Fundamentals of Investment Theory Flashcards
Give examples of Client Objectives
1) Stability of Principal
2) Income
3) Growth of Income
4) Capital Appreciation
5) Asset liability matching
Give examples of Client Circumstances
1) Financial Needs
2) Risk Profile (Risk Aversion / Risk Tolerance)
3) Constraints
What should you avoid exposing a client to, regardless of time-horizon
Unnecessary amounts of risk
e.g. if aim is CPI+2% - no need for large equity allocation, regardless of time horizon.
What is the formula for Risk Aversion?
1 / Risk Tolerance
What is the formula for Risk Tolerance
1 / Risk Aversion
What are the 4 types of annuity?
1) Variable
2) Deferred
3) Conventional
4) Guaranteed Annuities
What is a variable annuity?
Variable value based on performance of investment.
Level of income paid in retirement is variable
What is a deferred annuity?
Income commences at a a later date (will be paid at a higher amount)
Risk of dying before deferred period kicks in.
What is a conventional annuity?
Secured income for life - in exchange for a lump sum.
Pays fixed sum regardless of interest rate risks
What risk is there to the issuer of a conventional annuity?
Buyer may live for a long time
What is a guaranteed annuity?
Guarenteed sum paid - if client dies, estate receives remainder.
List 3 other features of annuities
1) Inflation Linked
2) Escalation Rate
3) Joint Annuities (e.g. 50% to spouse on death)
6 Investor risks
not investment risks
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
What is utility?
A feeling of well-being
The optimal portfolio is the one proiding the highest utility
How is utility calculated?
Return on Portfolio - (Variance * Risk Tolerance)
What are the 4 age/life-cycle stages
1) Foundation Phase
2) Accumulation Phase
3) Maintenance Phase
4) Distribution Phase
What is the foundation phase?
Starting to build an income and create wealth
High tolerance to risk (but large losses in first 3 years and put an investor off)
What is the accumulation phase?
Career has been build - assets available for investment increase (accumulate funds for retirement)
risk tolerance can increase
What is the maintenance phase?
Closer to retirement - focus shifts on maintaining lifestyle / financial security
Risk tolerance falls sharply
What is the distributinon phase?
Accumulated wealth now available for distribution
Tax saving measures now important
What is the purpose of a client risk questionnaire?
To determine a clients appetite and tolerance towards risk
What is useful about a client risk questionnaire?
Quantifies an investors attitude to risk
How many options should be given to clients on a questionnaire?
An even number to avoid mid-points and fence setting
How should questionnaire choices be written
1) Clear
2) Unambigous
3) Concise
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
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
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
helps an investor choose between risk free rate and an investment
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
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
How do you find portfolio risk given systematic and unsystematic risk
risk figures given as standard deviations
Square them, sum them, root them.
What does correlation measure?
The direction and strength of two variables relationship
What does covariance measure
non-standardized measure of the direction of a relationship
Divided by the sum of the variables standard deviations, it gives correlation (standardized)
When does the most effective diversification occur?
When combining two negatively correlated assets
What is the formula to find the standard deviation of a series of assets (given weightings and SDs)
Markowitz
(Weighting^2 * SD^2) + (Weighting^2 * SD^2) + (2* weight * weight)*(correlation * sd1 * sd2)
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).
relating to annuities usually
Do be considered a risk free asset, what two conditions must be met?
1) No Default Risk
2) No Reinvestment risk
What asset is generally used as the risk free rate?
3 Month T-Bill
What does Value at Risk Show?
Potential loss
over a given time period
at a certain confidence level
What does a VaR confidence of 95% mean
5% of the time, losses can exceed this figure
What is CVaR?
what is it sometimes known as?
Conditional Value at Risk
Expected Shortfall
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.
What is CVaR useful for?
what kinds of assets / portfolios
1) those that do not follow normal distributions
2) Those exposed to extreme market conditions
What is a pro of VaR?
1) Easy to understand / intrerpret single figure
What is one drawback of VaR?
If the model is based on a period of low volatility, VaR will not be accurately modeled.
too low / doesn’t fairly capture risk.
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
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.
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
What is CAPM used for?
Calculate expected return based on systematic risk
Pros of CAPM
Pros:
1) Simple to understand
2) Easy to calculate
3) Focuses on systematic risk (which cannot be diversified
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
Pros of Multifactor models
1) More comprehensive view (e.g. fama/french = value, size)
2) Adds to CAPM so still easy to understand
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.
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
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
How is price to book ratio calculated?
Share price / book price per share
Book price = NAV
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
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
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)
in general, irrationalities / efficient market anomalies
Why does a convertible trade at a premium?
Equity upside with no equity downside (fixed income downside)
