Investments Ch 4 Flashcards
PORTFOLIO MANAGEMENT
PORTFOLIO MANAGEMENT
Optimal portfolio is one designed to achieve a targeted rate of
return while minimizing risk.
Combining different sets of assets allows for the creation of a
portfolio that maximizes return for a given level of risk.
Understand that there are optimal risk-return trade-off portfolios
PORTFOLIO CONSIDERATIONS
PORTFOLIO CONSIDERATIONS
- Prior to portfolio construction, an investor needs to consider:
- Goals and objectives
- Time frame available
- Risk tolerance
- Asset classes available
- Risks those assets present
RISK TOLERANCE
RISK TOLERANCE
Investor’s ability and willingness to accept variability in returns
over the holding period of an asset Investment Risk
Associated with the variability of returns expected to be received on
an investment
TIME HORIZON
TIME HORIZON
- Once the investor’s time horizon is determined, investments suitable for achieving the investor’s goals can be chosen.
- Short-term goals should be funded with low-risk investments.
- Long-term goals can be funded with higher-risk investments
S&P 500 HISTORICAL ROLLING RETURNS 1930-2020
DIVERSIFICATION
DIVERSIFICATION
- Diversification reduces portfolio risk.
- Involves including a number of different investments in a portfolio to mitigate the risk presented.
- Each additional security added to a portfolio has the potential to
reduce the overall risk of the portfolio. - The incremental impact (on diversification) of each additional
security added the portfolio decreases.
CORRELATION
CORRELATION
- A statistical technique that measures the relationship of one asset
to another, ranges from +1 to -1. - Assets that move together = positively correlated
- Assets that move in opposite directions = negatively correlated
- As long as assets are not perfectly positively correlated, there are
diversification benefits. - To achieve the full benefit of diversification, an investor should
include assets that are negatively correlated
EXPECTED PORTFOLIO RETURN
EXPECTED PORTFOLIO RETURN
Calculating the expected return on a portfolio can be accomplished by weighting the expected returns of portfolio holdings by each security’s percentage of total portfolio value.
Example:
Jeremiah holds a portfolio of two assets:
* 50% in Stock A (expected return of 8%)
* 50% in Stock B (expected return of 6%)
The expected portfolio return is:
(50% x 8%)+(50% x 6%) = 7%
PORTFOLIO RISK
PORTFOLIO RISK
- Risk is the variability of returns compared to the expected return.
- Standard deviation measures all of the risk associated with price
variations in a security - systematic and unsystematic. - Standard deviation of a portfolio is NOT a simple weighted
average. The correlation between asset returns must be
incorporated into the equation
STANDARD DEVIATION
STANDARD DEVIATION
- The standard deviation of an asset is equal to the square root of
the variance in the asset’s returns. - The variance in the returns of a given asset is calculated by
taking the sum of the squared differences between the actual
return and expected return, and dividing that result by the
number of observations minus one - Unlike calculating portfolio expected return, a portfolio standard
deviation cannot be determined by a simple weighted average. The
correlation between asset returns must be incorporated into the
equation
VARIATION AROUND THE MEAN
VARIATION AROUND THE MEAN
PORTFOLIO RISK: STANDARD DEVIATION
PORTFOLIO RISK: STANDARD DEVIATION
- The standard deviation for a portfolio of securities is determined by:
–The individual standard deviation of each security
–The correlation between the securities within the portfolio
–The weightings of each security
PORTFOLIO RISK: TWO ASSET PORTFOLIO
The formula for calculating the standard deviation of a two-asset
portfolio:
PORTFOLIO RISK: TWO ASSET PORTFOLIO
The formula for calculating the standard deviation of a two-asset
portfolio:
PORTFOLIO RISK: EXAMPLE
Amount Standard Deviation Weighting Fund A $60,000 15% 60% Fund B $40,000 8% 40%
PORTFOLIO RISK: EXAMPLE
Amount Standard Deviation Weighting Fund A $60,000 15% 60% Fund B $40,000 8% 40%
THE EFFICIENT FRONTIER
THE EFFICIENT FRONTIER
Harry Markowitz created a model that identifies an efficient frontier
from all of the possible combinations of risky assets.
- For all possible investment portfolios, the expected return and
risk measures are calculated and plotted on a graph. - Coupled with the investor’s risk-indifference curve, the model
suggests the optimal investment portfolio.
