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
