Fundamentals of Investment Theory Flashcards

1
Q

Give examples of Client Objectives

A

1) Stability of Principal
2) Income
3) Growth of Income
4) Capital Appreciation
5) Asset liability matching

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2
Q

Give examples of Client Circumstances

A

1) Financial Needs
2) Risk Profile (Risk Aversion / Risk Tolerance)
3) Constraints

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3
Q

What should you avoid exposing a client to, regardless of time-horizon

A

Unnecessary amounts of risk

e.g. if aim is CPI+2% - no need for large equity allocation, regardless of time horizon.

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4
Q

What is the formula for Risk Aversion?

A

1 / Risk Tolerance

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5
Q

What is the formula for Risk Tolerance

A

1 / Risk Aversion

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6
Q

What are the 4 types of annuity?

A

1) Variable
2) Deferred
3) Conventional
4) Guaranteed Annuities

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7
Q

What is a variable annuity?

A

Variable value based on performance of investment.

Level of income paid in retirement is variable

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8
Q

What is a deferred annuity?

A

Income commences at a a later date (will be paid at a higher amount)

Risk of dying before deferred period kicks in.

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9
Q

What is a conventional annuity?

A

Secured income for life - in exchange for a lump sum.

Pays fixed sum regardless of interest rate risks

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10
Q

What risk is there to the issuer of a conventional annuity?

A

Buyer may live for a long time

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11
Q

What is a guaranteed annuity?

A

Guarenteed sum paid - if client dies, estate receives remainder.

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12
Q

List 3 other features of annuities

A

1) Inflation Linked
2) Escalation Rate
3) Joint Annuities (e.g. 50% to spouse on death)

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13
Q

6 Investor risks

not investment risks

A

1) Capital presevation in monetary terms
2) Preservation in real terms (purchasing power/inflation)
3) Avoiding undesirable outcomes
4) Possibility investment may fail
5) Liquidity risk (can’t raise cash when needed)
6) Relability of regular income stream

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14
Q

What is utility?

A

A feeling of well-being

The optimal portfolio is the one proiding the highest utility

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15
Q

How is utility calculated?

A

Return on Portfolio - (Variance * Risk Tolerance)

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16
Q

What are the 4 age/life-cycle stages

A

1) Foundation Phase
2) Accumulation Phase
3) Maintenance Phase
4) Distribution Phase

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17
Q

What is the foundation phase?

A

Starting to build an income and create wealth

High tolerance to risk (but large losses in first 3 years and put an investor off)

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18
Q

What is the accumulation phase?

A

Career has been build - assets available for investment increase (accumulate funds for retirement)

risk tolerance can increase

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19
Q

What is the maintenance phase?

A

Closer to retirement - focus shifts on maintaining lifestyle / financial security

Risk tolerance falls sharply

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20
Q

What is the distributinon phase?

A

Accumulated wealth now available for distribution

Tax saving measures now important

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21
Q

What is the purpose of a client risk questionnaire?

A

To determine a clients appetite and tolerance towards risk

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22
Q

What is useful about a client risk questionnaire?

A

Quantifies an investors attitude to risk

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23
Q

How many options should be given to clients on a questionnaire?

