Lecture 10

Question 1

Portfolio Return

Answer 1

• Weighted average of the stock in the portfolio

Question 2

Return over a period

Answer 2

Calculated by comparing the amount invested at the beginning and its value at the end of the period

Question 3

Excess Return

Answer 3

Difference between portfolio return and the risk-free rate

Question 4

Return calculation between time i and time i+1

Answer 4

Return_{i+1} = [ ( share price_{i+1} x No. of shares + dividend paid per share ) / ( share price_i x No. of shares ) ] - 1
Note: If dividends paid per share is £4 and you have ten shares, you don’t add 4x10 for the “dividend paid per share”, you only add 4

Question 5

Capital Allocation Line

Answer 5

• Expected return of a complete portfolio (mix of risky and risk-free assets)
• Steeper slope is preferred (Sharpe Ratio)

Question 6

Optimal portfolio graph

Answer 6

The point where CAL is tangent to the efficient frontier

Question 7

Sharpe Ratio

Answer 7

Average portfolio excess return over the sample period divided by the standard deviation of returns over that period
- Measures reward to (total) volatility trade-off
- Higher Sharpe Ratio is better

Question 8

Annualised Sharpe ratio

Answer 8

Sharpe ration x sqrt{N}
where N is the number of periods per year

Question 9

M^2 measure

Answer 9

E[return of P] - E[market return]
Where P is a portfolio consisting of the risky portfolio and the risk-free asset to match the volatility level of the market

Question 10

Capital Asset Pricing Model (CAPM)

Answer 10

Model for pricing an individual security or portfolio

Question 11

Jensen’s Alpha

Answer 11

Expected return of a portfolio consisting of a risk-free asset and the market
- If the alpha is positive, the risky asset/portfolio is outperforming the market portfolio

Question 12

Treynor Ratio

Answer 12

Same as Sharpe ratio but divided by beta_P instead of standard deviation of P
- This is the Beta in CAPM
- Higher Treynor Ratio is preferred

Question 13

T^2 Measure

Question 14

Information Ratio

Answer 14

Alpha of the active portfolio divided by the standard deviation of the residual terms in CAPM regression.
- Standard deviation of the residuals in the sum of their square divided by ( No. of residuals - 2 )

Question 15

Possibility of Performance Manipulation

Answer 15

• Sharpe Ratio is unaffected by the borrowing or lending of a risk-free asset at a fixed proportion y to form a complete portfolio
• However, y changes over time

Question 16

Morningstar Risk-Adjusted Rating

Answer 16

• Risk-adjusted measure which is regarded as impossible to manipulate
• Similar but much more complex than Sharpe Ratio

Question 17

Regression Approach

Question 18

Luck vs Skill

Answer 18

• All managers invest randomly in stocks, some funds unluckily perform worse than passive benchmarks while some luckily outperform