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CFP Exam > Portfolio Theory > Flashcards

Portfolio Theory Flashcards

1
Q

standard deviation - definition

A

a measure of risk and variability of returns

measures how something flip-flops around an average

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2
Q

what is the area under the normal distribution curve between 1 standard deviation?

A

68%

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3
Q

what is the area under the normal distribution curve between 2 standard deviations?

A

95%

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4
Q

what is the area under the normal distribution curve between 3 standard deviations?

A

99%

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5
Q

coefficient of variation - definition

A

useful in determining which investment has more relative risk when investments have different average returns

tells us the probability of actually experiencing a return close to the average

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6
Q

coefficient of variation - formula

A

CV = standard deviation / average return

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7
Q

skewness - definition

A

refers to a normal distribution curve shifted to the left or right of the mean return

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8
Q

the peak of the bell curve is shifted to the left or right when there is positive skewness?

A

left

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9
Q

the peak of the bell curve is shifted to the left or right when there is negative skewness?

A

right

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10
Q

kurtosis - definition

A

refers to the variation of returns

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11
Q

leptokurtic - definition

A

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

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12
Q

platykurtic - definition

A

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

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13
Q

mean variance optimization

A

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

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14
Q

Monte Carlo simulation

A

a spreadsheet simulation that gives a probabilistic distribution of events occurring

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15
Q

covariance - definition

A

the measure of two securities combined and their interactive risk

how price movements between two securities are related to each other

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16
Q

correlation coefficient - definition

A

measures the movement of one security relative to that of another

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17
Q

what is the range of the correlation coefficient?

A

+1 to -1

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18
Q

what does a correlation coefficient of +1 mean?

A

the two assets are perfectly positively correlated

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19
Q

what does a correlation coefficient of 0 mean?

A

the assets are completely uncorrelated

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20
Q

what does a correlation coefficient of -1 mean?

A

the two assets are perfectly negatively correlated

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21
Q

diversification benefits begin anytime correlation is … ?

A

less than 1

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22
Q

beta - definition

A

measure of an individual security’s volatility relative to that of the market

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23
Q

when is it best to use beta?

A

for a diversified portfolio

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24
Q

what is the beta of the market?

A

1

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25
Q

what does it mean when a stock has a beta of 1?

A

the stock will be expected to mirror the market in terms of direction, return, and fluctuation

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26
Q

what does it mean when a stock has a beta greater than 1?

A

the stock fluctuates more than the market, and greater risk is associated with that particular security

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27
Q

what does it mean when a stock has a beta lower than 1?

A

the stock fluctuates less than the market

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28
Q

the higher the beta, the … the systematic risk associated with that particular stock?

A

the higher the systematic risk

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29
Q

R-squared - definition

A

a measure of how much return is due to the market or what percentage of a security’s return is due to the market

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30
Q

how to calculate R-squared?

A

square the correlation coefficient

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31
Q

what must R-squared be to indicate if you should use beta as the measure of risk?

A

R-squared must be greater than or equal to 0.7 to indicate you should use beta

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32
Q

what must R-squared be to indicate if you should use standard deviation as the measure of risk?

A

R-squared must be lower than 0.7 to indicate you should use standard deviation

33
Q

systematic risk - definition

A

the lowest level of risk one could take in a fully diversified portfolio

inherent in the system as a result of the unknown element existing in securities that have no guarantee

34
Q

unsystematic risk - definition

A

the risk that exists in a specific firm or investment that can be eliminated through diversification

35
Q

what type of risk is nondiversifiable?

A

systematic risk

36
Q

what type of risk is diversifiable?

A

unsystematic risk

37
Q

what are the types of systematic risk?

A
  • purchasing power risk
  • reinvestment rate risk
  • interest rate risk
  • market risk
  • exchange rate risk
38
Q

what is the acronym used to remember the types of systematic risk?

