Portfolio Theory

Question 1

Key MPT Assumptions/Downfalls

Answer 1

• 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)

Question 2

Market Risk Premium

Answer 2

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

Question 3

MVO

Answer 3

Mean Variance Optimization

Maximize return, min risk (variance).

Inputs necessary:
-Security’s expected returns
-Expected risk (e.g., standard deviations)
-Expected cross-security correlations

Question 4

The Efficient Frontier

Answer 4

a set of optimal portfolios w the highest expected return for a set/defined amt of risk

Question 5

CAL

Answer 5

Capital Allocation/Asset Line

this line represents all possible combos of risk-free and risky assets. Returns v. risks. NOT the CML or SML.

Question 6

Sharpe Ratio

Answer 6

On formula sheet
maximizes the CAL for any portfolio

Question 7

the kinked CAL

Answer 7

indicates leverage is being used

Question 8

Brinson Beebower & Hood

Answer 8

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

Question 9

Black Litterman Model

Answer 9

combines CAPM, MPT, and MVO. tactical asset allocation
- can change input & assumptions, but then subject to user error

Question 10

Efficient Market Hypotheseis

Answer 10

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

Question 11

Technical Analysis

Answer 11

historical trends
trusts all info is already baked into stock price

Question 12

Fundamental Analysis

Answer 12

looks at financial statements & health of underlying companies/stocks. Arbitrage. Economic & accounting info used to predict stock prices. (Semi strong form)

Question 13

CAPM

Answer 13

Capital Asset Pricing Model

Expected Return = (risk free rate) + (market risk premium * beta of asset)

Systematic Risk - non diversifiable
NonSystematic = Idosyncratic

Question 14

SML

Answer 14

Security Market Line

graphical rep of CAPM

single stocks

slope represents market risk premium

Question 15

APT

Answer 15

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

Question 16

Assumptions of APT

Answer 16

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

Question 17

Fama French 3-Factor Model

Answer 17

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

Question 18

The Minimum Variance Portfolio

Answer 18

porfolio w the least risk. composed of the risky assets that has the smallest SD/variance

if Correlation = -1, SD of MVP is 0.

Question 19

Semi-Variance (Downside Deviation)

Answer 19

= the average of the squared deviations of all values less than the avg or mean

better measurement of downside risk

Question 20

VaR

Answer 20

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

Question 21

Expected Shortfall (ES)

Answer 21

more conservative than VaR

takes the average return of the worst cases

also called “conditional tail expectation (CTE)”

Question 22

Sortino Ratio

Answer 22

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