Investment Analysis Flashcards
What is an optimal portfolio
- A portfolio that maximises investor’s utility
What is the Sharpe Ratio
it is the reward to volatility ratio
A risky portfolio is optimal when
– It offers the highest reward to risk ratio among the feasible portfolios.
– The Sharpe ratio is maximised
explain the difference between the optimal risky portfolio and optimal complete portfolio
- All clients use same optimal risky portfolio as
their investment vehicle regardless of their risk
aversion level - More risk averse client will invest more in the
risk-free asset and less in risky asset - Optimal complete portfolio reflects clients’ risk aversion level, but optimal risky portfolio does not
pros of the single index model
Less estimates needed
allows specialisation of effort in security analysis
cons of the single index model
Oversimplification of real-world uncertainty
Ignores industry specific events:
The model assumes correlation of residuals is always zero.
But residuals of stocks in same industry can be correlated
What is the intrinsic value of a firm and how does it effect expected returns
The intrinsic value of stock depends on the
dividend and earnings expected from the firm
You expect positive return if you believe the
current price is lower than intrinsic value
What is the Efficient Market Hypothesis
States that Public information is already reflected in the current market price
meaning analyses based on public information are fruitless
– Investors are rational
– Markets are frictionless
– Prices are correct; equal to intrinsic value.
– Resources are allocated efficiently.
what is the separation property
the seperation property refers to the idea that an investors portfolio decsion can be sepearted into 2 distinct tasks: determine the optimal risky portfolio, and combining it with a risk free asset to suit the investor preference
How do Size and book-to-market ratios explain returns on securities
– Smaller firms experience higher returns.
– High book to market firms experience higher
returns
What is the small size effect
Portfolios consist of firms with small market
capitalisation (small size) consistently have
provided higher returns than portfolios of large
size even after the risk adjusted
What are some criticisms of the small size effect
– Not robust across time
The effect disappeared since mid-80’s.
– Concentrated in the extremes
Most of the returns come from very small firms, so-called “Microcap” stocks.
– January effect
The size effect is almost entirely due to higher
returns on small stocks in January
What is the momentum effect
▪ Good or bad recent performance of particular
stocks continues over time.
▪ Performance of individual stocks is highly
unpredictable, but portfolios of the bestperforming stocks in the recent past
outperform others.
What additonal factor does the Fama French four factor model have
momentum effect
What additonal factors does the Fama French five factor model have
– Robust minus Weak (RMW), is the difference in returns on diversified stock portfolios with strong versus weak profitability
– Conservative minus Aggressive, The investment factor is measured by CMA , the difference in returns on diversified portfolios comprising stocks of low-investment versus high-investment firms
What are the 3 version of the EMH ( Efficient Market Hypothesis)
Weak form
– Prices reflect all past market information such as price and volume
Semi-strong form
Prices reflect all publicly available information
including trading information, annual reports, press releases
Strong form
Prices reflect all information, including public and private
What is Liquidity provision
Liquidity provision in finance refers to the process of making sure there are enough buyers and sellers readily available for an asset, allowing for smooth trading activity. It essentially ensures that an investment can be easily bought or sold at a fair market price without significantly impacting the price itself.
Allow investors to buy/sell
assets whenever and at a price they want
Evidence against EMH (8)
– Short-run momentum
– Long-run reversal
– P/E Effect
– Small Firm Effect
– Neglected Firm Effect
– Liquidity Effects
– Book-to-Market Ratios
– Post-Earnings Announcement Price Drift
Active Management
Engage in security analysis to form risky
portfolio.
– An expensive strategy.
– Most managers do not do better than the
passive strategy.
– Performance persists only over short time
horizons.
Passive Management
No attempt to outsmart the market
– Low cost
– Avoiding any security analysis (Index tracking
fund).
What are the limits to arbitrage
Fundamental Risk:
– Intrinsic value and market value may take too long to converge
Implementation Costs:
– Transactions costs and restrictions on short
selling can limit arbitrage activity.
