Portfolio Management (5%)

Question 1

Portfolio Variance

Answer 1

Σw(x - µ)^{<span>2</span>}

Question 2

Portfolio Duration

Answer 2

Σ(w*Dur)

(Weights based on market value)

Question 3

Variance of a

2 Asset Portfolio

Answer 3

w_A²σ_A² + w_B²σ_{<span>B</span>}² + 2w_{<span>A</span>}w_{<span>B</span>}Covariance

Question 4

Covariance

Answer 4

Σ[(x_A - µ_A)(x_B - µ_B)] / (n - 1)

or

ΣP(E)(x_A - µ_A)(x_B - µ_B)

or

Correlation * σ_A * σ_B

Question 5

Correlation

Answer 5

Covariance

———————

σ_A * σ_B

Measures the strength of the linear relationship between two random variables.

• correlation -1, move oppposite,
• correlation 1, move together.
• 0 no correlation.

Question 6

Name investment constraints.

Answer 6

• RRTTLLU
• risk, return, time horizon, tax situation, liquidity, legal restrictions, and unique constraints of specific investors.

Question 7

CAPM?

Answer 7

• Capital asset pricing model
• k_{ce = RFR +}ß{E(R_m) - RFR}
• kce = cost of equity capital
  *

Question 8

What is the dividend discount model approach to determining equity cost of capital?

Answer 8

• If dividends expected to grow at constant rate g then….
• P₀= D₁/(k_ce- g)
• d1 = next year dividend
• g = firm expected growth rate

Question 9

What is the SML?

Answer 9

• Security market line.
• graph of relationship between covariance and return of market.
• Equation is:
• E(R_i) = RFR +(COV_i,mkt/σ²_mkt){E(R_mkt) - RFR
• remember ß = (COVi,mkt/σ2mkt)
• so x axis is ß, y is E(R)
• risk/return tradeoff for individual securities or port.

Question 10

What is the CML?

What is the CAL?

Answer 10

• Capital market line - optimal CAL.
• Capital allocation line - line of possible port risk and return combo given RFR and risk of return of port of risky assets
  
  • best CAL = one that gives best preferred port in returms of risk and return.
• CML eqn:
• E(R_p) = R_f+ (E(R_m) - R_f) (σ_p/σ_m)
• describes risk/return tradeoff of various combo of mkt port and a riskless asset

Question 11

What is an indifference curve? What is it used for? Explain the meaning of having a flat vs. steep curve.

Answer 11

• Plots relationship btwn risk (σ) and E(R).
• It’s like a curve supply line.
• Steeper is for more risk averse b/c they need more return for less units or risk.

Question 12

Strategic Asset Allocation

Answer 12

Assets in the same asset class have high paired correlations and low correlations with assets in other asset classes.

Question 13

Portfolio Management Process

Answer 13

Execution

• Asset Allocation
• Security Analysis
• Portfolio Construction

Feedback

• Performance Measurement

Question 14

Portfolio Alpha

Answer 14

r_p - ß[E(r_mkt) - r_rf] + r_rf

or

Portfolio Return - k_ce (CAPM)