An efficient portfolio is one with the highest return for a given amount of risk, or the lowest risk for a given amount of expected return.
THE EFFICIENT FRONTIER GRAPH
THE EFFICIENT FRONTIER GRAPH
OPTIMAL PORTFOLIO
OPTIMAL PORTFOLIO
The optimal portfolio for a client is the point of tangency between the investor’s highest indifference curve and the efficient frontier.
CAPITAL MARKET LINE
CAPITAL MARKET LINE
(CML) consists of all possible combinations of the risk-free asset and the market portfolio.
Uses = Standard Deviation as measure of risk
The point of tangent where the CML and efficient frontier meet is referred to as the market portfolio (M), which is a portfolio of all risky assets.
Portfolios to the left of point M are lending portfolios, and portfolios to the right of point M are borrowing portfolios.
The line fro the RISK FREE rate to the efficient Frontier , where it is tangent. This is the Market portfolio
You can get any portfolio along the Capital Market line, based on your level of risk
Only assets that plot on the Capital Market Line are well diversified Portfolios. that consist of investing in the Market portfolio and some of the risk free assets.
CAPITAL MARKET LINE: FORMULA
CAPITAL MARKET LINE: FORMULA
The formula for the CML is:
Rm - Rf Rp = R i + σp [ -------------------- ]
σ m
R p = required portfolio rate of return
r f = risk-free rate of return
r m = return on the market
σ m = standard deviation of the market
σp = standard deviation of the portfolio
MODERN PORTFOLIO THEORY
MODERN PORTFOLIO THEORY
- MPT takes the CML and efficient frontier strategy and creates a
more practical setting by incorporating a measure of systematic
risk, beta. - This combination of a risk-free asset, the market return, and beta
forms a new line called the Security Market Line (SML). The model
is called the Capital Asset Pricing Model (CAPM).
Modern Portfolio Theory assumes that investors are rational, that investors can borrow and lend at the risk-free rate, and that there are no taxes or transaction costs.
ri = rf + (r – rf) × 𝛃m
ri =The expected return on security I
rf = The risk-free return
rm = the expected return on the market portfolio
𝛃 = the beta of security I
SECURITY MARKET LINE GRAPHIC
SECURITY MARKET LINE GRAPHIC
graphical representation of expected return and beta
Security Market Line (CAPM): Uses Beta as a measure of risk
* This model determines the required rate of return on an
asset given its systematic risk
(SML) shows the relationship between the level of systematic risk, as measured by beta, and the expected return on an individual security. It is quite simply a picture of the capital asset pricing model (CAPM).
You can use the SML to determine the Required Rate of Return
CAPITAL ASSET PRICING MODEL (CAPM)
CAPITAL ASSET PRICING MODEL (CAPM)
CAPM = Rf + B(Rm – Rf) = the expected return based on beta, the market premium and the risk-free rate of return
CAPM is designed to predict investor behavior.
(CAPM) is a single-factor model for pricing assets based on their level of systematic risk, as measured by beta
“CAPM gives us an expected or Required rate of return , given the riskiness of the assets. “
Ri = Rf + ( Rm - Rf ) Beta
R i = required rate of return
R f = risk free rate
rm = return on the market
βi = beta of asset i
( Rm -Rf ) = market risk premium
( Rm - Rf ) βi = risk premium on asset i
- Assumptions of the model:
—All investors are rational and have uniform expectations
concerning the risk-return relationships of available investment
alternatives.
—Investors can borrow and lend at the risk-free rate of return.
—The model assumes that taxes are zero and there are no
transactions costs
RISK PREMIUM
RISK PREMIUM
( Rm -Rf ) = market risk premium
The term (r - rf) is the market risk premium, which is them
incremental return provided by a market portfolio over the risk-free
rate of return.
Additional expected return over the risk-free rate of
return that an investor will require to invest in the market which
exposes them to risk.
Risk premium on asset i = ( Rm - Rf ) βi
PORTFOLIO BETA
PORTFOLIO BETA
- The non-diversifiable (systematic) risk of the portfolio.
- Weighted average of the betas of the assets in the portfolio.
