Portfolio Theory

Question 1

Standard deviation

Answer 1

Measure of risk and variability of returns
Higher the st dev higher the riskiness
Can be used to determine the total risk of an undiversified portfolio

Question 2

Normal distribution, +/- 1, 2, 3 standard deviations from the average

Answer 2

1 st. dev = 68%
2 st. dev = 95%
3 st. dev = 99%

Question 3

Coefficient of variation

Answer 3

Determining which investment has more relative risk when investments have different average returns
Coefficient of variation tells us the probability of actually experiencing a return close to the average return
The higher the coefficient of variation the more risky an investment per unit of return

CV = standard deviation / average return

Question 4

Normal distribution

Answer 4

Appropriate for an investor considering a range of investment returns

Question 5

Lognormal distribution

Answer 5

Not a normal distribution
Appropriate if an investor is considering a dollar amount or portfolio value at a point in time
Looking for a trend line or ending dollar amount

Question 6

Skewness

Answer 6

Skewness refers to a normal distribution curve shifted to the left or right of the mean return
Commodity returns tend to be skewed

Question 7

Kurtosis

Answer 7

Variation of returns
If there is little variation of returns the distribution will have a high peak and positive kurtosis
If returns are widely dispersed the peak of the curve will be low and have a negative kurtosis

Question 8

Leptokurtic distribution

Answer 8

High peak and fat tails (higher chance of extreme events)

Question 9

Platykurtic distribution

Answer 9

Low peak and thin tails (lower chance of extreme events)

Question 10

Mean variance optimization

Answer 10

The process of adding risky securities to a portfolio but keeping the expected return the same
Finding the balance of combining asset classes that provide the lowest variance as measured by standard deviation

Question 11

Covariance

Answer 11

The measure of two securities combined and their interactive risk
How price movements between the two securities are related to each other

Covariance is a measure of relative risk
If the correlation coefficient is known or a given, covariance is calculated as the st deviation of investment A times the st deviation of investment B time the correlation of investment A to B

Question 12

Correlation/correlation coefficient

Answer 12

Measure movement of one security relative to that of another
Covariance and correlation coefficient are both relative measures

Correlation ranges from +1 to -1 and provides the investor with insights as to the strength and direction two assets move relative to each other

A correlation of +1 denotes that two assets are perfectly positively correlated
0 denotes completely uncorelated
-1 denotes perfect negative correlation

Diversification benefits begin anytime correlation is less than 1

The most diversification benefits received when correlation is equal to -1

Question 13

Beta

Answer 13

The beta coefficient is a measure of a securities volatility relative to that of the market
Is best used to measure the volatility of a diversified portfolio
It measures systematic risk

The beta of the market is 1
A stock with a beta of 1 will be expected to mirror the market in terms of direction return and fluctuation
A stock with a beta higher than 1 means the stock fluctuates more than the market
A beta lower than one means the security fluctuates less relative to market movements

Beta is the slope of the line that represents a securities return when plotted relative to market returns

An appropriate level of risk for a diversified portfolio

Question 14

Coefficient of Determination or R-Squared (r^2)

Answer 14

A measure of how much return is due to the market or what percentage of a securities return is due to the market

Calculate r^2 by squaring the correlation coefficient

The higher it is, the higher percentage of return is from the market (systematic risk) and less from unsystematic risk - which means it’s more diversified

If r^2 is greater than or equal to .70, then Beta is an appropriate measure of total risk.

Question 15

Modern portfolio theory

Answer 15

The acceptance by an investor of a given level of risk while maximizing expected return objectives

Question 16

Efficient frontier

Answer 16

The curve that illustrates the best possible returns that could be expected from all possible portfolios

Question 17

Indifference curves

Answer 17

Constructed using selections made based on this highest level of return given an acceptable level of risk

Question 18

Efficient portfolio

Answer 18

Occurs when an investor’s indifference curve is tangent to the efficient frontier

Question 19

Optimal portfolio

Answer 19

The one selected from all efficient portfolios

The assumption is made that investors are risk adverse

Question 20

Information ratio

Answer 20

A relative risk adjusted performance measure
Measures the excess return and the consistency provided by a fund manager relative to a benchmark
The higher the excess return (or information ratio) the better

Tracking error of active reruns = st dev of the difference between portfolio returns and index returns

Question 21

Treynor index

Answer 21

A measure of how much return was achieved for each unit of (systematic) risk

Question 22

Variability is measured by

Answer 22

Deviation (how far a return varies from what is expected as in the mean average)

Question 23

Volatility is measured by

Answer 23

Beta (relative relationship between a benchmark and a return of some investment relative to that market)

Question 24

NPV

Answer 24

NPV = PV of cash flows - initial cost

Used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period

Question 25

Efficient market hypothesis (EMH)

Answer 25

Investors cannot consistently achieve above-average market returns
Prices reflect all information that is available and change very quickly to new information
Stock prices will follow a “random walk”
Investors who believe in the efficient market hypothesis believe in a passive investment strategy