Modern PortfolionTheory Flashcards
What is Beta
Beta is a measure of volatility or sistematic risk of an investment or portfolio in comparison to the market as a whole. You can think of it as a tendency of an investment’s return to respond to swings in the market. By definition, the market has a Beta of 1
Explain Alpha
Alpha is the measure of an investment’s performance on a risk adjusted basis. It takes the volatility of a security and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of it’s benchmark is its “alpha”
What is R-squared?
R-squared is the return that can be explained by the return of the benchmark. A performance between 85 and 100, has a performance record that is closely correlated to the index.
Standard Deviation
Standard deviation measures the dispersion of data from its mean. Measures the volatility of the return of a security. A volatile stock would have a high standard deviation. In a mutual fund, it tells us how much the return of a fund is deviating from the expected returns based on its historical performance.
Sharpe Ratio
Measures the risk adjusted performance. The Sharpe ratio tells investors whether an investments returns are due to smart investing, or a result of excess risk.
CAPM formula:
Capital Asset Pricing Model formula is
Expected Return = Risk Free rt + Beta(Mkt rt - RF rt)
CML formula:
Capital Market Line:
CML=Rf + [(Standard Dev of P)(Rm - Rf) / (Standard Dev of Mkt)]
Expected Return =
Is the weighted average of the expected returns of the component securities.
E(Rp)= W1E(R1) + W2E(R2) + … WnE(Rn)
Efficiency of a portfolio is
The highest return for a given level of risk
What is APT?
Arbitrage Pricing Theory is an alternative to CAPM. APT assumes there are multiple sources of risk and that mean variance optimization may not represent the ideal portfolio for an investor.
E(Rj) = Rfree + Bn1 (Risk Premium1) + Bn2 (Risk Premium2) + …
SML
Security Market Line is the relationship between risk and return for the individual asset = CAPM
Risk is measured in terms of Beta coefficient
Define the Real Rate of Return
Is that rate of return that is above inflation
Real rate = [(1+ Nominal rate / 1+ Inflation rate) -1]*100
Simple interest
I = PrincipalRateTimePeriod(n)
Future Value formula
FV = PV*(1+r)^n
Present Value Formula:
PV = FV / (1+r)^n
What is the rule of 72?
It is a quick estimate of the time it will take for an investment to double.
72 / r = time it will take to double
72 / n = the rate it will take to double
What is the FV of an Annuity Due?
An investor deposits money on a periodic basis at the beginning of each period. The future compounding value is called Future Value of Annuity Due - FVAD.
FVAD = (1+r) [ ((1+r)^n-1)/r)*(initial deposit)
Formula for future value of an ordinary annuity
Ordinary annuity receives its contribution at the end of the period. The formula is:
FVOA = (((1+r)^n)-1) / r) + (initial deposit)
What is the present value of an annuity due?
PVAD = (1+r) [(1-(1/(1+r)^n)*(Initial Deposit) / r]
Formula for Present Value of an Ordinary Annuity:
PVOA = [(1-(1/(1+r)^n) / r) * (init dep)]
The effective rate of interest is:
Effective Rate = ((1+ Periodic Rate)^m) - 1
What is the equity risk premium?
The equity risk premium is the rate above the risk free rate :
Equity Premium = Rm - Rf
What is rhe formula for a taxable equivalent yield?
Taxable equivalent Yield = Tax free yield / (1- tax bracket)
Net Present Value Calculation:
Determines if a project is viable or not. To be viable the NPV must be > 0
The formula is:
NPV = CF0 + CF1/(1+r)^1 + CF2/(1+r)^2 + … CFn/(1+r)^n
What is the importance of an IPS?
An Investment Policy Statement contributes to the
What is the importance of an IPS?
An Investment Policy Statement improves the communication with the client, establishes a dramework for decision making, and sets a disciplined approach to investment management.
Arithmetic mean
Is the sum of the observations divided by the number of observations. Consequently, it ignores the effect of compounding
Geometric mean
The proxess by which money today (PV) grows to a larger amount (FV) over time, is called compounding.
What is UPMIFA
Uniform Management of Institutionl Funds Act. Along with the UMIFA are the core bodies of regulation for Endowments and Charities.
What is one important element of the UPIA?
The Uniform Prudent Investor Act allows for the use of methodologies established by MPT. Performance can be measured on the whole portfolio and not on individual assets, allowing for the use of commodities and futures.
