Portfolio Theory Flashcards
standard deviation - definition
a measure of risk and variability of returns
measures how something flip-flops around an average
what is the area under the normal distribution curve between 1 standard deviation?
68%
what is the area under the normal distribution curve between 2 standard deviations?
95%
what is the area under the normal distribution curve between 3 standard deviations?
99%
coefficient of variation - definition
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
coefficient of variation - formula
CV = standard deviation / average return
skewness - definition
refers to a normal distribution curve shifted to the left or right of the mean return
the peak of the bell curve is shifted to the left or right when there is positive skewness?
left
the peak of the bell curve is shifted to the left or right when there is negative skewness?
right
kurtosis - definition
refers to the variation of returns
leptokurtic - definition
high peak and fat tails (higher chance of extreme events)
platykurtic - definition
low peak and thin tails (lower chance of extreme events)
mean variance optimization
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
Monte Carlo simulation
a spreadsheet simulation that gives a probabilistic distribution of events occurring
covariance - definition
the measure of two securities combined and their interactive risk
how price movements between two securities are related to each other
correlation coefficient - definition
measures the movement of one security relative to that of another
what is the range of the correlation coefficient?
+1 to -1
what does a correlation coefficient of +1 mean?
the two assets are perfectly positively correlated
what does a correlation coefficient of 0 mean?
the assets are completely uncorrelated
what does a correlation coefficient of -1 mean?
the two assets are perfectly negatively correlated
diversification benefits begin anytime correlation is … ?
less than 1
beta - definition
measure of an individual security’s volatility relative to that of the market
when is it best to use beta?
for a diversified portfolio
what is the beta of the market?
1
what does it mean when a stock has a beta of 1?
the stock will be expected to mirror the market in terms of direction, return, and fluctuation
what does it mean when a stock has a beta greater than 1?
the stock fluctuates more than the market, and greater risk is associated with that particular security
what does it mean when a stock has a beta lower than 1?
the stock fluctuates less than the market
the higher the beta, the … the systematic risk associated with that particular stock?
the higher the systematic risk
R-squared - definition
a measure of how much return is due to the market or what percentage of a security’s return is due to the market
how to calculate R-squared?
square the correlation coefficient
what must R-squared be to indicate if you should use beta as the measure of risk?
R-squared must be greater than or equal to 0.7 to indicate you should use beta
what must R-squared be to indicate if you should use standard deviation as the measure of risk?
R-squared must be lower than 0.7 to indicate you should use standard deviation
systematic risk - definition
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
unsystematic risk - definition
the risk that exists in a specific firm or investment that can be eliminated through diversification
what type of risk is nondiversifiable?
systematic risk
what type of risk is diversifiable?
unsystematic risk
what are the types of systematic risk?
- purchasing power risk
- reinvestment rate risk
- interest rate risk
- market risk
- exchange rate risk
what is the acronym used to remember the types of systematic risk?
PRIME
purchasing power risk - definition
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
reinvestment rate risk - definition
the risk that an investor will not be able to reinvest at the same rate of return that is currently being received
interest rate risk - definition
the risk that changes in interest rates will impact the price of both equities and bonds
market risk - definition
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
exchange rate risk - definition
the risk that a change in exchange rates will impact the price of international securities
what are the types of unsystematic risks?
- accounting risk
- business risk
- country risk
- default risk
- executive risk
- financial risk
- government risk
what is the acronym used to remember the types of unsystematic risk?
ABCDEFG
accounting risk - definition
the risk associated with an audit firm being closely tied to the management of a company
business risk - definition
the inherent risk a company faces by operating in a particular industry
country risk - definition
the risk a company faced by doing business in a particular country
default risk - definition
the risk of a company defaulting on their debt payments
executive risk - definition
the risk associated with the moral and ethical character of the management running the company
financial risk - definition
the amount of financial leverage deployed by the firm
government risk - definition
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
modern portfolio theory
the acceptance by an investor of a given level of risk while maximizing expected return objectives
efficient frontier
the curve which illustrates the best possible returns that could be expected from all possible portfolios
efficient portfolio
occurs when an investor’s indifference curve is tangent to the efficient frontier
indifference curve
constructed using selections made based on the highest level of return given an acceptable level of risk
what is the term to describe portfolios that lie beneath the efficient frontier?
inefficient
what is the term to describe portfolios that lie above the efficient frontier?
unattainable
what does CML stand for?
Capital Market Line
what is the CML?
specifies the relationship between risk and return in all possible portfolios
what is on the x-axis for the CML?
standard deviation
where does the CML and the SML intersect the y-axis?
at the risk-free rate of return
what does CAPM stand for?
Capital Asset Pricing Model
what is the CAPM?
calculates the relationship of risk and return of an individual security using the beta as its measure for risk
what is on the x-axis for the SML?
beta
what does SML stand for?
Security Market Line
what is the market risk premium?
return of the market less the return of the risk-free rate
CML vs SML
CML uses standard deviation
SML uses beta
Information Ratio
measures the excess return and the consistency provided by a fund manager, relative to a benchmark
Treynor Index
a measure of how much return was achieved for each unit of risk
uses beta
Sharpe Ratio
a measure of how much return was achieved for each unit of risk
uses standard deviation
when a portfolio is deemed to be well diversified, should you use the Treynor Index or the Sharpe Ratio?
Treynor Index
when a portfolio is deemed to be non-diversified, should you use the Treynor Index or the Sharpe Ratio?
Sharpe Ratio
Jensen’s Alpha
capable of distinguishing a manager’s performance relative to that of the market
what does a positive alpha mean?
the fund manager provided more return than was expected for the risk undertaken
what does a negative alpha mean?
the fund manager provided less return than was expected for the risk that was undertaken
what does a zero alpha mean?
the fund manager provided a return equal to the return that was expected for the risk that was undertaken
if the R-squared is greater than or equal to 0.7, what should you use?
(Treynor, Sharpe, Alpha, Standard Deviation, Beta)
Treynor, Alpha, Beta
if the R-squared is less than 0.7, what should you use?
Treynor, Sharpe, Alpha, Standard Deviation, Beta
Sharpe, standard deviation
