Key Points Model Answers Flashcards
Advantages of Markowitz (2)
- Allows for identification and replacement of underperforming assets
- Can personalise to investors needs eg minimise tax impact
Disadvantages of Markowitz (5)
- 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
Rationality theory (5)
- 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
Proxy =
Substitute for the market to provide an indicator of market conditions and represent market risk
Advantages of single-index model (3)
- Easy to implement and simple
- Can forecast security risk premiums
- Uses only small number of estimates
Disadvantages of single-index model (2)
- Oversimplification
- Assumptions are not always appropriate (eg that return residuals are uncorrelated)
Differences between Markowitz and Index (4)
- Index requires less estimates
- Index can forecast security risk premiums
- Markowitz can take more factors into consideration
- Index relies on more assumptions than M
Advantages of Arbitrage Pricing theory (3)
- Uses simple assumptions
- Allows for multiple risk factors to be included
- It has fewer restrictions regarding the types of information allowed to perform predictions
Disadvantages of Arbitrage Pricing theory (3)
- 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
Assumptions of CAPM (6)
- 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
Goal of CAPM formula =
To establish whether a stock is valued fairly when its risk and the time value of money are compared to its expected return
Advantages of CAPM (3)
- Helps investors to make better decisions about adding securities to a portfolio
- Specifies the factors a stock is exposed to
- Easy to use
Disadvantages of CAPM (3)
- 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
APT vs CAPM Similarities (2)
- 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
APT vs CAPM Differences (5)
- 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
3 factors in Fama-French model
- Size of firms (small minus big)
- Book to market values (high minus low)
- Excess return on the market (market return less risk free rate of return)
Advantages of Fama-French Model (2)
- Model includes multiple risk factors, not juts one like CAPM
- Allows investors to access higher returns without employing managers
Disadvantages of Fama-French (2)
- More complicated than the single-index model, must decide how much of each 3 factors willing to hold
- Not clear whether SMB/ SML capture risk, or are simply persistent mistakes by investors
Errors in information processing can lead to
Investors mis-estimating the true probabilities of possible events/ rates of return
Technical analysis eg
Simple moving averages/ trend lines
Jensen measure (portfolio alpha) =
Average return on portfolio over and above that predicted by CAPM, given the portfolio’s beta and average market return
Treynor’s measure =
Excess return per unit of systematic risk (not total). Reward to volatility ratio.
Current yield =
Return an investor would expect to earn if the owner purchased the bond and held it for a year
Bonds selling at a premium =
Coupon rate > Current Yield > YTM
Bonds selling at a discount =
Coupon rate < Current Yield < YTM
Disadvantage of current yield =
Doesn’t factor in interest that could be earnt if annual coupon payment is reinvested
Yield to maturity =
The internal rate of return of an investment in a bond if the investor holds the bond until maturity.
Disadvantages of YTM (4)
- Complex and lengthy process
- Assumes that coupon payments can be reinvested at the same coupon rate, not always the case
- Doesn’t account for taxes/ transaction costs investors pay on bonds
- Makes assumptions about the future which may not stand (eg bond issuer may default)
Horizon yield =
Actual return earned on an investment during the holding period, assuming all coupon payments are reinvested, calculated on an annual basis. Total return when a bond is sold before maturity.
Disadvantages of horizon yield (3)
- Doesn’t factor in costs associated with selling bond before maturity
- Assumes all coupon payments are reinvested
- Estimates change in interest rate > may not be accurate
