Part 6. Portfolio Risk and Return: Part 2 Flashcards
Market risk premium
The difference between the expected return on the market and the risk free rate.
Active portfolio management
- This differentiates from passive investment strategy that utilises a market index for the optimal risky asset portfolio.
- Those who believe market prices are informationally efficient, follow a passive investment strategy.
- Many investors and portfolio managers believe their estimates of security values are correct and market prices are incorrect.
- Investors will not used the weights of the market portfolio, but will invest more than market weights in securities that they believe are undervalued, and less than market weights in securities believed to be overvalued.
Unsystematic risk
- The risk that is eliminated by diversification.
- When investor diversifies across assets not perfectly correlated, portfolios risk is less than weighted average of risks of individual securities in portfolio.
Systematic risk
- The risk that remain cannot be diversified away.
- Since market portfolio contains all risky assets, it must be well-diversified portfolio, all risk that can be diversified away has been.
e.g. luxury manufacturers such as Ferrari, as highly responsive to market changes, but utility companies respond very little to changes in systematic risk factors.
Capital market theory
- The conclusion of theory is equilibrium security returns depend on stocks or portfolios systematic risk, not total risk measured by standard deviation.
- Assumption of model is it is diversification free, where investors will not be compensated for bearing risk that can be eliminated at no cost.
- Conclusions implications are important to asset pricing (expected returns), where riskiest stock is measured as standard deviation of returns, not necessarily have greatest expected return.
- the equilibrium return on high unsystematic risk stock may be less than of stock with much less firm-specific risk, but more sensitivity to factors that drive return of overall market.
- unsystematic risk is not compensated in equilibrium as it can be eliminated for free through diversification.
- systematic risk is measured by contribution of security to risk of well-diversified portfolio, and expected equilibrium return on individual security will depend only on its systematic risk.
Return generating models
These are used to estimate the expected returns on risky securities based on specific factors.
For each security, we must estimate sensitivity of its returns to each specific factor, where factors that explain security returns can be classified as macroeconomic, fundamental, and statistical factors.
Multi factor models
- These most commonly use macroeconomic factors such as GDP growth, inflation or consumer confidence, along with fundamental factors, such as earnings, earnings growth, firm size, and research expenditures.
Multi factor models
- These most commonly use macroeconomic factors such as GDP growth, inflation or consumer confidence, along with fundamental factors, such as earnings, earnings growth, firm size, and research expenditures.
Single index model
The expected excess return (return above risk free rate) is the product of factor weight/sensitivity, beta i, and the risk factor which in this model is the excess return on market portfolio/index.
Market model (simplified form of single-indexed model)
This is used to estimate a security’s (or portfolio’s) beta, and to estimated a security’s abnormal return (return above expected return) based on actual market return.
Beta
The sensitivity of an assets return on market index in context of market model.
Assumptions of CAPM:
- Risk aversion - to accept greater degree of risk, investors require a higher expected return.
- Utility maximising investors - investors choose portfolio based on individual preferences, with risk and return combination that maximises their expected utility.
- Frictionless markets - there are no taxes, transaction costs or other impediments of trading.
- One-period horizon - all investors have same one-period time horizon.
- Homogenous expectations - all investors have same expectations for assets expected returns, standard deviation of returns, and returns correlations between assets.
- Divisible assets - all investments are infinitely divisible.
- Competitive markets - investors take market price as given and no investor can influence prices with their trades.
Performance evaluation
Of active managers portfolio choices refers to the analysis of risk and return on portfolio.
Attribution analysis
An analysis of source of returns difference between active portfolio returns and those of passive benchmark portfolio, is a part of performance evaluation.
Success in active portfolio management:
- Cannot be determined simply by comparing portfolio returns on benchmark portfolio returns, the risk taken to achieve returns must also be considered.
- Portfolio with greater risk than benchmark portfolio (especially beta risk) is expected to produce higher returns over time than benchmark portfolio.
Sharpe ratio
The excess returns per unit of total portfolio risk, where higher ratios indicate better risk-adjusted portfolio performance.
Based on total risk (standard deviation of returns), than systematic risk (beta); so can be used to evaluate performance of concentrated portfolios (affected by unsystematic risk) as well as diversified portfolios (with only systematic, or beta risk)