Model Risk:
– What if you have a bad model and the market value is actually correct?
* Due to Limits to Arbitrage:
– Violation of Law of One Price
– Bubble and Crash
Can the slope of the CAL be negative
If so can we still find an optimal portfolio
CAL can be negative if the risk free return is greater than the portfolio return, meaning as risk increases ( by adding the risky portfolio) returns also decrease. so the optimal portfolio is the one with 100% in the risk free asset
One of the drawbacks of applying single index model approach to optimal portfolio design is the assumption of uncorrelated firm specific factors. If this assumption is violated, how would it affect your portfolio optimisation?
assumes cov(ei,ej) = 0 if this is not the case and this value is positive it leads to an under estimation of covariance and therefore risk
if negative, this leads to an over estimation
can you apply the DDM ( dividend discount model) for a stock currently not paying dividends
yes as in the real world although a company has not paid a dividend in a certain year. shares are still traded at a positive price with the expectation of future dividends
which performance measure is most important: sharpe, treynor, or jensons alpha
- if a portfolio is well managed the systematic risk is the main worry meaning use treynors
- if not, and unsystematic risk is involved, use sharpe
- if an investor wants to know explicitly how much extra return she could earn compared to the CAPM prediction use jensons alpha
Definition of ethics
A set of moral principles or rules of conduct that provide guidance for our behaviour when it affects others
4 fundemental ethical principles
– Honesty
– Fairness
– Diligence
– Care and respect for others
Why does ethics matter in a professional setting
Unethical conduct from investment professionals
– not only has serious personal consequences
– but damage investor trust and thereby impair the sustainability of the global capital markets as a whole.
* We must develop a culture of integrity
Explain the difference between the spot rate, the forward rate and the short rate.
The rate that prevails today for a given
maturity is called spot rate
short rate is the rate for any given maturity, changing at different points in time
forward rate is the agreed-upon interest rate for a future transaction.
Define open interest
Open interest is the number of contracts
outstanding.
* If you are currently long, you simply instruct your broker to enter the short side of a contract to close out your position
Benefits of diversification
- aim to spread out our exposure to firm-specific factors
- diversification can reduce risk to arbitrarily low level
-Portfolios of less than perfectly correlated assets always offer some degree of diversification
benefit
why do we use the single index model
- Because the systematic factor affects the rate of return on all stocks, the rate of return on a broad market index can be used for that common factor
- it uses the market index to stand in for the common factor
What are the Fama-french Three-Factor Model’s factors
The multi factor model/ Equation
Small Minus Big
High Minus Low
What is the objective of using the fama french model
The market index is the first of the Fama-French factors and is expected to capture systematic risk originating from macroeconomic factors
The two extra-market factors are chosen because of long-standing observations that firm size, measured by market capitalization (the market value of outstanding equity), and the book-to-market ratio (book value per share divided by stock price) predict deviations of average stock returns from levels consistent with the CAPM.
- more on Kortex page 322
Fama’s three versions of EMH
- Weak form
Prices reflect all past market information such as
price and volume - Semi-strong form
Prices reflect all publicly available information
including trading information, annual reports, press
releases, etc. - Strong form
Prices reflect all information, including public and
private
what is the price discovery function
Price Discovery is the most important function
of the financial market:
– Quickly and correctly reflect the change in
value of company to asset price.
– New information and events are incorporated
into asset price through investors’ trades
with regrards to interest rate uncertainty, what is the expectation hypothesis
The Expectation Hypothesis states that the
forward interest rate should be equal to the
expectation of future short rate 𝑓𝑛 = 𝐸 𝑟𝑛 .
