Learning Outcome 3 - 7 standard questions / Understand the merits and limitations of the main investment theories Flashcards
What is the main aim of modern portfolio theory (MPT)?
Smallest amount of risk is taken for the maximum amount of reward
What does MPT assume about investors and how they deem risk?
That they are risk averse and will choose the smallest amount of risk if given a choice, for the same return
What does the standard deviation measure?
How widely the actual return vs. the average of expected return
Securities with a beta greater than 1 are also known as what type of security?
Aggressive security
What is the theory behind efficient market hypothesis (EMH)?
Impossible to outperform the market by picking undervalued securities. You cannot beat the market.
Which form of EMH suggests that security prices reflect all HISTORICAL PRICES and RETURNS?
Weak-form efficiency
Which form of EMH suggests that security prices reflect all PUBLIC information?
Semi-strong efficiency
Which form of EMH suggests that security prices reflect all PUBLIC and PRIVATE information?
Strong-form efficiency
Does EMH support active stock selection or passive investing?
Passive
If EMH is correct, what should an investor do instead of picking stocks?
Invest in index tracking funds
What is the practice of arbitrage?
Taking advantage of security mispricing to make a risk-free profit
How many securities are recommended in a portfolio to eliminate non-systematic risk?
15-20
What are the limitations of CAPM?
What to use as the risk free rate?
What is the market portfolio?
The suitability of beta?
Which factors did the Fama and French model add to the CAPM?
Formula allowing for company size and value
What are the two basic ideas that all multifactor models share?
Investors require extra return for taking risk
They appear concerned with the risk that cannot be eliminated by diversification
What is the general theory behind arbitrage pricing?
A security’s returns can be predicted using the relationship between the security and a number of common risk factors, where sensitivity to changes in each factor is represented by a factor specific beta
What is usually used as representing a risk-free asset in the CAPM equation and why?
91 day treasury bills
Because there is virtually no default risk and, because of their short life, interest and inflation risks are minimal
What is the key difference between the capital asset pricing model (CAPM) and arbitrage pricing theory (APT)?
APT - more than one type of risk influences security returns
CAPM - returns are based on the market risk to which a security is exposed, rather than total risk
How does behavioural finance explain market anomalies such as bubbles and crashes?
Investors behaving irrationally with new market information
What does the Fama and French multi-factor pricing model say about small and large cap stocks?
Small caps tend to outperform large caps
What are the least and most efficient markets according to EMH?
Venture capital the least
Government bonds the most
According to EMH, which are more efficient, large or small caps?
Larger
According to EMH, active fund managers are less likely to outperform passive managers in which markets over which duration?
Developed markets, over the long term
What are the 3 ways to measure risk-adjusted returns?
Sharpe ratio
Alpha
Information ratio
What is the Sharpe ratio formula?
Actual return, minus the risk-free return, divided by, standard deviation of investment
What is the Sharpe ratio used to compare and why?
To see which investment offers the most return for a given amount of risk
What does a higher Sharpe ratio indicate?
The investor has been compensated better for the risk taken
What does a negative Sharpe ratio indicate?
The risk-free asset would have performed better than the investment being analysed
If an investor wants to see the difference between the return he would expect from a security, given its beta, which ratio would he use?
Alpha
What is the Alpha formula?
F - [R+B(M-R)]
Where:
F = fund return
R = risk free rate of return (i.e. treasury bill)
B = market beta
M = market return
Which risk-adjusted return ratio would you be working on if you were using the standard deviation in your calculations?
Sharpe
The information ratio can only be used for active or passive fund managers?
Active
Which risk-adjusted ratio is often used to gauge the skill of fund managers and shows the consistency with which a manager beats a benchmark index?
Information ratio
Which risk-adjusted return ratio would you be working on if you were using the tracking error in your calculations?
Information ratio
What is the information ratio formula?
Actual return - benchmark return, divided by tracking error
What does a higher information ratio suggest when comparing 2 figures?
The manager has added more value through active management
“Active fund managers cannot beat the market”, says which investment theory?
Efficient Market Hypothesis (EMH)
What is the main difference between the Sharpe and Information ratios with regards to their benchmarks used in calculations?
Sharpe ratio = risk-free return as benchmark
Information ratio = risky index as benchmark