A

An even number to avoid mid-points and fence setting

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24
Q

How should questionnaire choices be written

A

1) Clear
2) Unambigous
3) Concise

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25
3 benefits of a client risk questionnaire
1) Easy to calculate and explain 2) Can update to track client's change in attitude 3) Can allocate different portfolios despite similar objectives
26
2 drawbacks of a client risk questionnaire
1) It does not include need or capacity for risk 2) Risk aversion changes - may not be constantly accurate
27
What is a certainty equivalent?
a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future ## Footnote helps an investor choose between risk free rate and an investment
28
Give an example of Socioeconomic characteristics
Women save at a greater rate & are more risk averse than men or Families have a greater saving propensity than single individuals
29
List 9 types of investment risk
1) Systematic (market) risk 2) Unsystematic Risk 3) Inflation Risk 4) Interest Rate Risk 5) Exchange Rate Risk 6) Capital Risk 7) Event Risk 8) Political Risk 9) Operational Risk
30
How do you find portfolio risk given systematic and unsystematic risk ## Footnote risk figures given as standard deviations
Square them, sum them, root them.
31
What does correlation measure?
The direction and strength of two variables relationship
32
What does covariance measure
non-standardized measure of the direction of a relationship ## Footnote Divided by the sum of the variables standard deviations, it gives correlation (standardized)
33
When does the most effective diversification occur?
When combining two negatively correlated assets
34
What is the formula to find the standard deviation of a series of assets (given weightings and SDs) ## Footnote Markowitz
(Weighting^2 * SD^2) + (Weighting^2 * SD^2) + (2* weight * weight)*(correlation * sd1 * sd2)
35
What is mortality risk?
the risk that their investments are unable to support an investor for as long as they require (ie, until they die). ## Footnote relating to annuities usually
36
Do be considered a risk free asset, what two conditions must be met?
1) No Default Risk 2) No Reinvestment risk
37
What asset is generally used as the risk free rate?
3 Month T-Bill
38
What does Value at Risk Show?
Potential loss over a given time period at a certain confidence level
39
What does a VaR confidence of 95% mean
5% of the time, losses can exceed this figure
40
What is CVaR? ## Footnote what is it sometimes known as?
Conditional Value at Risk ## Footnote Expected Shortfall
41
What does CVaR show?
Quantifies the unexpected losses that occur at a given confidence level e.g. the 5% of losses that occur at a 95% confidence interval.
42
What is CVaR useful for? ## Footnote what kinds of assets / portfolios
1) those that do not follow normal distributions 2) Those exposed to extreme market conditions
43
What is a pro of VaR?
1) Easy to understand / intrerpret single figure
44
What is one drawback of VaR?
If the model is based on a period of low volatility, VaR will not be accurately modeled. ## Footnote too low / doesn't fairly capture risk.
45
If a stock is undervalued, where does it lie on the SML?
Above the SML. It offers a higher return for its risk vs what CAPM predicts
46
If the expected return for a stock is lower than the CAPM value. Is it overpriced or underpriced
Overpriced - Return is lower than what CAPM predicts.
47
What does the Fama-French model suggest have higher returns?
1) Small Companies 2) Value Stocks Higher returns due to additional risks not captured by CAPM
48
What is CAPM used for?
Calculate expected return based on systematic risk
49
Pros of CAPM
Pros: 1) Simple to understand 2) Easy to calculate 3) Focuses on systematic risk (which cannot be diversified
50
Cons of CAPM
1) CAPM makes unrealstic assumptions 2) It is a single factor model 3) Static model = does not account for changing betas 4) Hard to specficy the risk free rate
51
Pros of Multifactor models
1) More comprehensive view (e.g. fama/french = value, size) 2) Adds to CAPM so still easy to understand
52
What is a multifactor model, give an example of one
Fama-French three-factor model incorporating additional factors like size and value to provide a more comprehensive assessment of risk and return.
53
4 reasons an inverted yield curve may signal recession
1) Investor sentiment - lower growth expected = lock in rates for longer = yields fall at long end 2) Risk aversion - investors see inversion as a risk and as such reduces confidence in economy 3) Monetary policy - short term rates increasing can signal unusually high inflation 4) Banks borrow short and lend long - inversion can hurt profit margins and lead to tighter credit condition
54
How can a portfolio be diversified?
1) By Asset 2) By Exposure (geography, currency) 3) Correlation 4) By time (e.g. short term and long term investments) 5) By manager
55
How is price to book ratio calculated?
Share price / book price per share Book price = NAV
56
What are benefits of using P/B Ratio?
1) easy to calculate and understand 2) useful for asset heavy companies e.g. banks 3) useful for physical asset companies e.g. infrastructure 4) More stable than EPS
57
What are drawbacks of using P/B ratio?
1) Misleading when book and market price are different (e.g. PE valuations) 2) Accounting effects can alter BV 3) Does not recognise intangible capital
58
Examples of reasons share price can deviate from company value
1) Information inefficency (e.g. small cap / EM) 2) Momentum (herd behaviour / asset bubbles) 3) Poor sentiment (e.g. China, Infrastructure) 4) Subjective valuations (differences in views) ## Footnote in general, irrationalities / efficient market anomalies
59
Why does a convertible trade at a premium?
Equity upside with no equity downside (fixed income downside)
60