A

PRIME

39
Q

purchasing power risk - definition

A

the risk that inflation will erode the amount of goods and services that can be purchased, and the risk that a dollar today cannot purchase the same amount of goods and services tomorrow or the day after

40
Q

reinvestment rate risk - definition

A

the risk that an investor will not be able to reinvest at the same rate of return that is currently being received

41
Q

interest rate risk - definition

A

the risk that changes in interest rates will impact the price of both equities and bonds

42
Q

market risk - definition

A

impacts all securities in the short term because the short term ups and downs of the market tend to take all securities in the same direction

43
Q

exchange rate risk - definition

A

the risk that a change in exchange rates will impact the price of international securities

44
Q

what are the types of unsystematic risks?

A
  • accounting risk
  • business risk
  • country risk
  • default risk
  • executive risk
  • financial risk
  • government risk
45
Q

what is the acronym used to remember the types of unsystematic risk?

A

ABCDEFG

46
Q

accounting risk - definition

A

the risk associated with an audit firm being closely tied to the management of a company

47
Q

business risk - definition

A

the inherent risk a company faces by operating in a particular industry

48
Q

country risk - definition

A

the risk a company faced by doing business in a particular country

49
Q

default risk - definition

A

the risk of a company defaulting on their debt payments

50
Q

executive risk - definition

A

the risk associated with the moral and ethical character of the management running the company

51
Q

financial risk - definition

A

the amount of financial leverage deployed by the firm

52
Q

government risk - definition

A

the risk that tariffs or restrictions may be placed on an industry or firm that may impact the firm’s ability to effectively compete in an industry

53
Q

modern portfolio theory

A

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

54
Q

efficient frontier

A

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

55
Q

efficient portfolio

A

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

56
Q

indifference curve

A

constructed using selections made based on the highest level of return given an acceptable level of risk

57
Q

what is the term to describe portfolios that lie beneath the efficient frontier?

A

inefficient

58
Q

what is the term to describe portfolios that lie above the efficient frontier?

A

unattainable

59
Q

what does CML stand for?

A

Capital Market Line

60
Q

what is the CML?

A

specifies the relationship between risk and return in all possible portfolios

61
Q

what is on the x-axis for the CML?

A

standard deviation

62
Q

where does the CML and the SML intersect the y-axis?

A

at the risk-free rate of return

63
Q

what does CAPM stand for?

A

Capital Asset Pricing Model

64
Q

what is the CAPM?

A

calculates the relationship of risk and return of an individual security using the beta as its measure for risk

65
Q

what is on the x-axis for the SML?

A

beta

66
Q

what does SML stand for?

A

Security Market Line

67
Q

what is the market risk premium?

A

return of the market less the return of the risk-free rate

68
Q

CML vs SML

A

CML uses standard deviation

SML uses beta

69
Q

Information Ratio

A

measures the excess return and the consistency provided by a fund manager, relative to a benchmark

70
Q

Treynor Index

A

a measure of how much return was achieved for each unit of risk

uses beta

71
Q

Sharpe Ratio

A

a measure of how much return was achieved for each unit of risk

uses standard deviation

72
Q

when a portfolio is deemed to be well diversified, should you use the Treynor Index or the Sharpe Ratio?

A

Treynor Index

73
Q

when a portfolio is deemed to be non-diversified, should you use the Treynor Index or the Sharpe Ratio?

A

Sharpe Ratio

74
Q

Jensen’s Alpha

A

capable of distinguishing a manager’s performance relative to that of the market

75
Q

what does a positive alpha mean?

A

the fund manager provided more return than was expected for the risk undertaken

76
Q

what does a negative alpha mean?

A

the fund manager provided less return than was expected for the risk that was undertaken

77
Q

what does a zero alpha mean?

A

the fund manager provided a return equal to the return that was expected for the risk that was undertaken

78
Q

if the R-squared is greater than or equal to 0.7, what should you use?

(Treynor, Sharpe, Alpha, Standard Deviation, Beta)

A

Treynor, Alpha, Beta

79
Q

if the R-squared is less than 0.7, what should you use?

Treynor, Sharpe, Alpha, Standard Deviation, Beta

A

Sharpe, standard deviation

CFP Exam (24 decks)

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