Lesson 1: Financial Markets, Instruments and Risk/Return Measures

Question 1

Describe difference between top down (AA->SS) and Bottom up (SS->AA) portfolio construction

Answer 1

Within top down the investor chooses asset classes within they wish to focus their resources (AA). In Bottom up (SS first) the investor focuses on a few securities first.

Question 2

Within Asset allocation, what is the difference between tactical and strategic.

Answer 2

Strategic: the weights assigned to various asset classes always remain the same

Tactical: Weights may change

Question 3

What is Alpha and Beta risk

Answer 3

Alpha is firm-specific risk, which comes from attempting to beat the market through active investing.

Beta is market risk - is the only risk in play if passive investing.

Question 4

What is the insurance principle?

Answer 4

Reducing the total risk to a minimum level when all firm-specific sources of risk are independent

Question 5

Explain a market order

Answer 5

Buy and sell orders that are executed immediately. The Bid-ask spread is what the dealer earns

Question 6

Limit order

Answer 6

Buy and sell some number of shares only when the stock price is below or above a specified level

Question 7

Stop order

Answer 7

Buy and sell if its price rises above or falls below a specified level

Question 8

Buying on margin

Answer 8

Part of the funds are borrowed: Margin in the amount contributed by the investor

Question 9

Initial percentage margin formula

Answer 9

Investor’s funds/Total value of position

Question 10

Maintenance Margin (description + formula)

Answer 10

If the purchasing price drops, the percentage margin will also decrease, but to a certain level set by the broker

Maintenance Margin = (Num. shares bought * Min price - Loan value)/(Num. shares bought * min price)

Question 11

Explain the arithmetic return and its formula

Answer 11

For security i at time t

Ri,t = [(Pi,t + Di,t)/(Pi,t - 1)] - 1

Question 12

Portfolio return

Answer 12

Rp,t = SUM (Wi * Ri,t) where Wi is the wight attached to security i

Question 13

Cumulative return

Answer 13

Over ‘k’ periods from ‘t’ to ‘t+k’

Ri,t,t+k = (1+Ri,t+1)…(1+Ri,t+k) - 1

Question 14

Arithmetic average return

Answer 14

AE[Ri,t] = SUM (1/S) * Ri,t

Question 15

Geometric (time-weighted) average return

Answer 15

GRi,t,t+k = [(1+Ri,t+1)…(1+Ri,t+k)] ^ 1/k - 1

Question 16

Logarithmic return

Answer 16

LRi,t = log(Pi,t) - log(Pi,t-1) = log(1+Ri,t)

LRi,t,t+k = LRi,t+1 + LRi,t+2 + … LRi,t+k

Question 17

Risk measurement (Variance)

Answer 17

Std. Dev^2 = E[Ri,t - E(Ri,t)]^2

Question 18

Sample estimate (based on sample avg. R) Variance of returns

Answer 18

Std. dev is the square root of variance.

Std. dev^2 = (1/S-1) * SUM (Ri,t - meanRi,t)^2

Question 19

How do you increase the accuracy of avg. return estimate and variance estimate respectively?

Answer 19

You increase the avg. return estimate through taking a longer sample from the same distribution

Variance estimate is through increasing the frequency of observations