Portfolio Theories and Models Flashcards by Josh Johnsrud

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

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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

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Mean variance optimization developed by

Harry Markowitz

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MVO defined

quantitative model designed to select securities for inclusion in an optimal portfolio that maximizes return for a stated level of risk

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Necessary inputs for MVO

Securities expected returns
Expect risk (SDEV)
expected cross security correlations

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MVO portfolio optimization includes

maximize return and minimize risk

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Portfolios on the mean variance efficient frontier are found by

searching for the portfolio with the least variance given some minimum return

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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

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Efficient frontier demonstrates what

Best use of investment capital “IF” optimizing for risk-adjusted return is the objective

more effective diversification

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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

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Capital asset line also commonly called

capital allocation line

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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

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Black - Litterman Model combines

CAPM, MPT and MVO

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Black Litterman Model allows what

flexibility to change data and add more data points

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Efficeint market hypothesis says what about stock prices

already reflected all available information

Follow a random walk

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Weak Form claims that

past price movements and volume do not impact prices

Technical analysis is not beneficial, fundamental analysis can add value

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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

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Strong Form Claims that

All public and private information is reflected in a stock’s current price

not even insider information can add value

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Implications of EMH

Technical analysis - using prices and volume information to predict future prices

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Magnitude issue

only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort

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Selection bias issue

only unsuccessful investment schemes are made public; good schemes remain private

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Semi Strong Tests : Anomalies

PE Effect

Small Firm Effect

Neglected Firm Effect

Book-to-market ratios

Post earning announcements

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CAPM explains what

the relationship between risk and expected return

investors should be compensated for both the time value of money and risk taken

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CAPM formula

Risk free rate + Market risk premium times the beta of the asset

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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