Portfolio Theories and Models Flashcards
Key MPT Assumptions
Normal distributions
Fixed correlations
Rational investors and risk averse
Risk is known and constant
All info is public
No taxes or transactions costs
Market risk premium defined
the risk premium on the market portfolio will be proportional to its risk and the degree of risk aversion of the investor
Mean variance optimization developed by
Harry Markowitz
MVO defined
quantitative model designed to select securities for inclusion in an optimal portfolio that maximizes return for a stated level of risk
Necessary inputs for MVO
Securities expected returns
Expect risk (SDEV)
expected cross security correlations
MVO portfolio optimization includes
maximize return and minimize risk
Portfolios on the mean variance efficient frontier are found by
searching for the portfolio with the least variance given some minimum return
Efficient Frontier defined
a set of optimal portfolios with the highest expected return for a set or defined amount of risk as measured by SDEV
Efficient frontier demonstrates what
Best use of investment capital “IF” optimizing for risk-adjusted return is the objective
more effective diversification
Capital asset line defined
line represents all possible combination of risk free and risk assets; represents possible returns by taking on different levels of risk
Capital asset line also commonly called
capital allocation line
Brinson Beebower and Hood
Asset allocation is the primary determinant of a portfolio’s return variability
Securities selection and market timing played only a minor role in portfolio performance
Black - Litterman Model combines
CAPM, MPT and MVO
Black Litterman Model allows what
flexibility to change data and add more data points
Efficeint market hypothesis says what about stock prices
already reflected all available information
Follow a random walk
Weak Form claims that
past price movements and volume do not impact prices
Technical analysis is not beneficial, fundamental analysis can add value
Semi Strong Form claims that
all public information is reflected in a stock’s current price
states that neither technical nor fundamental analysis can add value
Strong Form Claims that
All public and private information is reflected in a stock’s current price
not even insider information can add value
Implications of EMH
Technical analysis - using prices and volume information to predict future prices
Magnitude issue
only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort
Selection bias issue
only unsuccessful investment schemes are made public; good schemes remain private
Semi Strong Tests : Anomalies
PE Effect
Small Firm Effect
Neglected Firm Effect
Book-to-market ratios
Post earning announcements
CAPM explains what
the relationship between risk and expected return
investors should be compensated for both the time value of money and risk taken
CAPM formula
Risk free rate + Market risk premium times the beta of the asset
Security market line is a graphical expression of what
CAPM
The slope of the SML represents what
the market risk premium
SML is measured by what
BETA
Arbitrage Pricing Theory
seeks to explain security returns beyond the usual metrics by introducing risk factors such as expected return, sector and systematic factors
APT assumptions
does not require an expected market return
Arbitrage occurs if there is what
zero investment portfolio with a sure profit
APT applies well to
well-diversified portfolios not necessarily individual stocks
Fama French Three Factor Model
Small minus big
High minus low book-to-market ratios (Value style)
Risk premium
Semi Variance measures
dispersion of data that is below the mean or target value of a data set
Semi Variance defined
is the average of the all squared deviations of values less than the average or mean
VAR defined
measure of risk that quantifies potential loss, the probability of the potential loss and the time frame for the potential loss
VAR assumes what
market to market pricing, no trading and normal market conditions
VAR is most frequently associated with
extreme negative returns
Expected Shortfall (ES)
More conservative measure of downside risk than VAR
VAR takes
the highest return from the worst cases
ES takes
the average return return from the worst cases
Kurtosis defined
measures the peakedness of a probability distribution or normal distribution curve
Positive Kurtosis
Leptokurtic
Leptokurtis shows
more slender distribution, higher peak that is concentrated more around the mean and may have fatter tails
Low Kurtosis
Platykurtic
Platykurtis shows
thinner tails and distribution that is less concentrated around the mean, thus a flatter peak
What is the equation of Capital Allocation Line with the below assumptions:
T Bill rate of 3.6%
SDEV of portfolio 7.2%