- The beta of the market is 1.0
EXAMPLE
Ben owns a portfolio of stocks. The portfolio beta is 0.80. The expected market return is 11% and a risk-free security returns 4%. Using CAPM, the expected portfolio return is:
EXAMPLE
Ben owns a portfolio of stocks. The portfolio beta is 0.80. The expected market return is 11% and a risk-free security returns 4%.
Using CAPM, the expected portfolio return is:
rp = rf + β(rm - rf)
r = 4% + 0.80 (11% - 4%) = 4% + 5.6% = 9.6%p
What is the market risk premium?
What is the risk premium for this portfolio?
ARBITRAGE PRICING THEORY
ARBITRAGE PRICING THEORY
Asset-pricing model that measures the relationship between risk and expected return.
(APT) is a multi-factor asset-pricing model that is designed to overcome some of the limitations, such as unrealistic assumptions about investor rationality, in the CAPM.
Founded on the belief that there are other important factors that can explain asset returns.
Does not define these other factors but allows them to be any
variable that the analyst feels is important (ex: inflation and changes
in GDP).
ARBITRAGE PRICING THEORY: FORMULA
APT is generally expressed as
RISK TOLERANCE MEASURE
RISK TOLERANCE MEASURE
A measure of an investor’s ability and willingness to expose themselves to risk (price fluctuation in investments) in order to seek higher investment returns.
- Factors affecting an investor’s risk tolerance include loss aversion and risk aversion; available liquidity, savings, and insurance programs; time horizon; goals; phase in the life cycle; and psychographics.
- Function of:_____________________________
- Loss aversion and risk aversion
- Available liquidity, savings, and insurance programs
- Time horizon
- Goals
- Phase in the life cycle
- Psycho-graphics
LIFE CYCLE
LIFE CYCLE
RISK TOLERANCE AND ASSET ALLOCATION
RISK TOLERANCE AND ASSET ALLOCATION
Asset allocation is the largest contributor to investment performance over time.
- Risk tolerance and time horizon are important in determining a
proper asset allocation. - Financial planners employ tools to assess the client’s willingness to
accept investment risk: Monte Carlo Simulations, Value at Risk (VaR),
Global Portfolio Allocation Scoring System (PASS).
RISK TOLERANCE TOOLS
RISK TOLERANCE TOOLS
PASS ASSET ALLOCATION RECOMMENDATIONS
ASSET ALLOCATION
ASSET ALLOCATION
Process of constructing portfolios to maximize portfolio return based on the risk of the underlying investments, and the risk tolerance of the investor.
Asset allocation is the largest contributor to investment performance over time, and the two key components in determining a proper asset allocation are risk tolerance and time horizon.
3 common approaches to asset allocation:
- Strategic asset allocation
- Tactical asset allocation
- Mean-variance optimization models
STRATEGIC ASSET ALLOCATION
STRATEGIC ASSET ALLOCATION
- Develops an appropriate diversification strategy across a broad set
of asset classes. - Factors that must be considered:
Long-term expected return on equities
Fixed income and real assets
Long-term goals
Risk tolerance
Strategic asset allocation addresses the risk-return tradeoff of the investments in a portfolio by developing an appropriate diversification strategy across a broad set of asset classes to
minimize the probability of substantial losses in one investment category significantly impacting the performance of the portfolio as a whole.
TACTICAL ASSET ALLOCATION
TACTICAL ASSET ALLOCATION
Seeks to outperform the market over shorter periods of time by placing investment dollars in those asset classes that the investor expects will outperform market returns over the period
OTHER STRATEGIES
OTHER STRATEGIES
- Core satellite uses index funds to fulfill the “core” components at a
lower cost and active management are utilized for the satellite
portion of the portfolio. - Market timing is an attempt to anticipate the movement of equities
and earn returns in excess of the market through the use of
technical analysis. - Sector rotation is a strategy using data an attempt to predict where
the economic cycle is headed in the future and based on that
information, position the portfolio in the most opportune industry
sectors.