* If investors are risk neutral, they should only
care about the expectation of their investment
strategies.
what is Liquidity Preference Theory
Liquidity Preference Theory explains the
generally observed upward-sloping yield curve
as an evidence of short-term investors
dominating the market, so a positive liquidity
premium
week 8 slide 37
5 Rules for Duration
- The duration of a zero-coupon bond
equals its time to maturity - Holding maturity constant, a bond’s
duration is higher when the coupon rate is lower - Holding the coupon rate constant, a
bond’s duration generally increases with its time
to maturity - Holding other factors constant, the
duration of a coupon bond is higher when the
bond’s yield to maturity is lower
-The duration of a perpetuity is equal to:
(1+y) / y, independent of its coupon rate c
Describe Convexity
Relationship between bond prices and yields is
not linear.
* Price-yield relation is plotted as a convex curve.
* The curvature is called the convexity of the
bond
what is Reinvestment Rate Risk
Refers to the risk when payoff are received earlier than the desired investment horizon
Reinvestment risk is the inability to reinvest money into securities that will earn the same or higher rates as your original investment
What is the aim of immunisation strategy
- Immunization is a strategy to protect investors
from changes in interest rate. - It aims at produce zero net interest rate risk,
so that the portfolio is immune to changes in
interest rate
Problems of Immunization
The portfolio is protected against one interest
rate change only.
* Thus, once interest rates change, the portfolio
must be rebalanced to maintain immunization.
* Duration assumes a horizontal yield curve
* Duration also assumes that any shifts in the
yield curve are parallel
* Portfolio managers may have trouble locating
acceptable bonds that produce immunized
portfolios
* Both duration and horizon dates change with the
mere passage of time, but not in a lockstep
fashion, thus rebalancing is required
* tradeoff between transaction cost and not being perfectly immunised at all times
What is a typical value for A in the utility function
2 to 4
Drawback of the markowitz procedure
Too many inputs
Why would a company pay more dividend in
future
- sign of confidence in the company’s future prospects
- Shifting growth strategy. more focus on maintaining market position than aggressive expansion
What is the long term reversal effect
Based on the historical performance in a timeframe between three to five years, the long-term reversal states that the past losers will reverse and become the future winners and the past winners will reverse and become the future losers
Even if market is perfectly efficient in Semi-strong
form, how can news effect price
price can move due to: surprise, confirmation, resolution of uncertainty
Assumptions in CAPM
– Risk-free investment can be done by lending ( A to B B to A)
- Representative investor: Consider investors A and B together as one investor
- Net borrowing and lending across all investors is
zero ( no risk free asset)
How is CAPM derived
starting point is the Markowitz procedure
All investors share an identical investable universe
All investors use the same input list to draw their efficient frontiers
facing the same risk-free rate, all draw an identical tangent CAL
all arrive at the same risky portfolio
proposition that CAPM formula is derived from
If the market is in equilibrium, Reward-to-risk
ratio of individual assets and that of market
portfolio must be the same
Betas are not observations
but estimates
3 assumptions of APT
- Security returns can be described by a factor model
- There are sufficient securities to diversify away idiosyncratic risk
- Well-functioning security market do not allow for the
persistence of arbitrage opportunities
Law of one price
Equivalent assets should have the same price
arbitrage occurs when alpha is
non zero
APT vs CAPM
APT only requires small number of sophisticated
arbitrageurs
– CAPM requires investors are all mean variance optimizers
APT is based on observable portfolios such as
the market index.
– CAPM is not testable in strict sense, as it
relies on unobserved, all-inclusive portfolio
- APT is silent for individual assets
If markets were inefficient, resources would be
systematically misallocated, How?
– Firm with overvalued securities can raise capital too cheaply.
– Firm with undervalued securities may have to
pass up profitable opportunities because cost of capital is too high
what is noise trader risk
This risk comes from when short-term and emotional investors over-buy or over-sell a given stock. They drive its price past where it should actually be.
what is The Value Effect
The Value Effect states that resources tend to move from a place of low perceived value and importance to a place of high perceived value
Liquidity risk premium
Investors hesitate to hold less liquid assets
small stocks tend to be illiquid
2 types of interest rate risk
Price risk - refers to the risk of changes in the value of bonds when interest rate fluctuates (liquidation risk)
reinvestment rate risk