Expected return of portfolio 12%
12%-3.6%/7.2% = 1.167
If one estimates expected single period returns and standard deviations of available securities, as well as the correlations among them, then one can what
calculate SDEV and the expected returns of any portfolio consisting of those securities
The capital allocation tangency point represents the
optimal portfolio
Optimal portfolio is found at the what
point of tangency
A portfolio with a one day 7% VAR of $2MM mean what
has a .07 probability of dropping $2MM in one day
Figure that is the maximum real loss that can occur and the probability of that loss is what
VAR
According to MPT, investors will take on increased risk when
If compensated with higher returns
In MPT, investors are what type of risk
risk averse , so they will need more return to take more risk
Using the efficient frontier line to contstruct portfolios requires belief in what
strong form of EMH
CAPM subscribes to what type of EMH
Strong form
According to Harry Markowitz, to reduce risk in a portfolio, portfolios should have only
systematic risk
Systematic risk is the only relevant risk in what
MPT
The two factor models use in MPT are widely considered to be what
Too simple
Data that are skewed to the right will have a mean and median that are
greater than the mode
Which form of EMH rejects inside information
strong form
What can flucuate in MPT
Returns
What comparative tool is primarily used in conjunction with MPT
SML
The bais of black-litterman model is a combination of what
CAPM and MVO
The efficient frontier line is a set of portfolio that represents what
highest expected return for a given level of risk
In the financial industry, VaR is commonly used by regulators to what
guage the assets needed to cover a loss
In the context of MPT, during a market downturn, investors will what
rebalance or maintain their balances
Arbitrage pricing theory is considered to be not only a multi factor model but also a supply-side model primarily because why
Its beta coefficients reflect sensitivity to economic factors
SML is most associated with
systemic or market risk
Skewness, while common, allow investors to estimate what
A future data point in relation to the mean. Distributions are used as predictive measures.
MPT is a how many factor model
two
Harry Markowitz and William Sharpe define risk as what
volatility
The CAPM is based on what form of risk
volatility
The goal of MVO is to what
Maximize return for selected levels of risk
One way of avoid purchasing power risk as it relates to systematic risk is to
buy TIPS
Semi Strong EMH proponents believe what
Inefficiencies in the market prices; inside information
What are the two core components of MPT
Volatility and return
Investors wishing to capture current economic data in models should use what
APT
According to MPT and the role of correlation in the theory, investors should select portfolios that what
have low correlations; not necessarily -1
The sortino ratio is thought to be better ratio than sharpe for what reason
Investors are comfortable with upside risk
A leptokurtic distribution usually indicates what
large fluctuations occurring in the distribution tails
The optimal portfolio has what type of assets
risky and risk free
The underlying theme of factor investing is that
Anomalies exist even in efficient markets
Single factor models require
that investors time their investments
Failure swings can indicate what
reversal
As momentum slows, the price of the security is a
signal of mean reversion
The goal of incorporating technical analysis in dynamic asset allocation is to
add positions that are outpacing the market
In institutional management, dynamic asset allocation returns usually are linked to
floating rate
Dynamic asset allocation can utilize the principles of both
rebalancing and sector rotation
The Sortino ratio is thought to be a better ratio than the Sharpe ratio because
investors are comfortable with upside risk
Extrapolating patterns based on small historical data can be an example of an investor exhibiting which type of bias
Recency
When gauging the expected returns of securities at given levels of risk, the capital asset pricing model may be used in concert with
APT
Which investor type would need to be challenged to be introspective in their investment decisions?
Followers
When individuals are predisposed to making a particular decision in advance of reviewing evidence, this may be due to their:
selective decision making
The capital asset pricing model (CAPM) attempts to explain the relationship between expected return and risk of an asset. An asset above the security market line (SML) can be considered to be:
undervalued
Home country bias can lead investors to:
miscalculate risk and return in the capital markets
