Investment Theory

Question 1

Modern Portfolio Theory

Answer 1

• Investors consider each investment opportunity as represented by a probability distribution of expected returns over a specified holding period or “investment time horizon”
• Standard deviation is the true measure of risk
• investors base their investment decisions solely on the amount of expected return and level of assumed risk
• investors base their indifference to alternative investments on the maximization of wealth over a specified period, with this indifference diminishing as they get beyond this period.
• for a given level of risk, investors prefer higher returns to lower returns (investors assumed to be risk averse)

Question 2

Capital Market Line (CML)

Answer 2

• a portfolio that combines a risk free asset with a portfolio of risky assets
• graphed out as a straight line that starts with the risk free rate and extends out to the point of tangency between the straight line and the efficient frontier of all risky portfolios
• it defines the relationship between the markets expected return (or all efficient frontiers) and its standard deviation.

Question 3

Mean-variance optimization

Answer 3

• the variance of expected returns from the mean or average return of an investment should be as small as possible.
• the investor is achieving a maximum amount of return for each unit of assumed risk, as measured by the standard deviation of the investment asset.

Question 4

Security Market Line (SML)

Answer 4

• a graphical depiction of the relationship between risk and expected return for individual assets.
• tells us that the standard deviation of a stock should not be used to measure its risk in the portfolio, because some of the risk may be reduced through diversification
• SML tells us that an individual stock’s return is equal to the risk free rate plus a premium (beta) for assuming systemic risk.
• the formula for the SML line is CAPM.
• if security markets are in equilibrium, all individual assets should plot on the SML, ie the investments required return should be equivalent to its expected return as currently priced in the market.
• if the security is not on the line it is deemed to be either overvalued or undervalued. Either way, market forced will drive the price back to the SML line.

Question 5

Efficient Market Hypothesis

Answer 5

• suggests that investors are unable to outperform the market on a consistent basis.
• the basic tenant of the theory is that current stock price reflects all available information for a company and the prices rapidly adjust to any new information.
• the theory contends that daily fluctuations in prices is a result of a random walk pattern

Question 6

Strong Form EMH

Answer 6

• all public and private information is already reflected in the price of securities, hence neither technical analysis or fundamental analysis can improve upon the efficiency of the market to determine prices.
• possessing insider information is not a factor in outperforming the market.

Question 7

Semi-Strong EMH

Answer 7

• all historical and economic industry conditions are already reflected in security prices.
• possessing insider information can lead to achieving returns in excess of the market

Question 8

Weak Form EMH

Answer 8

• past price and volume data reflect security prices
• in direct contradiction with technical analysis
• credible fundamental analysis may generate superior performance
• there is no value in predicting future price changes

Question 9

Anomalanies

Answer 9

Strategies that appear to be contrary to an efficient market.

• P/E Effect- Low P/E stocks appear to outperform high P/E stocks
• Small firm effect- small firms have shown to outperform large firms on a risk adjusted basis.
• January effect- observed as the tendency of small firms to be higher in january
• neglected firm effect- means that few analysts follow the stock
• value line phenomenon- the value line rankings for timeliness have performed extremely well over time and appear to offer the average investor a chance to outperform the averages.

Question 10

prospect theory

Answer 10

-investors fear losses much more than they value gains/ As a result they will choose the smaller of two potential gains if it avoids a sure loss.

Question 11

Confirmation Bias

Answer 11

-investors tend to look for information that supports their previously established decision, even if that decision was imprudent

Question 12

Building an Asset Allocation

Answer 12

• each portfolio should be built with the following considerations:
• the clients level of risk tolerance
• the clients level of sophistication with regard to investment alternatives
• the required rate of return necessary to meet the objectives of the client
• the financial position and tax situation of the client.

Question 13

Strategic Asset Allocation

Answer 13

• assets are combined in a manner designed to produce superior results with minimum risk.
• the allocation is based on a client’s long-term financial goals, risk tolerance, and client’s life cycle.
• allocation remains constant until a life-changing event occurs.
• most investment policy statements incorporate strategic asset allocation into their risk/reward agreement between client and portfolio manager.

Question 14

Tactical asset allocation

Answer 14

• uses security selection and market timing as its main approach to portfolio building
• the mix of investment classes is changed based on changes in market conditions
• the disadvantage is that is normally generates high transaction costs from constantly changing the mix between asset classes.

Question 15

Control of Volatility

Answer 15

-include assets that are positively correlated of less than .50 in order to control/reduce volatility in a portfolio.

Question 16

CAPM

Answer 16

assumptions that underlie the application of the capital asset pricing model

• All investors have uniform expectations about the risk-return relationship of risky assets.
• all investors have the same one-period time horizon
• investors can borrow and lend at a specific risk free rate of return
• transaction cost = 0
• Taxes are 0
• inflation= 0
• no one investor can affect stock prices with their buy/sell decisions.
• capital markets are in equilibrium - stock prices are at levels such that there is no incentive for speculative trading.
• A macro model of CAPM is represented by the CML
• A micro model of CAPM is represented by the SML

Question 17

major difference between the CML and SML

Answer 17

-the risk undertaken with and shown by the CML is measured by standard deviation (total risk), whereas the risk associated with the SML is measured by beta (systemic risk)

Question 18

Macro-View of the CAPM

Answer 18

• CML
• specifies the relationship between risk and return on all possible portfolios
• assumes a completely diversified portfolio at point Y
• total risk is measured by the portfolio’s standard deviation.

Question 19

Micro-View of the CAPM

Answer 19

• SML
• specifies the risk-return relationship of efficient portfolios and individual securities
• SML relationship is similar to the CML, except that risk is measured by Beta
• the equation for the SML is the same as the CAPM
• SML can be used to compare actual returns to expected returns on a risk adjusted basis.

Question 20

Arbitrage Pricing Theory

Answer 20

• considers pricing factors other than systemic risk of an investment and is predicated upon the law of one price.
• the premise behind the theory is that pricing of securities in different markets cannot differ for any significant length of time. Thus, any unanticipated changes that cause pricing changes must be eliminated at some equilibrium point in the future.
• APT suggests that a stock’s return is determined by arbitraguers seeking to exploit perceived differences in the prices of securities that present the same degree of risk.

Question 21

Black-Scholes Option Valuation Model

Answer 21

five variables are used:

• the current market price and the call premium is higher for higher priced stocks
• Exercise price of the option and the call premium is higher for lower strike prices
• the more volatile the stock, the greater the option premium
• the option premium will increase as its time to expiration increases
• as the risk free rate increases so does the price of the call premium.

Question 22

Binomial Option Pricing

Answer 22

• assumes that the price of an option changes in discrete increments based on the movements of the underlying stock on which the option is written
• differs from the black scholes because the bs assumes that the price of the underlying stock, and thus the option, moves in a constant or “geometric bownian” motion.