MEAN VARIANCE OPTIMIZATION MODELS
MEAN VARIANCE OPTIMIZATION MODELS
- MVO models calculate an efficient frontier based upon user
supplied estimates of the returns, standard deviations, and
correlations among sets of investment vehicles. - Seek to maximize the expected return of a portfolio based on a
selected level of risk - Uses software to calculate
- One factor or multi-factor models
TIME DIVERSIFICATION
TIME DIVERSIFICATION
- Investors should be aware that while risk appears to diminish over
long holding periods, the possibility of significant variation in returns
in any one year or years is ever present. - There is always the possibility that an asset held over a long time
frame will have to be sold at an inopportune time, resulting in a
lower-than-expected return on the asset
MUTUAL FUNDS AND ETFs
MUTUAL FUNDS AND ETFs
- While MPT provides the tools for investors to create and manage
their own investment portfolios, constructing and managing those
investment portfolios requires time and skill. - Many individuals delegate that task by:
- Investing in mutual funds and ETFs
- Focusing on the strategic asset allocation of their overall
portfolio
Jocko was just told that the expected return for Echo stock was 20%, based on the CAPM. Assuming that the market return and the risk-free rate are 12% and 4%, respectively, what is the beta for Echo?
a. 1.0. b. 1.5. c. 2.0. d. 2.5.
Capital Asset Pricing Model: equation
Ri = Rf + B [ Rm - Rf ]
Ri = expected return of security
Rf = Risk Free rate of Return
B = Beta
Rm = Return on the market
20 % = 4% + B [ 12% - 4% ]
solve for B = 2
Portfolio construction
Based on the investor’s goals, objectives, time horizon, and risk tolerance, with additional consideration for types of available investments and their risk characteristics.
Portfolios should be designed to achieve a targeted rate of return while minimizing risk.
The risk of an investment, as measured by its standard deviation,
tends to decrease as the holding period of the investment increases. Risk is not eliminated with longer holding periods because there is still no protection from volatility that occurs during the last years of the time horizon.
High standard deviation implies that there is a higher variability of returns, and therefore more risk, associated with an investment when compared to an asset with a low standard deviation.
Monte Carlo simulation measures the
Monte Carlo simulation measures the
probability of success in achieving a particular investment objective by running hundreds or thousands of iterations of random potential combinations of investment returns.
Style drift occurs when an actively managed mutual fund’s portfolio begins to ?
Style drift occurs when an actively managed mutual fund’s portfolio begins to
diverge from its stated investment style or objective. When mutual funds have been selected to match an investor’s desired asset allocation and style drift occurs, it may be necessary to rebalance the portfolio to match the stated asset allocation.
R-Squared
Beta & R-Squared Implications
R-Squared___________________________________________
- Indication of how good your model (Beta) is
- What percent of return is due to the market
- Measure of how well diversified your portfolio is
- Calculated by squaring correlation coefficient
- Correlation = .8
- r-squared = .64 or 64%
- Measure of how well diversified your portfolio is
- S&P 500 Index Fund ~ r-squared = 100%
- Sector Mutual Fund ~ r-squared 40-50%
Beta & R-Squared Implications__________________________
* R-Squared will give us insight as to whether or not Beta is an
appropriate measure of risk
* If R-Squared is greater than .70 then YES
* If R-Squared is less than .70 then NO
What is the required rate of return when the risk free rate of
return is 3%, the beta is 1.2 and the risk premium is 8%?
Ri = Rf + ( Rm - Rf ) Beta
( Rm -Rf ) = market risk premium
so,,,,,
= 3 + ( 8 ) 1.20 = 12.60 %
Which of the following is a graphical representation of expected return and beta?
The SML represents the expected return relative to risk as measured by beta
What type of risk does a portfolio have with a beta of 1.5?
Systematic risk onlY
Unsystematic risk only.
Systematic and unsystematic risk
Cannot determine from the question.
Cannot determine from the question.
Rationale
Recall that beta is a measure of the risk of a portfolio relative to the market.
It is derived through regression analysis, and its significance and reliability are measured by R-squared.
A portfolio with a beta of 1.5 will certainly have systematic risk but may also have unsystematic risk.
Which tools can help to determine an optimal investment portfolio?
- Mean-variance optimization model
- Risk tolerance questionnaire
- Tactical asset allocation
1 and 2.
Rationale
The mean-variance optimization model and the risk tolerance questionnaire can be used to help determine an optimal investment portfolio. The mean-variance optimization model is designed to determine the optimal portfolio, given a client’s risk tolerance level; therefore, the risk tolerance questionnaire will be utilized to assess the appropriate level of risk to be used within the model.
XYZ common stock has a beta of 0.50, while ABC common stock has a beta of 2.0.
