EVERYTHING Flashcards
portfolio management
the professional management of securities/assets (real or financial to meet pre-specified investment objectives set by investors
real assets
land,building,machines and knowledge of service
financial assets
stocks, bonds, derivatives or any combination of these assets. no more than thin sheets of paper
pre-specified investment objectives
based on an investor’s need and risk tolerance - achievable and for a fixed time horizon
where are securities traded?
- equity markets
- fixed income markets
equity markets
exchanges: TSE, NYSE, NASDAQ, american stock exchange
market indexes
hypothetical portfolio that represents financial markets (or a particular sector)
Canada: S&P 500/TSX composite index (market-value index)
US: S&P500, dow jones 30 industrial average (DJIA)
fixed-income markets
Canada and US
exchanges: no exchanges but over-the-counter (OTC)
barclay’s capital bond index: (corporate&gov bonds, MBS, treasuries,etc.)
In fixed income markets, bonds are the most common security traded. these are solely interest-earning investments.
depository receipts
certificates traded in one country’s market that represent ownership in shares of foreign company
mutual funds
-money pooled from different investors for the purpose of investing in securities as equity fixed income and derivatives.
-you can only trade them at 4pm. one price/day
-disclosed every quarter
open-ended funds
redeemable at any time.An Open-End Fund is a type of investment vehicle that uses pooled assets, allowing for ongoing new contributions and withdrawals from investors1. It is a diversified portfolio of pooled investor money that can issue an unlimited number of shares1. The fund sponsor sells shares directly to investors and redeems them as well1. These shares are priced daily based on their current net asset value (NAV).
exchange traded funds
a combination of mutual funds and stocks. tracks the performance of an index of share returns for a particular country or sector.
how are equities traded?
securities are bought and sold in two main markets. primary and secondary
primary market
firms raise capital by issuing new securities like equities and bonds. IPOs and seasoned new issues (new equity offered by a company that already has floated equity)
secondary market
purchase and sale of already issued securities among investors done (e.g. stock market)
4 types of secondary markets
- direct search markets
- brokered markets
- dealers market
-auction markets
direct search market
buyers and sellers find each other, directly characterized by limited participation, low-prices, and non-standard goods
brokered markets
brokers facilitate buyers and sellers meetings based on comissions or brokerage
dealers market
dealers buy securities for their own accounts and sell these securities later for profit. (price bought minus price sold)
auction markets
buyers and sellers converge at one place and bid for securities
arithmetic average
does not given equivalent per period returns
geometric average
gives equivalent per period returns
market orders
execute at current market (bid/ask) prices. adv. order execution guaranteed (immediate) disadv. uncertainty about execution price.
limit order
allows investors to buy/sell securities at a specific price (or better)
adv: max profits - orders to buy(sell) at maximum(minimum) price
no oversight
time bound execution
disadv: no protection against loses
stop orders
help minimize losses, trades will not be executed unless price hits the “stop price”
trading on margins
-margin accounts allow investors to borrow money to invest.
- refers to collateral against the fall in value of investments
- investors need to provide security whenever their account values fall below the amount of money they have borrowed
- margin ratio = MV - loan/MV
margin call
if the margin of your account falls below a certain level, (the maintenance margin) the broker will issue a margin call. you’ll need to deposit more money or sell securities to meet the margin requirement.
probability theory
- assume stock returns are continuous random variables
-how is this probability distributed? generated from the probability distribution functions - thus random variables are completely characterized by their PDFs
mean variance criterion
the expected (mean) return- standard deviation trade-off is equivalently known as mean-variance criterion.
- asset A dominates asset B if:
E(ra)>E(rb) and Oa=Ob
portfolio construction process
- specify the return characteristics of all securities (E(r), O, covariance)
- calculate the optimal risky portfolio (max sharpe ratio)
- allocate funds b/w the optimal risky portfolio and the risk-free asset
-determine the level of risk aversion
- calculate the fraction of the complete portfolio allocated to optimal risky portfolio and to risk-free asset (T-bill)
Markowitz Model
-his model is “step one”. that is, identifying the efficient set of portfolios (efficient frontier)
- efficient portfolio = minimum variance portfolio for a given level of expected return & correlation structure
- any (mean-variance) investor should choose an efficient portfolio to benefit from diversification
-a portfolio manager can form a set of efficient portfolios by running an optimization program over given characteristics of securities.
