Modern Port Theory

Question 1

Modern Port Theory

Answer 1

Acceptance by investor of given level risk while maximizing expected return

Question 2

Efficient Frontier

Answer 2

Curve that shows best possible returns from all possible portfolios

Above is unattainable

Want to be on the curve (most efficient)

Below is inefficient

Question 3

Indifference curves

Answer 3

Built using selections based on highest level of return given acceptable level of risk

Steep means very risk averse (needs much more return for tiny more risk)

Flat or shallow means not as risk averse

Question 4

CAPM Formula

Answer 4

Return = Rf + (Rm - Rf) B

When graphed out, gives us Security Market Line SML

Question 5

Security Market Line SML

Answer 5

Above line = Undervalued, Buy

Below Line = Overvalued, Sell Short

Relationship between risk and return defined by CAPM and put on a graph

Question 6

What’s the intersection of the Y axis of the CML/SML?

Answer 6

Risk-free rate

Question 7

Covariance Formula for portfolio

Answer 7

Standard deviation of 1 times std dev of 2 times correlation

Question 8

Information Ratio

Answer 8

A relative risk-adj performance measure

Shows excess return and consistency by fund manager relative to benchmark

Higher is better

IR= (Rp - Rb) / Tracking error or std dev

Rp is return of portfolio, Rb is benchmark

Question 9

Treynor Ratio

Answer 9

Relative Risk-adj measure

Measures reward achieved relative to systematic risk (beta)

Doesn’t say if manager has outperformed benchmark

Question 10

Sharpe Ratio

Answer 10

Relative Risk-adj measure of risk premiums of portfolio relative to total amount of risk in portfolio

Used Std. Dev.

Higher the better, shows most return for each unit of risk

Doesn’t show manager’s performance against the market

Question 11

Jensen’s Alpha

Answer 11

Measures absolute performance on risk-adjusted basis

Actual return minus expected return

Positive alpha is above the SML, negative alpha is below SML (indicative of manager’s performance)

Question 12

Efficient Market Hypothesis

Answer 12

Random Walk Theory:

Stock prices are unpredictable but not arbitrary

At any moment, prices on stocks are the best incorporation of all available info and a true reflection of value of that stock

Prices are in equilibrium

Question 13

Weak Form

Answer 13

Doesn’t use Technical Analysis (historical info)

Believes Fundamental analysis
(Public info, 10-K filings) and Private Info (insider) can get you above average returns

Question 14

Semi-Strong Form

Answer 14

Doesn’t believe Technical analysis (historical info) and Fundamental (Public info) can help

Does believe that Private (insider) info can help get above average returns

Question 15

Strong Form

Answer 15

Doesn’t believe that Technical, Fundamental, or Private Info can help get above average returns

So, diversify stocks randomly or go with an Index

Question 16

Active Investment Strategy Views markets as efficient or not?

Answer 16

They think it’s inefficient

Can get above average return by active investing

Active asset allocation with active security selection