine Flashcards
What type of risk can diversification eliminate?
It can only eliminate unsystematic risk
What else can unsystematic risk be called?
Specific, non-systematic, or idiosyncratic risk
What does positive correlation imply on two securities?
On average they move in the same direction
What is perfect positive correlation between two securities?
They move in the same direction to the same extent
What is true of idiosyncratic risk?
It is specific to an investment and can be diversified away
Idiosyncratic risk equals what?
Idiosyncratic risk = specific risk = diversifiable risk = unsystematic risk
What does moving against the market imply in terms of beta?
It implies a negative beta
What does less volatility than the market in terms of beta?
A value less than 1
CAPM formula?
Capital asset expected return = Risk free rate of interest + (beta * expected return of the market) - risk free rate of interest
Beta formula
Covariance (i,m) / variance of the market
How can beta be correctly described from assumptions of CAPM?
- The proportion of a given fund that would have to be invested in the market portfolio to create a given risk/return profile.
- An index of a security’s systematic risk relative to that of the market
What risks would remain within a randomly selected portfolio of securities?
Market risk and systematic risk as they cannot be diversified away
What does CAPM suggest about the return of a portfolio with the highest beta?
The portfolio with the highest beta will have the highest expected return
If a portfolio has no specific or systematic risk, what rate of return willl be obtained?
Risk-free rate
What will a rational investor expect to recieve in terms of risk?
Expect to receive a higher return on an investment that has a higher risk
Can specific risk be reduced by diversification?
Yes
Market risk premium formula?
Market risk premium = r_m - r_f
Expected return of a portfolio using beta, market risk premium and expected market return?
Expected return of a portfolio = Risk free rate + beta(expected market return - risk free rate)
What is the best way to diversify?
Choose shares that are uncorrelated which means that if one goes up in value the other does not, diversifying the portfolio and reducing risk. Negatively correlated shares would also be a good way to do this
What is the arbitrage pricing theory?
It is a multi factor model in which the factors are not specified
What is a limitation of the APT
It’s difficult in establishing relevant betas and their stability
The CAPM asserts that portfolio returns are best explained by what risk?
Systematic risk
The covariance of the returns of two securities can be caluclated as?
The correlation of the securities multiplied by the product of their standard deviations
A fund has a one week VAR of £1 million at a 95% level, what does this mean?
5% chance of losing £1 million or more in any one week
What are the liabilities of pension funds predominantly?
Long-term real liablities where the liabilities it needs to meet in the future are linked to inflation (real)
What is the correlation between bonds and commodities?
Negatively correlated with that correlation increasing with investment horizon. With long-term bonds the correlation will be strongly negative
An investor in an indexed equity fund is exposed to what risks?
Systematick risk and tracking error
What is market timing?
Market timing involves the short-term variation of the asset allocation of a fund in order to take advantage of market changes and potential market fluctuations
What is market timing referred to as?
It is referred to as tactical asset allocation
Who is the Stewardship Code for?
Institutional investors
Why is a CDO based on mortgage-backed securities least likely to be trading at its fair value?
The least liquid assets are likely to be furthest from the fair value and this will include OTC derivatives and securities on illiquid markets. The CDO is opaque and hard to value
What do general insurance business relate to?
Insurance policies such as building insurance policies, contents insurance, and car insurance policies
What does SRI mean?
Socially responsible investment
What are examples of SRI activites?
Positive screening, negative screening and shareholder advocacy and engagement
Is tactical asset allocation SRI?
No
Immunisation risk is minimised in what portfolio?
A bullet portfolio
What is an advantage of a barbell strategy?
An investor can select from a much greater range of bonds however it implies a greater degree of immunisation risk compared to the more focused bullet portfolio strategy
Bullet vs barbell portfolio?
A barbell portfolio combining short- and long-term bond positions will have greater convexity than a bullet portfolio concentrated in a single maturity for a given duration
What is strategic asset allocation?
Allocating the portfolio across various asset classes and currencies
What does LDI seek to do?
To match fund assets and liabilities
What does LDI stand for?
Liability driven investment
Explain LDI
It is an investment approach that seeks to match the liabilities of a financial institution or an individual with its assets. An LDI is associated with pension funds and life assurance firms
What is negative screening?
An SRI approach where certain activities are screened out. Negative screening excludes certain securities based on ethical criteria. They can sometimes be referred to as sin stocks
What are the main risks of LDI?
Credit risk and immunisation risk
What is cash matching?
It is also known as perfect immunisation. This means that the investor is not exposed to reinvestment risk or interest rate fluctuations as the future liability has been matched exactly in both timing and amount
How does cash matching work?
By buying a bond where the redemption of that bond meets the date of the liability, and the proceeds upon maturity meet the size of the liability
What are the key issues facing a tracker fund manager?
The method in index replication is important as is the freequency of portfolio rebalancing to ensure the index being tracked is reflected in the relevant fund
UK vs. European pension funds
UK pensions tend to have a higher percentage of equities in their fund than ficed income whereas European pension funds ten to have a higher exposure to fixed income
What is a yield curve ride?
The aim is to invest in a bond where the duration of that bond is greater than the date of the liability. The intention is then to sell what is left on the bond upon meeting the date of the liability
What are the assets required by a mature pension fund?
A mature pension fund is where the average age of the investors is older than other funds, i.e. close to retirement. The fund manager will wish to invest in lower risk investments that have shorter maturities e.g. money market instruments or short dated gilts
What is weak form efficiency?
It implies that any information that can be established from charts is already factored into the price. Charting therefore reveals no new information whereas fundamental analysis does
Which theory best describes the fact that individuals have been shown to value gains and losses differently?
Loss aversion. This includes selling winning stocks too soon and holding losing stocks too long
What is a semi-strong market?
All information is reflected in the current price. As a result technical and fundamental analysts are deriving no new information and cannot beat the market. Insider dealers however are aware of unpublished information and can benefit
What is a weakly efficient market?
All information is reflected in the current price and technical analysts derive no new information. Fundamental analysts and insider dealers can benefit
What will a pension fund with an increasing average age do?
Invest more in fixed interest securities
Does MiFID permit off-exchange trading?
Yes
Are MTFs expected to increase or reduce trading costs?
They are expected to reduce trading costs
Put bills, bonds and notes in the correct order of increasing maturity
Bills, notes, bonds
What is immunisation?
It is where a portfolio will provide an asset return over a specific time horizon, irrespective of interest rate changes. Therefore, the aim is to select a portfolio where the duration of the portfolio is the same as that of the liability it is intended to meet