The expected return on the market is 12% and the risk-free rate is 4%.
Based on the capital asset pricing model (CAPM) and making use of the information, the required return on XYZ common stock should be ____, and the required return on ABC common stock should be____.
8%; 20%.
Rationale
FORUMLA
Rp = Rf + Beta ( Rm - Rf )
Rp = Expected return on security
Rf = risk free return
Beta = beta on security
Rm = expected return on the market
XYZ: 0.04 + 0.5(0.12 - 0.04) = 8%
ABC: 0.04 + 2.0(0.12 - 0.04) = 20%
When the market risk premium decreases, whilst the risk-free rate remains unchanged, then the SML should:
Remain parallel to the original SML but shift upwards.
Remain parallel to the original SML but shift downwards.
Rotate downward (clockwise).
Rotate upwards (counterclockwise).
Rotate downward (clockwise).
Rationale
If the perception of risk decreases, then the return for the market portfolio should decrease. Since the Rf remains the same, it results in a rotation downward – the slope decreases.
Jordan has a fairly diversified portfolio and is considering adding another security to it. Which of the following is correct?
She should add a security that is negatively correlated to achieve the best diversification.
Rationale
The best correlation to add to a portfolio would be negative. Correlation ranges from +1 to -1.
The _____ is a graphical representation of expected return and risk, as measured by standard deviation.
The CML shows the expected return for a portfolio, given its level of risk as measured by standard deviation
Jocko was just told that the expected return for Echo stock was 20%, based on the CAPM. Assuming that the market return and the risk-free rate are 12% and 4%, respectively, what is the beta for Echo?
2.0.
Rationale
CAPM formula
Rp = Rf + Beta ( Rm - Rf )
Rp = Expected return on security
Rf = risk free return
Beta = beta on security
Rm = expected return on the market
Rationale
20% = 4% + β(12% - 4%)
Solving for β = 2.0
Antwon believes that the market premium will go up over the next two months due to expectations about the market portfolio. What should happen to the SML?
The slope of the SML should increase.
Rationale
If the expected return on the market increases, then the slope of the SML should increase as the Rf remains the same
Ollie wants to increase the expected return on his portfolio above that of the market portfolio. According to the CML, what should he do?
Borrow money at the risk-free rate of return and invest in the market portfolio.
Rationale
The CML consists of portfolios that are a combination of the risk-free return and the market portfolio.
Lending portfolios have less than 100% invested in the market portfolio.
Borrowing portfolios have more than 100% invested in the market portfolio.
When the market risk premium increases, whilst the risk-free rate remains unchanged, then the SML should:
Rotate upwards (counterclockwise).
Rationale
If the market risk premium increases, then the return for the market portfolio should increase. Since the Rf remains the same, it results in a rotation upward – the slope increases.
Which of the following statements regarding time diversification and forecasting is NOT correct?
Aincorrect forecast spread across may periods will be discounted and will not significantly distort results.
Rationale
If the forecast is wrong and was spread across many periods, the error is compounded and can significantly distort the results. Furthermore, as the length of the projection period increases, the uncertainty about the accuracy of the forecast grows
Which of the following statements about the CAPM and APT are correct?
Both models are used as asset pricing models.
Rationale
CAPM is a single factor model while APT is a multi-factor model. APT does not use beta nor the market portfolio. Both models are asset pricing models.
Gus is considering two portfolios:
1) Portfolio A with a return of 12% and a standard deviation of 20%, and
2) Portfolio B with a return of 6% and a standard deviation of 10%.
Which of the following statements are correct about portfolio return and risk
If the correlation between A and B is 1.0, then the standard deviation of a 50/50 portfolio will be the same as an 80/20 portfolio.
At a correlation of -1, 100% of the portfolio invested in B will generate the lowest portfolio standard deviation.
Both a and b are correct.
Neither a or b is correct. ??? need help
Rationale
Option a is incorrect as the standard deviation will change based on the change in the portfolio weightings. Option b is incorrect as investing 100% in a single asset does not provide any diversification benefits. Investing in both negatively correlated assets will reduce the overall portfolio risk.
An asset that lies above the SML are considered to be _______
undervalued based on its beta.
Rationale
An asset above the SML would have a higher expected return than CAPM would suggest and therefore be considered undervalued.
Horizontal.
