E1 P2- Lectures 5-7 Flashcards
What does a high standard deviation indicate?
That there is a lot of variance in the observed data around the mean
What type of standard deviation can be seen with blue-chip stocks?
Low, little variance and little risk
Example in this
What is one of the main benefits of standard deviation?
It helps investors identify underlying risk. If an investment option has an average annual return of 10% but in the last 3 years it has returned 50%, -15% and 5% then it is unlikely it will actually return 10%.
What is the formal measure of risk?
SD
How does portfolio theory help investors?
Offers the framework needed to build portfolios with an optimal risk-return profile
Define the covariance of returns
describes the linear relationship between the return of 2 securities
What does a positive and negative covariance show?
A positive covariance means asset returns move together, while a negative covariance means they move inversely.
When the correlation coefficient is equal to 0 what does it mean for 2 securities?
there is no linear relationship between them - their returns are independent
When does SD indicate an asset is risky?
SD is positive
What does the SD of a portfolio depend on ?
the ws - the share %
the p - the correlation of the asset’s returns
If p AB = 1 what does this mean for the portfolio?
It is risky because σP will always be above 0
what does it mean when a portfolio is dominated?
there are other portfolios offering a higher level of return for the same risk
What is the segment between the riskless portfolio called and what does it represent?
It is called the efficient frontier - showing the optimal balance between risk and return for a portfolio
What is the opportunity set?
the set of portfolios that can be obtained by combining A and B in different amounts
What is the role of an indifference curve in PT?
helps investors decide what portfolio on the efficiency frontier they want, ie which one has maximum utility
Does a low risk averse investor have a shallow indifference curve or steep?
shallow, highly risk averse has steep
How do investors choose between portfolios on an efficient frontier?
they choose the point at which their indifference curve is tangent to the efficient frontier
How does an investor know their utility functions?
Advisors may help them identify acceptable levels of risk through risk tolerance tests
How can portfolio diversification help investors?
Can reduce risk, however some risk will always persevere - systematic risk
What are the key assumptions of CAPM?
- investors only differ over their preference toward risk
- investors share the same efficient frontier
- no taxes and transaction costs
How do you work out the market portfolio?
Draw a straight line from Er = rf and SD = 0, the point of tangency with the efficient frontier is the market portfolio, M.
the line itself is the CML
What is the the market portfolio ? (M)
-a theoretical bundle of investments that includes every asset in the market, each one proportionally represented according to its market value.
- the most attractive portfolio of risky securities that are more efficient than the ones on the efficient frontier
- in a perfect capital market, investors are only interested in holding M
What is Tobin’s Separation theorem?
- states that investment happens in two stages:
-1. find CML
2. find optimal portfolio on it
to do with risk
What is the Sharpe Ratio? word form
a measure of performance that indicates excess return per unit of risk
T or F, In perfect capital markets all securities traded have different return-to-risk ratios
False. all the same
therefore, they should all have same risk-return tradeoff as M portfolio
What does a security’s beta indicate?
a measure of the systematic risk of a security or portfolio compared to the market as a whole.
measures a security’s responsiveness to movements of the market portfolio
NON-DIVERSIFIABLE
What is the market portfolio’s beta (B.M)?
1, because it’s compared to itself
When does a securities beta show it is entirely risk-free?
when it = 0
If a company has a beta of 2.57% and the market rises 10% how much does the company rise?
12.57%
What is a Security Market Line? and what does it help indicate?
a securities E(r) as a function of its beta
- helps determine whether a security is over or under valued
What is the Capital Asset Pricing Model (CAPM)?
- identifies a theoretical relationship between a security expected returns and beta
Difference between CAPM and CLM?
- CAPM - relationship between a security expected returns and beta
- CLM - relationship between portfolio expected return and SD
When is a security undervalued (bad investment) and vice versa on a graph with SML?
when it falls below the line
above is good
How do you find the risk-free rate (R.F) in practice?
either the short-term 90 day treasury bill rate (avr over 5 years) or the 5-10 year bond rate
How do we find the expected market return E(R.M) in practice?
We must move from expected to actual using averages of actual returns, often over 5 years from places like FTSE100 and S&P500
we use the Single index model to do the first bit
How do derivatives help investors reduce risk exposure?
- enable investors to adjust their risk / return profiles, without having to trade in the underlying securities
- companies and investors use them to hedge (reduce risk)
Name two benefits of derivatives other than risk hedging.
- not having to trade securities means they save high transaction costs
- you do not miss out on gains if fears prove to be groundless
Define derivatives
futures, forwards and options are all derivatives
an asset whose performance is derived from changes in the value of an underlying stock
- the legal right to compensation for changes in an underlyer that becomes the asset
common underlyers are commodities, shares, bonds, currencies, interest r
What is the difference between a futures and forwards contract?
3 each
futures are traded on public exchanges
futures = low risk, high regulation
futures are settled daily, over the counter
forwards are between two private parties and taylor made
forwards = more risk due to low regulation
forwards are settled on maturity
What are forward and futures
- contracts that a certain thing will be exchanged at specified future time for a price specified today
both parties are obligated to hold up their end
What are the two positions an investor maintains in futures and forwards?
- long / buyers position - expects underlyer to increase in value
- short / sellers position - expects underlyer to drop in value
What is the inital margin?
The amount (margin) needed in your account to take a trade
usually in the region of 0.1 to 15 percent of the underlying value
What is the maintenance margin?
The lowest amount (margin) you need in your account to maintain it
protects the party in the event of a default
What is the variation margin?
Variation margin refers the amount of funds needed to ensure margin levels for trading.
Define an option
- gives the holder the right (but not obligation) to buy or sell a given amount of an asset on or before a given date, at prices agreed today
What is the difference between European options and American Options ?
- European options can be exercised only at expiry
- American options can be exercised any time up to expiry
What do in, at and out-the-money mean?
In = positive payoff when exercised
At= zero payoff
Out= negative paypff
What is the diff between call and put option?
Call - gives holder right to buy a stock
Put - gives holder right to sell a stock
Options means you don’t have to exercise it, however what will you always be subject to? Y
The premium, so if you avoid losing or only gain a little you still pay the premium
Profit = payoff - premium
On a long call option graph, where is the break-even point?
Where the profit curve intercepts X axis
You buy a long put option for 5x 200 p a share, at a premium of 5p per share and the share drops to 0p. What is your profit after exercising the option?
975 p
How can you hedge with options?
- if you own shares, you can by a protective put option that limits your losses to only the intrinsic value + the premium whilst still keeping your profits unlimited minus the premium
What is the SD, correlation with the market portfolio and the beta of the risk-free asset?
The risk-free asset has zero standard deviation.
The risk-free asset has zero correlation with the market portfolio.
The beta of the risk-free asset is 0.
ALL 0
In CAPM how do you measure risk?
In standard models it is SD
Beta
What is the protective put strategy?
It is where a put option is purchased of a particular asset to hedge any ownership of this asset. Losses are capped but gains remain unlimited
