Major Investment Theories

Question 1

What does the standard deviation show?

Answer 1

The extent to which a return varries from expected or average return. (Volitility)

Question 2

What does a high standard deviation imply?

Answer 2

That return varies wildly from expected return, meaning higher risk

Question 3

Under normal distribution, what % would be expected to fall between the mean and +/- 1 deviation? And 2 deviation?

Answer 3

1=68%
2=95%

Question 4

What is kurtosis?

Answer 4

The real-life non symmetrical deviations that accrue when ploting on a graph.

Question 5

What is corelation?

Answer 5

The degree to which to assets will co-vary

Question 6

What scale can corelation be measured?

Answer 6

Between +1 to -1

Question 7

What does a positive correlation mean?

Answer 7

As one investment moves up/down, the other will move with it.

Question 8

What does a negative correlation mean?

Answer 8

If a stock moves up/down, the other will move down/up

This protects against risk.

Question 9

How can you use put options to hedge?

Answer 9

These allow the right but not the obligation to sell at a certain price in the future.

If your investment falls, you can sell an option at the agreed price.

Question 10

How can futures be used to hedge?

Answer 10

These allow a stock to be sold at a specific time for an agreed upon price. If your investment drops, the future will be sold when the time elapses protecting the investment. No option not to sell so can result in markets moving the wrong way.

This is an open-ended obligation

Question 11

What is the efficiency frontier?

Answer 11

Grapgh showing risk vs returns.

Question 12

What problems come with using efficiency frontiers to pick portfolios?

Answer 12

Standard deviation is not always precise
The model relies on past performance
The model does not include costs and charges
An investor does not pick their portfolio on risk alone,
It assumes the portfolio is made up of index funds

Question 13

What are the two elements of risk?

Answer 13

Systemic (market) risk
Non-systemic (investment) risk

Question 14

What can diversification not do?

Answer 14

Prevent Systemic Risk.

Question 15

Major theories of risk look at what and why?

Answer 15

Systemic risk because they believe individual risk will be covered by diversification.

Question 16

How many securities need to be held to effectively manage risk?

Answer 16

35

Question 17

What should you get on top of the risk-free return for risky stocks?

Answer 17

Risk premium

Question 18

What does CAPM cover, and what is it known as?

Answer 18

Systemic risk
BETA CAPM

How does the price of a security move in relation to movement in the price of the market.

Question 19

What BETA rating is the market given?

Answer 19

1

Question 20

What do the BETA ratings of securities mean

Answer 20

1 moves with the market
>1 to <0 moves slower (less volatile)
<1 moves faster (more volatile)

Question 21

What are the assumptions made by the CAMP model?

Answer 21

All assets have the same term
Risk is the only factor in the investor making decisions.
There are no liquidity issues, and no one individual can affect the market price.
The market is transparent.
Risk -free return is freely available to investors.
No costs, taxes or restrictions on short selling.

Question 22

What key problems are there to CAPM

Answer 22

Risk free return are not always available
Different markets have different BETAs
BETAs are based on past performance
US study showed no correlation to CAPM
Studies suggest both systemic and non-systemic risk are being valued in the market.

Question 23

What is used to counter when there is no risk-free return in the market?

Answer 23

Goverment treasury bills due to very low defult risk and because they are short term with low interest and inflation risk.

Question 24

What does APT seek to do?

Answer 24

Price the assets correctly by looking at systemic risk but taking it further and more flexible than CAPM

Uses factor specific BETA to look at different factors of the market.

Question 25

What are the downsides to APT?

Answer 25

Time consuming
Factors may be missed

Question 26

What factors might APT look at?

Answer 26

Inflation sensitivity
Interest rates
Business productivity
Movements in the long term Gilt/T-yield curve
Changes in bond defult risk
Exchange rates

Question 27

What were Fama and French’s findings?

Answer 27

That small cap business outperform large
Value companies (high ratio between book value and share price) outperform growth stocks

Question 28

What does efficient market hypothesis suggest?

Answer 28

In efficient markets, all investors have access to all relevant information, and over time, it will not be possible to deliver constant outperformance by analysis. as

This is because all factors have been added to the price already.

Question 29

What would a fully efficient market disincetivise?

Answer 29

Any active investment.

Question 30

What is shown at the 3 levels for efficient market hypothesis?

Answer 30

Weak- all past price and trading information. Already available, so already built into price.

Semi-strong - information that is in the public domain, i.e., fianacial reports.

Strong- all information that could be obtained, i.e., private information

Question 31

What does the efficiency hypothesis actually tell us?

Answer 31

Most commonly, available information can and will be used in setting the price. Therefore, there is no point in further analysis.

Less easily accessed information is the more chance of outperformance through analysis.

Ie efficient markets use trackers. Opt for active for inefficient.

Question 32

What are most efficient markets? What are least?

Answer 32

Most-
Gilt markets.
Markets for shares in larger companies

Least-
Smaller less liquid companies

Question 33

Examples of behavioural finance.

Answer 33

People overestimate how happy they will feel and underestimate how unhappy they will feel.

People don’t like to admit when they got it wrong.

People overestimate their own ability and back their own predictions.

People often panic and sell out at the wrong time.