Portfolio Management I

Question 1

Covariance formula

Answer 1

Sum[(Xr - Xbar)*(Yr-Ybar)] / N-1

Question 2

Capital allocation line

Answer 2

(1) Combining risk free asset with risky asset
(2) Correlation is 0, volatility is reduced
(3) Line runs from risk free asset to optimal portfolio

Question 3

Capital allocation line optimal portfolio

Answer 3

Where indifference curve and capital allocation line meets

Question 4

CAPM assumption expectations

Answer 4

Investors have homogenous expectations, meaning same estimates of risk, return and correlations.

Question 5

CAPM Market Line Formula

Answer 5

E(Rp) = RFR + (E(Rm) - RFR) * (stdev portfolio / stdev market)

Question 6

CAPM Theory

Answer 6

Security returns depend on SYSTEMATIC risk, because diversification is free so no benefit from unsystematic risk

Question 7

Beta definition

Answer 7

Sensitivity of asset return to the market

Question 8

Beta formula

Answer 8

COVAR(asset return, market return) / Var(market return)

Question 9

Security Market Line (SML) formula

Answer 9

SML = E(Ri) = RFR + Beta * [E(Rmkt) - RFR)]

Question 10

Security Market Line meaning

Answer 10

Expected return is risk free rate + beta adjusted market premium.

Question 11

CAPM and discount rates

Answer 11

Can use the CAPM / SML rate to get the discount rate for a project given its beta

Question 12

Security Market Line (buy/sell)

Answer 12

All correctly priced assets should be on the SML. If expected > required, buy. Etc.

Question 13

Jensen’s Alpha

Answer 13

(1) % return in excess from portfolio with same beta but on the SML
(2) (return of portfolio - RFR) - Beta*(Return on market - RFR)

Question 14

Investment Constraints (RRTTLLU)

Answer 14

Risk, Return, Time Horizon, Taxes, Liquidity, Legal Restrictions and Unique Characteristics

Question 15

Dealers / Brokers

Answer 15

Dealers facilitate trades through their own inventory

Brokers act as agent

Question 16

Leverage Ratio

Answer 16

value of asset / value of equity position

Question 17

Maintenance Margin

Answer 17

Typically 25% of position

Question 18

Margin call price formula

Answer 18

Initial purchase price * [(1-initial margin) / (1-maintenance margin)]

Question 19

Underwritten offer

Answer 19

Bank agrees to purchase entire issue at negotiated price

Question 20

Best efforts

Answer 20

Bank is not obligated to buy remaining shares.

Question 21

Shelf registration

Answer 21

Firm makes public disclosures as in regular offering, but sells over time as needed

Question 22

Price weighted indices

Answer 22

(1) Higher priced stocks have a greater weight

Question 23

Equal-weighted indices

Answer 23

(1) each security has the same weighting

(2) transaction costs from rebalancing can be high

Question 24

Market capitalization weighted indices

Answer 24

(1) more accurately reflect changes in investor wealth

(2) Do not need to be adjusted for splits or stock dividends

Question 25

Fundamental weighted indices

Answer 25

(1) avoids overvalue bias present in other indices

(2) will naturally have a value bias

Question 26

Weak form market efficiency

Answer 26

(1) Prices fully reflect all available data.
(2) Based data has no predictive power
(3) Technical analysis doesn’t work

Question 27

Semi-strong form market efficiency

Answer 27

(1) Prices rapidly adjust without bias.
(2) Prices fully reflect all publicly available info
(3) Fundamental analysis does not work

Question 28

Strong form

Answer 28

(1) Prices fully reflect all information (public and private)
(2) No one can beat the market

Question 29

Loss aversion

Answer 29

More risk averse when faced with losses than gains

Question 30

Representativeness

Answer 30

Assuming a good company is a good investment

Question 31

Gambler’s fallacy

Answer 31

Recent results affect estimates of future outcomes

Question 32

Conservatism

Answer 32

Reacting slow to changes

Question 33

Disposition effect

Answer 33

Willing to realize gains but not losses