markowitz steps
step 1: risk-return opportunities available to the investor. these are summarized by the minimum-variance frontier
step 2: search for the “optimal risk” portfolio P with highest sharpe ratio
step 3: choose appropriate mix of ORP and T-bills to form OCP
- having formed the efficient frontier, we choose a portfolio P which is at the tangency point of the efficient fronteir and with the highest sharpe ratio
two fund separation theorem
- suggests you can separate the problem of investing into 2 funds:
- optimal risky portfolio
- risk free asset
weight of an asset in the optimal risky portfolio is the weight of that asset in the market portfolio
capital asset pricing model (CAPM)
- CAPM helps to fill in the gap about what should be expected returns of the assets
market price of risk
quantifies the marginal return that investors demand to bear one unit of portfolio risk
CAPM assumptions
- many small investors w endowment (initial wealth) that is small compared to total wealth in the economy. investors are price takers not price makers
- identical holding periods for all investors for simplicity
- can invest only in publicly-traded financial assets, such as stocks, bonds, and risk free assets (zero net supply)
- no taxes and transaction costs
- investors are rationale - mean variance optimizers
- investors have homogenous expectations and beliefs
- these ensure that the frontier is the same for every investor, and all investors optimal portfolio have a fraction of initial wealth invested in risk-free asset and rest in identical ORP
CAPM application
step 1: identify your “optimal risky portfolio” or market portfolio - commonly used proxy for the market portfolio is value weighted stock portfolio
step 2: get the historical data of prices (incl. dividends) for stocks, market index, and risk-free assets
step 3: calculate historical returns of these assets
setp 4: regress historical returns of the stocks on market portfolio returns to get beta coefficient for each stock
step 5: apply capm formula
security market line
works as a benchmark to assess fair expected return on a risky asset (anything above the line you buy)
beta
Beta (β) is a measure of a stock’s volatility in relation to the overall market. By definition, the market, such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market
beta trading strategy
- estimate beta for all stocks traded in the us
- rank all stocks based on beta and divide stocks into 5 groups every month
- create equally weighted or value weighted portfolios each month
- balance each month (buy all at the beginning and sell all at the end)
- repeat this each month for as long as your investment horizon
low beta risks
- great for risk averse investors
- however could be non-diversified or concentrated or liquidity risks
efficient market hypothesis
- claims that stock prices already reflect all available information
-EMH argues that prices are determined rationally, then only “new info” will cause them to change - this new info should be unpredictable in an efficient market
three versions of EMH
- strong form
- semi strong form
- weak form
strong form
- predicts you cannot predict stock prices at all
- relies on three assumptions: new info is random, instantaneous price adjustment, perfect competition
- expected returns will drive away inefficiency in market
- predicts stock picking is a useless exercise
semi-strong form
asserts that all publicly available info regarding the firm’s future prospect are already incorporated in stock price
- fundamental analysis is no use
weak form
asserts that stock prices already reflect all info that can be derived by examining market trading data such as historical prices, volumes
- technical analysis is of no use to predict future stock values
technical analysis
security analysis based on the historical market data, primarily historical stock values, trade volumnes
- aim to find recurrent and predictable patterns in the stock prices
- all analysis based on two key assumptions:
1. history repeats itself
2. price adjustment mechanism is slow
- these are opposite to EMH
fundamental analysis
- security analysis based on the firm specific info as well as other publicly available info.
- this info set includes earnings and dividends, expectations of future interest rates and risk evaluation of the firm
can calculate intrinsic value and compare with the price
find firm’s that are better than everyone else’s estimate
active investing
tries to beat the market to generate returns. if you believe to market is inefficient
passive investing
tries to get the same returns as the market. if you believe the market is efficient
empirical test of weak-form EMH
short horizon returns: these are tests for the efficacy of technical analysis
serial correlation returns: tests if past stock returns are correlated with current stock returns
positive serial correlation: momentum
negative serial correlation: reversal
momentum
-the idea that if stocks are high performers in the past they will continue to be
- based on 3-12 month holding period returns
- based on momentum effect
reversal portfolio
long-term horizon: returns in the lt have found to have been pronounced neg serial correlation. might have to do with overreaction to positive serial correlations in the short/intermediate term
-short winners and long losers
empirical test of semi-strong form EMH
empirical test related to semi-strong form
- small size effect
- high book/ market effect
- interaction of size and value effect
- January effect
- post-earning annoucement
-day/night effect
- halloween effect (nov sell may)
- neglected firm effect
-day of week effect: mondays bad, wednesdays and fridays good
- low P/E effect
treynor ratio
excess return per unit of systematic risk
return-rf/beta
higher is better
information ratio
alpha of portfolio (in excess of benchmark portfolio) by non-systematic risk
return-benchmark/sd of the return difference
higher implies a better portfolio manager who’s achieving return higher than benchmark
multifactor model
- allows for multiple sources of risk
- uses other factors in addition to market returns
fama french model
best known approach
observes both small cap outperform large cap (SMB) and high b/m outperform low b/m (HML)
explains 90% of stock returns
carhart 4 factor
market, smb, hml, mom
ps 5 factor
add liquidity as a factor, less liquid outperform highly liquid
fama-french 5 factor model
add profitability(h-l) and investments (low-high) to normal FF3
morgan stanley’s factor model
factors
- gdp growth
- lt interest rate
- foreign exchange
- market factor
- commodities or oil price index
what is factor investing?
