Learning Outcome 3 - 7 standard questions / Understand the merits and limitations of the main investment theories

Question 1

What is the main aim of modern portfolio theory (MPT)?

Answer 1

Smallest amount of risk is taken for the maximum amount of reward

Question 2

What does MPT assume about investors and how they deem risk?

Answer 2

That they are risk averse and will choose the smallest amount of risk if given a choice, for the same return

Question 3

What does the standard deviation measure?

Answer 3

How widely the actual return vs. the average of expected return

Question 4

Securities with a beta greater than 1 are also known as what type of security?

Answer 4

Aggressive security

Question 5

What is the theory behind efficient market hypothesis (EMH)?

Answer 5

Impossible to outperform the market by picking undervalued securities. You cannot beat the market.

Question 6

Which form of EMH suggests that security prices reflect all HISTORICAL PRICES and RETURNS?

Answer 6

Weak-form efficiency

Question 7

Which form of EMH suggests that security prices reflect all PUBLIC information?

Answer 7

Semi-strong efficiency

Question 8

Which form of EMH suggests that security prices reflect all PUBLIC and PRIVATE information?

Answer 8

Strong-form efficiency

Question 9

Does EMH support active stock selection or passive investing?

Answer 9

Passive

Question 10

If EMH is correct, what should an investor do instead of picking stocks?

Answer 10

Invest in index tracking funds

Question 11

What is the practice of arbitrage?

Answer 11

Taking advantage of security mispricing to make a risk-free profit

Question 12

How many securities are recommended in a portfolio to eliminate non-systematic risk?

Answer 12

15-20

Question 13

What are the limitations of CAPM?

Answer 13

What to use as the risk free rate?
What is the market portfolio?
The suitability of beta?

Question 14

Which factors did the Fama and French model add to the CAPM?

Answer 14

Formula allowing for company size and value

Question 15

What are the two basic ideas that all multifactor models share?

Answer 15

Investors require extra return for taking risk

They appear concerned with the risk that cannot be eliminated by diversification

Question 16

What is the general theory behind arbitrage pricing?

Answer 16

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

Question 17

What is usually used as representing a risk-free asset in the CAPM equation and why?

Answer 17

91 day treasury bills

Because there is virtually no default risk and, because of their short life, interest and inflation risks are minimal

Question 18

What is the key difference between the capital asset pricing model (CAPM) and arbitrage pricing theory (APT)?

Answer 18

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

Question 19

How does behavioural finance explain market anomalies such as bubbles and crashes?

Answer 19

Investors behaving irrationally with new market information

Question 20

What does the Fama and French multi-factor pricing model say about small and large cap stocks?

Answer 20

Small caps tend to outperform large caps

Question 21

What are the least and most efficient markets according to EMH?

Answer 21

Venture capital the least
Government bonds the most

Question 22

According to EMH, which are more efficient, large or small caps?

Answer 22

Larger

Question 23

According to EMH, active fund managers are less likely to outperform passive managers in which markets over which duration?

Answer 23

Developed markets, over the long term

Question 24

What are the 3 ways to measure risk-adjusted returns?

Answer 24

Sharpe ratio
Alpha
Information ratio

Question 25

What is the Sharpe ratio formula?

Answer 25

Actual return, minus the risk-free return, divided by, standard deviation of investment

Question 26

What is the Sharpe ratio used to compare and why?

Answer 26

To see which investment offers the most return for a given amount of risk

Question 27

What does a higher Sharpe ratio indicate?

Answer 27

The investor has been compensated better for the risk taken

Question 28

What does a negative Sharpe ratio indicate?

Answer 28

The risk-free asset would have performed better than the investment being analysed

Question 29

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?

Answer 29

Alpha

Question 30

What is the Alpha formula?

Answer 30

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

Question 31

Which risk-adjusted return ratio would you be working on if you were using the standard deviation in your calculations?

Answer 31

Sharpe

Question 32

The information ratio can only be used for active or passive fund managers?

Answer 32

Active

Question 33

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?

Answer 33

Information ratio

Question 34

Which risk-adjusted return ratio would you be working on if you were using the tracking error in your calculations?

Answer 34

Information ratio

Question 35

What is the information ratio formula?

Answer 35

Actual return - benchmark return, divided by tracking error

Question 36

What does a higher information ratio suggest when comparing 2 figures?

Answer 36

The manager has added more value through active management

Question 37

“Active fund managers cannot beat the market”, says which investment theory?

Answer 37

Efficient Market Hypothesis (EMH)

Question 38

What is the main difference between the Sharpe and Information ratios with regards to their benchmarks used in calculations?

Answer 38

Sharpe ratio = risk-free return as benchmark
Information ratio = risky index as benchmark