Portfolio Theory Flashcards
Key MPT Assumptions/Downfalls
- Normal return distributions
- Fixed asset correlations
- Investors are rational
- Investors are risk-averse
- Risk is known and constant
- All information is public
- No taxes or transactions costs
- Return vs. Risk
- Mean Variance Optimization (MVO)
- Efficient Frontier
- How portfolios may be constructed
from this methodology (portfolio
construction)
Market Risk Premium
The risk premium on the market portfolio will be
proportional to its risk and the degree of risk
aversion of the investor
E(rM) - r(f) = A * σ(2)M
- where σ(2)M is the variance of the market portolio and
- A is the average degree of risk aversion across investors
MVO
Mean Variance Optimization
Maximize return, min risk (variance).
Inputs necessary:
-Security’s expected returns
-Expected risk (e.g., standard deviations)
-Expected cross-security correlations
The Efficient Frontier
a set of optimal portfolios w the highest expected return for a set/defined amt of risk
CAL
Capital Allocation/Asset Line
this line represents all possible combos of risk-free and risky assets. Returns v. risks. NOT the CML or SML.
Sharpe Ratio
On formula sheet
maximizes the CAL for any portfolio
the kinked CAL
indicates leverage is being used
Brinson Beebower & Hood
studied pension funds
- asset allocaion is the main determinant of a portfolio’s return variability
- security selection & market timing only play a small role in portfolio performance
Black Litterman Model
combines CAPM, MPT, and MVO. tactical asset allocation
- can change input & assumptions, but then subject to user error
Efficient Market Hypotheseis
stock prices already reflect all available info
WEAK - technical analysis is NOT helpful but fundamental is. past price movements do not affect current prices
SEMI STRONG - neither technical nor fundamental add value. All public info is reflected in stock’s current price
STRONG - all public & private info is baked into stock price. not even insider info can add value
Technical Analysis
historical trends
trusts all info is already baked into stock price
Fundamental Analysis
looks at financial statements & health of underlying companies/stocks. Arbitrage. Economic & accounting info used to predict stock prices. (Semi strong form)
CAPM
Capital Asset Pricing Model
Expected Return = (risk free rate) + (market risk premium * beta of asset)
Systematic Risk - non diversifiable
NonSystematic = Idosyncratic
SML
Security Market Line
graphical rep of CAPM
single stocks
slope represents market risk premium
APT
Arbitrage Pricing Theory
seeks to explain security returns beyond the usual metrics by introducing risk factors such as expected return, sector, and systematic factors
while far more expansive that CAPM, given the flexibility, it’s accuracy is limited due to the variables
Assumptions of APT
does not require an expected market return
uses the asset’s expected return and the risk premium of a number of macro-exonomics factors
Arbitragers use APT to buy underpriced assets and short overvalued ones
Better for well-diversified portfolios rather than ind stocks
Fama French 3-Factor Model
Adds size (small/large), equity, and value (book to mrkt retio) variable to CAPM
smaller firms exp higher returns
high book to mrkt ratios exp higher returns (value style)
4th factor: Momentum; based on past returns. winners/losers
The Minimum Variance Portfolio
porfolio w the least risk. composed of the risky assets that has the smallest SD/variance
if Correlation = -1, SD of MVP is 0.
Semi-Variance (Downside Deviation)
= the average of the squared deviations of all values less than the avg or mean
better measurement of downside risk
VaR
Value at Risk
a measure of risk that quantifies potential loss (ex. $1M), the probability of the loss (ex. 3%) and the time frame for the potential loss (ex. 3 months).
Assumes market to market pricing, no trading, and normal conditions
measure of loss most freq. associated with extreme negative returns
takes the highest return from the worst cases
Expected Shortfall (ES)
more conservative than VaR
takes the average return of the worst cases
also called “conditional tail expectation (CTE)”
Sortino Ratio
risk adjusted measure of return that uses downside volatility (semi standard deviation) to measure risk
unlike Shapre, only uses agative returns in the caluc to measure downside risk
considered a more effective way than other ratios to measure high volatility portfolios
