Investments Ch 4 Flashcards

Question

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:

Answer 1

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?

Answer 2

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).

Answer 3

ARBITRAGE PRICING THEORY: FORMULA APT is generally expressed as

Answer 4

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

Answer 5

LIFE CYCLE

Answer 6

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).

Answer 7

RISK TOLERANCE TOOLS

Answer 8

PASS ASSET ALLOCATION RECOMMENDATIONS

Answer 9

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: 1. Strategic asset allocation 2. Tactical asset allocation 3. Mean-variance optimization models

Answer 10

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.

Answer 11

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

Answer 12

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.

Answer 13

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

Answer 14

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

Answer 15

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

Answer 16

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

Answer 17

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.

Answer 18

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.

Answer 19

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.

Answer 20

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.

Answer 21

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

Answer 22

Ri = Rf + ( Rm - Rf ) Beta ( Rm -Rf ) = market risk premium so,,,,, = 3 + ( 8 ) 1.20 = 12.60 %

Answer 23

The SML represents the expected return relative to risk as measured by beta

Answer 24

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.

Answer 25

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.

Answer 26

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%

Answer 27

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.

Answer 28

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.

Answer 29

The CML shows the expected return for a portfolio, given its level of risk as measured by standard deviation

Answer 30

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

Answer 31

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

Answer 32

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.

Answer 33

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.

Answer 34

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

Answer 35

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.

Answer 36

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.

Answer 37

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.

Answer 38

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.

Answer 39

1 and 2. Rationale The market portfolio consists of all risky assets. Therefore, it would not include the risk-free asset.

Answer 40

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

Answer 41

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

Answer 42

SML. Rationale The SML represents the expected return relative to risk as measured by beta.

Answer 43

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.

Answer 44

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

Answer 45

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%

Answer 46

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.

Answer 47

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

Answer 48

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.

Answer 49

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.

Answer 50

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

Answer 51

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

Answer 52

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

Answer 53

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

Answer 54

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.