PM: Risk and Return I Flashcards
Measures from quant:
holding period return
arithmetic/geometric mean return
money weighted rate of return
note for money weighted rate of return we have to use the smallest inflow/outflow period.
Gross vs Net Return =
pre tax/after tax nominal Return =
net is after fees are deducted
pretax nominal return is prior to paying taxes.
Real & Leveraged return =
real is the increase in purchasing power.
Leveraged return: gain/loss on the investment as a percentage of an investor’s cash investment.
(sample) Variance/SD of individual security return =
if we are calculating population variance, we use T instead of T-1.
Covariance of two securities’ returns =
FROM QUANT
Covariance is an absolute measure and is measured in return units squared.
Correlation of two securities’ returns =
FROM QUANT
standardized measure of co movement –> correlation coefficient
RISK/RETURN of asset classes =
returns vary greatly - less so for real returns.
evaluating investments using expected return and variance of returns is a simplification
- returns are not normally distributed
- distribution is negatively skewed
- has positive kurtosis (leptokurtic, >3)
Liquidity is another consideration when choosing investments - can affect price/expected return, particularly for EM or low quality securities.
Risk aversion, risk seeking, risk neutral =
based on two investments with equal expected returns:
risk averse will choose the least risky.
risk averse investors may select a very risky portfolio if they feel the compensation is adequate.
Portfolio Variance/SD =
FROM QUANT
Portfolio variance: correlation =
when returns are perfectly correlated the SD is a weighted average of the standard deviations of the individual asset return.
Risk is greatest when correlation between assets is +1.
When corr is <1, portfolio variance is reduced
Variance is further reduced when correlation is 0, and then when correlation is negative.
Minimum variance and efficient frontiers =
for a given expected return we can adjust the portfolio weights to create the portfolio of least risk (making up the MINIMUM VARIANCE PORTFOLIOS)
these make up the MINIMUM VARIANCE FRONTIER
assuming risk aversion/desire for greatest return at a given level of risk, investors should choose from portfolios on the EFFICIENT FRONTIER - providing the greatest return for a given risk level
The portfolio with the least risk on the efficient frontier is the GLOBAL MINIMUM VARIANCE PORTFOLIO
INDIFFERENCE CURVES =
same as econ, investors are indifferent to the combinations of risk and return on one indifference curve
we’re assuming that E(r) and SD are the only factors for consideration
INDIFFERENCE CURVES SLOPE UP FOR RISK AVERSE INVESTORS
A MORE RISK AVERSE INVESTOR WILL HAVE A STEEPER INDIFFERENCE CURVE - MORE RETURN PER UNIT OF RISK
Introduction of RISK FREE ASSETS =
We can introduce a risk free asset into consideration.
the portfolio variance/sd eqn is reduced, given the risk free asset has zero sd and no correlation to risky assets
Two fund separation theorem and the capital allocation line =
TWO FUND SEPARATION THEOREM states all investors’ optimum portfolios will consist of a combination of risky and risk free assets.
these combinations are represented along the CAPITAL ALLOCATION LINE, where risk and return are positively related
intersection of the CAPITAL ALLOCATION LINE and INDIFFERENCE CURVES =
Investors will choose the point on the capital allocation line that intersects with the curve of greatest utility
Comparing indifference curves of investors with different risk appetites =
INVESTORS WHO ARE LESS RISK AVERSE WILL CHOOSE MORE RISKY PORTFOLIOS, and will have FLATTER INDIFFERENCE CURVES
this will result in points of intersection (OPTIMAL PORTFOLIOS) that are further out on the capital allocation line - less invested in risk free assets and more in risky assets.