investment strategy that uses certain characteristics of securities that are important in explaining risk and return relationship
popular factors:
- small size
- value
- winner(momentum)
- low beta (or low volatility)
-market
top-down
This approach starts with the broader economy, analyzes the macroeconomic factors, and targets specific industries that perform well against the economic backdrop. From there, the top-down investor selects companies within the industry. starts with asset allocation
bottom-up
This approach focuses on analyzing individual stocks and de-emphasizes the significance of macroeconomic and market cycles2. Bottom-up investors focus on a specific company and its fundamentals, whereas top-down investors focus on the industry and economy. starts with security analysis
middle out
This term is not commonly used in portfolio construction. It might refer to a balanced approach that considers both macroeconomic (top-down) and company-specific (bottom-up) factors
buy and hold
This is a passive investment strategy where an investor buys stocks (or other types of securities such as ETFs) and holds them for a long period regardless of fluctuations in the market. The goal is to benefit from long-term gains in the market
asset allocation construction
This refers to the ongoing process of allocating and reallocating money within an investment portfolio to different asset classes. The three main asset classes—equity, fixed-income, and cash and equivalents—all have different levels of risk and expected return.
systematic risk
This is the risk inherent to the entire market or market segment. It’s also known as “non-diversifiable risk” or “market risk” since it impacts the entire asset class.
non-systematic risk
This is the risk associated with a specific company or industry. It’s also known as “specific risk”, “diversifiable risk”, “idiosyncratic risk”, or “residual risk”. reduce through diversification.
what does an ETF do
tracks the performance of an index of share returns for a particular country or industry sector
what indices are market-value weighted?
NYSE and S&P500
how much can you lose when you short a stock?
unlimited, as short sellers lose money when the price rises
what are mutual fund advantages?
they offer a variety of investments, they offer small investors the benefits of diversification, however the costs are high
equity mutual funds
they invest primarily in stock, they may hold fixed income securities as well
most hold money market securities as well as stock, two types of equity funds are income funds and growth funds
How do we know if a stock is over priced in the CAPM model?
A security is over priced if the actual return is less than the calculated expected return
what is the variance of a portfolio of risky securities?
the weighted sum of the securities’ variances and covariances
the efficient frontier of risky assets is
the portion of the investment opportunity set that lies above the gloabl minimum variance portfolio
when is diversification most effective?
when securities returns are negatively correlated
portfolio theory as described by Markowitz is most concerned with what?
the effect of diversification on portfolio risk
what happens to unsystematic risk as a portfolio diversifies?
it reaches 0
in a signle factor model, what is the return on a stock related to
firm specific events and market events
security returns are…
based on macro and firm specific events, and are usually positively correlated
if a portfolio manager consistently obtains a high sharpe ratio, the manager’s forecasting ability is ___
above average
why have risk adjusted mutual funds decreased in popularity?
because in nearly efficient markets, it is extremely difficult for portfolio managers to outperform the market. as well the measure usually results in negative performance results for the portfolio managers.
the security market line is…
the line that represents the expected return-beta relationship
alpha
In the Capital Asset Pricing Model (CAPM), Alpha is a measure of the performance of an investment as compared to a suitable benchmark index. if the security is fairly priced, alpha is 0
the expect return-beta relationship
is the most familiar expression of the CAPM to practitioners. refers to the way in which the covariance between the returns on a stock and returns on the market measures the contribution of the stock to the variance of the market portfolio, which is beta. assumes that investors hold well-diversified portfolios.
value effect
found that firms with low P/e ratios earned higher returns than firms with high p/e ratios
abnormal return
=ann. return - (rf +beta(market return-rf))
if positive there was good news, if negative there was bad news