Rationale
An investor that is indifferent to risk does not demand higher returns for increases in risk. Therefore, the investor’s indifference curve will be flat or horizontal.
Which of the following would be included in the market portfolio?
- Stocks & bonds
- Hedge funds
- Risk-free asset
1 and 2.
Rationale
The market portfolio consists of all risky assets. Therefore, it would not include the risk-free asset.
Portfolio X consists of 60% in Fund A with the remainder in Fund B. The standard deviation for Fund A and Fund B is 20% and 14%, respectively. The correlation between Fund A and B is 1.0. Portfolio Z consists of 65% in Fund C with the remainder in Fund D. The standard deviation for Fund C and Fund D is 20% and 14%, respectively.
The correlation between Fund C and D is 0.6.
Which portfolio is the most risky?
Portfolio X.
Rationale
Correlation between A and B is 1.0
port x std dev
Fund A 60% 20%
Fund B 40% 14%
The correlation between Fund C and D is 0.6.
Port Z
Fund C 65% 20%
Fund D 35% 14%
Both funds in each portfolio have the same risk and similar weightings. However, the correlation for the funds in Portfolio Z is much lower, which results in a lower risk for the portfolio
Leona invests $9,600 of her $12,000 available assets into the Metro Doughnut Company with the remainder in the Safe Bond Fund.
The Metro Doughnut Company and the Safe Bond Fund are positively correlated.
Changes in the Safe Bond Fund explain 4% of the returns for the Metro Doughnut Company.
If the Metro Doughnut Company has a standard deviation of 20% and the Safe Bond Fund has a standard deviation of 5%,
what is the standard deviation of the combined portfolio?
16.23%. ????? help
Rationale
Both funds in each portfolio have the same risk and similar weightings. The question does not provide the correlation between the two investments. Rather, it provides the r-squared value of 4%, which means that the correlation must be 20%. r2 = correlation coefficient2; therefore, correlation coefficient = the square root of r2.
4 % = R2 provided
so
Since the COV is not provided, we must substitute:
correlation coefficient x standard deviation of A x standard deviation of B
Which of the following is a graphical representation of expected return and beta?
SML.
Rationale
The SML represents the expected return relative to risk as measured by beta.
Antwon believes that the market premium will go up over the next two months due to expectations about the market portfolio. What should happen to the SML?
The slope of the SML should increase.
Rationale
If the expected return on the market increases, then the slope of the SML should increase as the Rf remains the same.
The _____ is a graphical representation of expected return and risk, as measured by standard deviation.
CML
ocko was just told that the expected return for Echo stock was 20%, based on the CAPM. Assuming that the market return and the risk-free rate are 12% and 4%, respectively, what is the beta for Echo?
CAPM formula
Ri = Rf + B ( Rm - Rf )
SOLVE FOR B:
20% = 4% + B ( 12% - 4% )
20% = 4% + ( 12%B - 4%B )
20% = 4% + 8%B
- 4 -4
16% = 8 B
/8 /8
2 = B which is beta
XYZ common stock has a beta of 0.50, while ABC common stock has a beta of 2.0. The expected return on the market is 12% and the risk-free rate is 4%. Based on the capital asset pricing model (CAPM) and making use of the information, the required return on XYZ common stock should be ____, and the required return on ABC common stock should be____.
XYZ beta = .50
ABC Bet a = 2.00
Expected return on the market is 12% and the risk-free rate is 4%.
What is the required return for XYZ and ABC ?
use the CAP formula.
Ri = Rf + B ( Rm - Rf )
XYZ = 0.04 + 0.5(0.12 - 0.04) = 8%
ABC = 0.04 + 2.0(0.12 - 0.04) = 20%
Portfolio X consists of 60% in Fund A with the remainder in Fund B. The standard deviation for Fund A and Fund B is 20% and 14%, respectively. The correlation between Fund A and B is 1.0. Portfolio Z consists of 65% in Fund C with the remainder in Fund D. The standard deviation for Fund C and Fund D is 20% and 14%, respectively. The correlation between Fund C and D is 0.6. Which portfolio is the most risky?
Portfolio X.
Rationale
Both funds in each portfolio have the same risk and similar weightings.
However, the correlation for the funds in Portfolio Z is much lower, which results in a lower risk for the portfolio.
