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CWM - Portfolio Construction Theory > Fundamentals of Investment Theory > Flashcards

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
Q

3 benefits of a client risk questionnaire

A

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
Q

2 drawbacks of a client risk questionnaire

A

1) It does not include need or capacity for risk
2) Risk aversion changes - may not be constantly accurate

27
Q

What is a certainty equivalent?

A

a guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future

helps an investor choose between risk free rate and an investment

28
Q

Give an example of Socioeconomic characteristics

A

Women save at a greater rate & are more risk averse than men

or

Families have a greater saving propensity than single individuals

29
Q

List 9 types of investment risk

A

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
Q

How do you find portfolio risk given systematic and unsystematic risk

risk figures given as standard deviations

A

Square them, sum them, root them.

31
Q

What does correlation measure?

A

The direction and strength of two variables relationship

32
Q

What does covariance measure

A

non-standardized measure of the direction of a relationship

Divided by the sum of the variables standard deviations, it gives correlation (standardized)

33
Q

When does the most effective diversification occur?

A

When combining two negatively correlated assets

34
Q

What is the formula to find the standard deviation of a series of assets (given weightings and SDs)

Markowitz

A

(Weighting^2 * SD^2) + (Weighting^2 * SD^2) + (2* weight * weight)*(correlation * sd1 * sd2)

35
Q

What is mortality risk?

A

the risk that their investments are unable to support an investor for as long as they require (ie, until they die).

relating to annuities usually

36
Q

Do be considered a risk free asset, what two conditions must be met?

A

1) No Default Risk
2) No Reinvestment risk

37
Q

What asset is generally used as the risk free rate?

A

3 Month T-Bill

38
Q

What does Value at Risk Show?

A

Potential loss
over a given time period
at a certain confidence level

39
Q

What does a VaR confidence of 95% mean

A

5% of the time, losses can exceed this figure

40
Q

What is CVaR?

what is it sometimes known as?

A

Conditional Value at Risk

Expected Shortfall

41
Q

What does CVaR show?

A

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
Q

What is CVaR useful for?

what kinds of assets / portfolios

A

1) those that do not follow normal distributions
2) Those exposed to extreme market conditions

43
Q

What is a pro of VaR?

A

1) Easy to understand / intrerpret single figure

44
Q

What is one drawback of VaR?

A

If the model is based on a period of low volatility, VaR will not be accurately modeled.

too low / doesn’t fairly capture risk.

45
Q

If a stock is undervalued, where does it lie on the SML?

A

Above the SML.

It offers a higher return for its risk vs what CAPM predicts

46
Q

If the expected return for a stock is lower than the CAPM value.

Is it overpriced or underpriced

A

Overpriced - Return is lower than what CAPM predicts.

47
Q

What does the Fama-French model suggest have higher returns?

A

1) Small Companies
2) Value Stocks

Higher returns due to additional risks not captured by CAPM

48
Q

What is CAPM used for?

A

Calculate expected return based on systematic risk

49
Q

Pros of CAPM

A

Pros:
1) Simple to understand
2) Easy to calculate
3) Focuses on systematic risk (which cannot be diversified

50
Q

Cons of CAPM

A

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
Q

Pros of Multifactor models

A

1) More comprehensive view (e.g. fama/french = value, size)
2) Adds to CAPM so still easy to understand

52
Q

What is a multifactor model, give an example of one

A

Fama-French three-factor model

incorporating additional factors like size and value to provide a more comprehensive assessment of risk and return.

53
Q

4 reasons an inverted yield curve may signal recession

A

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
Q

How can a portfolio be diversified?

A

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
Q

How is price to book ratio calculated?

A

Share price / book price per share

Book price = NAV

56
Q

What are benefits of using P/B Ratio?

A

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
Q

What are drawbacks of using P/B ratio?

A

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
Q

Examples of reasons share price can deviate from company value

A

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)

in general, irrationalities / efficient market anomalies

59
Q

Why does a convertible trade at a premium?

A

Equity upside with no equity downside (fixed income downside)

60
Q
A

CWM - Portfolio Construction Theory (13 decks)

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