Key Points Model Answers Flashcards
1
Q
Advantages of Markowitz (2)
A
- Allows for identification and replacement of underperforming assets
- Can personalise to investors needs eg minimise tax impact
2
Q
Disadvantages of Markowitz (5)
A
- Past performance is never a guarantee for future results
- Investment objectives can change over time, therefore periodical analysis is required
- Investors don’t always act rationally
- Requires huge number of estimates to fill covariance matrix
- Doesn’t provide guidelines for forecasting security risk premiums > essential to construct efficient frontier
3
Q
Rationality theory (5)
A
- Investor regret theory > emotionally affected by purchase price therefore hold and don’t sell (would admit loss)
- Mental accounting behaviours
- Prospect theory > depends how opportunity presented
- Over/ under reacting
- Over-confidence
4
Q
Proxy =
A
Substitute for the market to provide an indicator of market conditions and represent market risk
5
Q
Advantages of single-index model (3)
A
- Easy to implement and simple
- Can forecast security risk premiums
- Uses only small number of estimates
6
Q
Disadvantages of single-index model (2)
A
- Oversimplification
- Assumptions are not always appropriate (eg that return residuals are uncorrelated)
7
Q
Differences between Markowitz and Index (4)
A
- Index requires less estimates
- Index can forecast security risk premiums
- Markowitz can take more factors into consideration
- Index relies on more assumptions than M
8
Q
Advantages of Arbitrage Pricing theory (3)
A
- Uses simple assumptions
- Allows for multiple risk factors to be included
- It has fewer restrictions regarding the types of information allowed to perform predictions
9
Q
Disadvantages of Arbitrage Pricing theory (3)
A
- Does not specify systematic factors
- Generates a large amount of data that must be sorted through
- Can only be used on single security, not portfolio
10
Q
Assumptions of CAPM (6)
A
- Investors are rational
- Investors analyse securities in same way
- Plan for identical holding period
- No taxes/ transaction costs
- Limited to publicly traded assets
- Many investors each with a small amount of wealth relative to total wealth of all investors
11
Q
Goal of CAPM formula =
A
To establish whether a stock is valued fairly when its risk and the time value of money are compared to its expected return
12
Q
Advantages of CAPM (3)
A
- Helps investors to make better decisions about adding securities to a portfolio
- Specifies the factors a stock is exposed to
- Easy to use
13
Q
Disadvantages of CAPM (3)
A
- Many of the assumptions do not hold in reality
- Risk-free rates may change over the discounting period
- Assumes that future cash flows can be estimated for the discounting process, if they could with a high level of accuracy, would be no need for CAPM
14
Q
APT vs CAPM Similarities (2)
A
- Both provide benchmark for rates of return to use in investment evaluation
- Both assume a factor model can effectively describe the correlation between risk and return
15
Q
APT vs CAPM Differences (5)
A
- APT highlights distinction between non-diversifiable risk which requires reward in the form of a risk premium, and diversifiable which does not
- APT is derived using data from a large number of securities, CAPM is derived using inherently unobservable ‘market’ portfolio
- CAPM provides expected beta-return relationship for all securities, APT implies it holds for all but a few
- APT allows for multiple risk factors, CAPM only uses single factor
- APT does not assume that investors hold efficient portfolios, whereas CAPM does