TEST
Asset Allocation
* Factors to consider
* Economy, capital preservation, goals, risk tolerance, time horizon
PORTFOLIO CONSIDERATIONS
* Prior to portfolio construction, an investor needs to consider:
* Goals and objectives
* Time frame available
* Risk tolerance
* Asset classes available
* Risks those assets present
TEST
EFFICIENT FRONTIER
__Compare portfolios on their risk/return relationship.
__An investor cannot achieve returns above the efficient frontier
Harry Markowitz created a model that identifies an efficient frontier
from all of the possible combinations of risky assets.
- For all possible investment portfolios, the expected return and
risk measures are calculated and plotted on a graph. - Coupled with the investor’s risk-indifference curve, the model
suggests the optimal investment portfolio.
An efficient portfolio is one with the highest return for a given amount of risk, or the lowest risk for a given amount of expected return.
TEST
- Modern Portfolio Theory –is the acceptance by an investor of a given level of risk while maximizing their expected return objectives.
- The Efficient Frontier— the curve which illustrates the best possible
returns that could be expected from all possible portfolios. - Investors are risk averse – they require additional compensation for
taking on additional risk.
− Investors seek the highest return attainable at any level of risk.
− Investors want the lowest level of risk at any level of return.
− The assumption is also made that investors are risk averse.
TEST
The Capital Asset Pricing Model (CAPM) calculates the relationship
of risk and return of an individual security using the beta (b) as its
measure for risk.
The CAPM formula is often referred to as the Security Market Line (SML) equation because it’s inputs and results are used to construct the SML. The formula looks like this:
Ri = Rf + B ( Rm - Rf )
ri = required or expected rate of return
rf = risk-free rate of return
rm = return of the market
b = beta of the individual security
If the risk free rate of return is 3% and the beta of a security is 1.5 and the return of the market is 9%, what is the required rate of return?
A. 13.5%
B. 12.5%
C. 16.5%
D. 12%
E. 13%
TEST
If the risk free rate of return is 3% and the beta of a security is 1.5 and the return of the market is 9%, what is the required rate of return?
A. 13.5%
B. 12.5%
C. 16.5%
D. 12% ««< correct answer
E. 13%
Ri = Rf + B ( Rm - Rf )
ri = required or expected rate of return
rf = risk-free rate of return
rm = return of the market
b = beta of the individual security
S0
Ri = 3 % + 1.5 ( 9 - 3 )
Ri = 12
- CAPM
- Assumptions
− Should earn a minimum rate of return equal to risk free rate
− Investors should be rewarded for risk
− Investors should earn a return on the SML - Risk Premium in CAPM?
TEST
- CAPM
- Assumptions
− Should earn a minimum rate of return equal to risk free rate
− Investors should be rewarded for risk
− Investors should earn a return on the SML - Risk Premium in CAPM?
( Rm -Rf ) = market risk premium
The term (r - rf) is the market risk premium, which is them
incremental return provided by a market portfolio over the risk-free
rate of return.
Additional expected return over the risk-free rate of
return that an investor will require to invest in the market which
exposes them to risk.
Risk premium on asset i = ( Rm - Rf ) βi
Which of the following are true statements about the Capital Asset Pricing Model (CAPM)?
I The Capital Market Line (CML) by itself does NOT determine the optimal portfolio for an investor.
II Beta is used as a measure of risk on the Security Market Line (SML).
III The required return is beta times the market return.
IV As investors substitute risky securities in place of risk-free assets, both risk and return increase.
A I and III only. B II and IV only. C I, II, and IV only. D II, III, and IV only
Solution: The correct answer is C.
The required rate of return is determined by adding the risk premium (which is the market rate of return minus the risk free rate times the beta) to the risk free rate of return
Considering the CML, which of the following is correct?
The point at which the CML is tangent to the efficient frontier consists of a portfolio of 50% risky assets and 50% risk-free asset.
As a portfolio moves from the point of tangency to the risk-free rate, the percentage of bonds will increase.
As a portfolio moves beyond the point of tangency (to the right), the allocation to equities increases.
None of the above is correct.
None of the above is correct.
Rationale
Option a is incorrect as the point of tangency represents the market portfolio, which consists of all risky assets.
Option b is incorrect because the percent of the risk-free asset increases, not bonds.
Option c is incorrect as the percent of stocks does not increase, the portfolio is simply leveraged.
