Exam II - Essay Questions Flashcards
What is the Fama McBeth test of the CAPM? Use formulas and illustrations.
- Regression method used to estimate parameters for asset pricing models such as the capital asset pricing model (CAPM).
- Estimates the betas and risk premia for any risk factors that are expected to determine asset prices.
What were Roll’s critique of the Fama-MacBeth?
- There is only one testable hypothesis associated with the CAPM, M
- If the index you choose is mean variance efficient, you will get a linear relation between expected return and beta
- We cannot identify the components of portfolio M.
- If you use an index to judge performance, different indexes will give you different performance ratings (buy sell decision). We refer to this as a benchmark error problem.
- Benchmark Error Problem
What is the benchmark theory problem? Explain with an illustration.
If you use an index to judge performance, different indexes will give you different performance ratings (buy sell decision). We refer to this as a benchmark error problem.
What are the assumptions of the Arbitrage Pricing Theory (APT)?
- Capital markets are perfect, inflation is zero or known, fractional shares, markets in equilibrium
- Investors are risk averse
- Homogeneous expectations that returns are generated by a multifactor model with agreement on the factors
- The rate of return is a linear function of the factors
- The number of assets must be larger than the number of factors
- The error terms are independent of the factors and each other - Arbitrage portfolios can be created without money or risk
What is the Arbitrage Pricing Theory (APT)? Explain with formulas and illustrations.
- APT is a multi-factor technical model based on the relationship between a financial asset’s expected return and its risk
- The model is designed to capture the sensitivity of the asset’s returns to changes in certain macroeconomic variables.
- The APT diversifies away unsystematic risk by holding large portfolio with a small amount of wealth in each one.
What is the treynor ratio? What is it’s formula? What is it based upon? Use illustrations in your explanation.
- Risk adjusted measurement that shows how much reward was gained for the risk taken
- T = (Rj - Rf) / βj
- Based upon the SML
- Also called the reward to volatility ratio
What is the sharpe ratio? What is it’s formula? What is it based upon? Use illustrations in your explanation.
- Risk adjusted measurement that shows how much reward was gained for the risk taken
- S = (Rj - Rf) / σj
- Based upon the CML
- Also called the reward to variability ratio
What is Jensen’s Alpha? What is its formula? What does it assume?
- Jensen’s alpha is used to determine the abnormal return of a security or portfolio of securities over the theoretical expected return.
- Rj - Rf = aj + βj(Rm-Rf) + ej
- Systematic risk gets pulled into the alpha, unsystematic risk stays in the error term
- Based upon the SML
- Assumes diversification
Explain the Event Study or Backtest, use illustrations to explain your answer.
How do you calculate standard unexpected earnings (SUE)?
SUE = (Actual Earnings - Forecasted Earnings) / Std. Deviation of the Forecase
How do you calculate mean adjusted return?
E(Ri) = (1/T) ΣRit
How do you calculate market adjusted return?
E(Ri) = Rmt
How do you calculate market model return?
E(Ri) = ai + bi(RMT)+ei
What 9 factors does Peter Lynch consider important?
- Growth in Stock Price vs. Earnings
- Growth in earnings with dividends vs. P/E Ratio
- Real price of the stock adjusting for cash
- Free Cash flow
- Debt to equity ratio
- Inventory Growth vs. Sales growth
- Pension fund assets
- Bottom Line
- Dividends
What are the 11 O’Neil Momentum Screen Variables?
- Current quarterly EPS
- Annual earnings increases
- New products, managements and hires
- Supply and demand, small capitalization plus volume demand
- Leader or laggard
- Institutional sponsorship
7 Market direction
- Debt ratio
- Operating profit margin
- Insider buying / Insider selling
- Technicals
What are the 4 factors that cause you to rebalance your portfolio or asset allocation? Use illustrations to explain your answer.
- Life Cycle
- Liquidation Date
- Net Worth
- Level of prices
Explain strategic asset allocation with an illustration.
Explain tactical strategic asset allocation with an illustration.
What are the steps towards security selection?
1st: Investment Policy + Market Conditions
2nd: Rebalance Strategic Asset Allocation
3rd: Rebalance Tactical Asset Allocation
- Asset Classes
- Sectors / Industries
4th: Security Selection
What is a debenture?
A bond secured by the un-mortgaged assets and earnings power of the corporation
What forms of collateral more senior than debentures?
- Mortgage bonds
- Equipment Trust Certificate
- Collateral Trust Bond
Illustrate and describe a rising yield curve.
- Formed when the yields on short-term issues are low and rise consistently with longer maturities
Illustrate and describe a declining yield curve.
- Formed when the yields on short-term issues are high and yields on longer maturities decline consistently
Illustrate and describe a flat yield curve.
- Formed when yields on short-term and long-term issues are approximately equal
Explain classic bond immunization with an illustration.
- Bond immunization protects against price risk and reinvestment risk
- These two rates will perfectly offset each other when duration = investment horizon
- By immunizing from interest rate risk the YTM you’re expecting will be the YTM you’ll get
- Shorten duration to decrease mark to market effect
What is price risk?
As interest rates rise, bond prices fall
What is reinvestment risk?
As interest rates rise, reinvestment risk goes up
What is Jensen’s Alpha? What is it based on? What is its formula? What does it assume?
- Jensen’s alpha is used to determine the abnormal return of a security or portfolio of securities over the theoretical expected return.
- Rj - Rf = aj + βj(Rm-Rf) + ej
- Systematic risk gets pulled into the alpha, unsystematic risk stays in the error term
- Based upon the SML
- Assumes diversification
