Portfolio Theory Flashcards
What is modern portfolio theory?
MPT is based on the use of diversification to reduce risk. The number of assets required for diversification depends on the correlation between assets. The goal is to put together optimal portfolios - referred to as the mean-variance optimization.
Mean-variance optimization requires we look at the returns (mean), the standard deviation (the variance) and the correlation between each asset.
What is efficient frontier?
A curved parabola plotted on a x-y risk return graph. Portfolios on the curve are said to be efficient with portfolios above and below the curve to either be too risky or unattainably efficient for low risk.
What are indifference curves?
These are curves on the x-y risk reward graph which represent the risk-reward tradeoff that the investor is willing to take. These curves are tangent to the efficient frontier and where they cross the efficient frontier at a single point, is where the optimal portfolio is.
What are the considerations for constructing an efficient MPT?
Diversification: be careful not to over-diversify. Should only take 10-15 large cap, 20-30 small cap
Overlap: holding many stocks risks holding many of the same stocks (mutual funds)
Correlation: holding similarly correlated stocks does not mitigate risk when the market moves
What is the mean-variance optimization approach?
An efficient portfolio. Investors are trying to maximize the return (mean), for any level of risk (variance).
All portfolios on the efficient frontier are, efficient. But not all portfolios are on the efficient frontier are optimal. Explain.
It comes down to the level of risk an individual is willing to take. The optimal portfolio is both on the efficient frontier and at the level of risk the investor is willing to take.
What is capital market theory (CMT)?
A continuation of efficient frontier using a market portfolio made entirely of risk (systematic and unsystematic). That market portfolio is plotted along with the risk-free rate, A straight line, known as the Capital Market Line (CML) is drawn between the two which then marks the new efficient frontier.
What is the Capital Asset Pricing Model (CAPM)?
ri = rf + (rm – rf)βi
Allows the investor to determine an asset’s expected rate of return, in a form of risk-adjustment that allows the investor to see how much risk they should assume for such a return.
What are the two components of the CAPM formula?
The stock risk premium: the inducement necessary to entice the individual to invest
(rm− rf)βi
The market risk premium: the incentive required for the individual to invest in the securities market in general
rm− rf
What does the Capital Market Line (CML) represent?
It expands on the efficient frontier to state that every portfolio can at least start with the risk free return. From there, with more risk, it can move directly to point M (the apogee of the efficient frontier), and can continue in a straight line to point A, which uses margin and the most risk to get the most returns.
What is the security market line (SML)?
The depiction of the relationship between risk and reward for individual efficient portfolios which has the same formula as CAPM. Assuming the market is in equilibrium, all assets should plot along this axis, moving from the risk free rate, up and to the right.
Along SML, how would one expect to see asset plots that are over and under valued?
Over valued would be to the right of the line, under valued would be to the left.
How does the slope of the line change with inflation and investor risk levels?
With inflation, all rates change. All other things being equal, the slope of the line parallels the old line
With investor risk levels, (rm - rf), the slope of the line will either steepen for risk aversion or flatten for risk acceptance.
What is Arbitrage Pricing Theory (APT)?
As CAPM uses Beta as a single factor effecting stock prices, APT uses multiple factors such as inflation, GDP, risk premiums, and yield curves to determine expected return rates.
ri = a0 + b1F1 + b2F2 + . . . + bnFn + e
b1 = sensitivity of the expected return F1 = unfactored risk a0 = risk free return
What is efficient market hypothesis?
Suggests that investors cannot beat the market. If prices move in a completely random motion, then any strategies to take advantage of price movements, are useless