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Investment Planning > Portfolio Theory (Lesson 2) > Flashcards

Portfolio Theory (Lesson 2) Flashcards

1
Q

What is standard deviation

A
  • measure of risk and variability of returns
  • measure of total risk
  • determines total risk of an undiversified portfolio
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2
Q

What does a higher standard deviation mean

A
  • higher the riskiness of the investment
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3
Q

What is the percent of +- 1, +- 2, +- 3 standard deviations

A
  • 68%, 95%, 99%
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4
Q

How do you find expected return using probability

A
  • Multiply expected return times probability of return and add them together
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5
Q

What does the Coefficient of Variation tell you

A
  • which investment has more relative risk when investments have different average returns
  • probability of experiencing a return close to the average return
  • Lower the better
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6
Q

What is the formula for coefficient of variation

A

CV= Standard deviation/ Mean Return

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7
Q

When is normal distribution appropriate

A
  • if an investor is considering a range of investment returns
  • 68%, 95%, 99%
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8
Q

What is lognormal distriubtion

A
  • not a normal distribution
  • Appropriate if an investor is considering a dollar amount or portfolio value at a point in time
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9
Q

What is skewness

A
  • refers to a normal distribution curve shifted to the left or right of the mean return
  • Commodity returns tend to be skewed
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10
Q

With positive skewness mode, median, and mean are to the

A

left

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11
Q

With negative skewness mode, median, and mean are to the

A

right

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12
Q

What is kurtosis

A
  • refers to variation of returns
  • if there is a little variation of returns there is a high peak (Treasuries) and positive kurtosis
  • if returns are widely dispersed the peak of the curve will be low and have a negative kurtosis
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13
Q

What is Leptokurtic kurtosis

A
  • high peak and fat tails (higher chance of extreme events)
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14
Q

What is Platykurtic kurtosis

A
  • Low peak and thin tails (lower chance of extreme events)
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15
Q

What is mean variance optimization

A
  • process of adding risky securities to a portfolio but keeping the expected return the same
  • combining asset classes that provide the lowest variance as measured by standard deviation
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16
Q

What are some characteristics of Monte Carlo Simulation

A
  • spreadsheet simulation that gives a probabilistic distribution of events occurring
  • Monte Carlo simulation then adjusts assumptions and returns the probability of an event occurring depending upon the assumption
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17
Q

What is covariance

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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18
Q

What does Covariance measure

A
  • Relative risk
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19
Q

Is the formula for Correlation of coefficient on the board sheet

A
  • No but it is the just the covariance formula rearranged to solve for P
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20
Q

What type of measurement is correlation of coefficient

A
  • relative measurement
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21
Q

What does a correlation of +1 mean

A
  • denotes that two assets are perfectly correlated
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22
Q

What does a correlation of 0 mean

A
  • denotes that two assets are completely uncorrelated
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23
Q

What does a correlation of -1 mean

A
  • denotes that two assets are perfectly negatively correlated
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24
Q

When do diversification benefits begin for correlation

A

less than 1

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25
Q

What is beta a measure of

A
  • Measure of an individual securities volatility relative to that of the market
  • Best used to measure the volatility of a diversified portfolio
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26
Q

What type of risk does beta measure systemic or unsystematic

A
  • Systematic
  • Greater the beta the greater the systematic risk
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27
Q

What does a beta of 1 mean

A
  • expected to mirror the market terms of direction, return, and fluctuation
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28
Q

Beta can be calculated by the formula on the board sheet or

A
  • dividing the security risk premium by the market risk premium
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29
Q

Which does beta or standard deviation measure risk of a non diversified portfolio

A
  • Standard deviation
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30
Q

What is Coefficient of Determination or R2

A
  • measure of how much return is due to the market or what percentage of a securities return is due to the market
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31
Q

How do you calculate Coefficient of Determination

A
  • by squaring the correlation of coefficient
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32
Q

What does r2 give the investor insight to

A
  • how well diversified a portfolio is because the higher the r2 the higher the percentage of return from the market (systematic risk) and less from unsystematic risk
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33
Q

What does the r2 have to be greater than in order for beta to be reliable

A

0.70

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34
Q

How can the risk of a portfolio be measured

A
  • through determination of the interactivity of the standard deviation and covariance of securities in the portfolio
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35
Q

What is systematic risk

A
  • the lowest level of risk one could expect in a fully diversified portfolio
  • Nondiversifiable
  • market risk
  • economy based risk
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36
Q

What is unsystematic risk

A
  • is the risk that exists in a specific firm or investment that can be eliminated through diversification
  • Diversifiable risk
  • unique risk
  • company specific risk
37
Q

What are systematic risks

A

(PRIME)

  • Purchasing power
  • Reinvestment risk
  • Interest rate risk
  • Market risk
  • Exchange rate risk
38
Q

What is purchasing power risk

A
  • risk that inflation will erode the amount of goods and services that can be purchased
  • a dollar today cannot purchase the same amount of goods and services tomorrow
  • impacts equities and bonds
39
Q

What is reinvestment rate risk

A
  • risk that an investor will not be able to reinvest at the same rate of return that is currently being received
  • Mostly impacts bonds
40
Q

What is interest rate risk

A
  • risk that changes in interest rates will impact the price of both bonds equities and bonds
  • inverse relationship between interest rates for bonds and equities
41
Q

What is market risk

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
42
Q

What is exchange rate risk

A
  • is the risk that a change in exchange rates will impact the price of international securities
43
Q

(Unsystematic Risks)

Accounting Risk

A
  • risk associated with an audit firm being too closely tied to the management of a company
44
Q

(Unsystematic Risks)

Business Risk

A
  • inherent risk a company faces by operating in a particular industry
  • Oil industry is different than tech industry
45
Q

(Unsystematic Risks)

Country Risk

A
  • risk that a company faces by doing business in a particular country
  • unique risks in doing business in Iraq
46
Q

(Unsystematic Risks)

Default Risk

A
  • risk of a company defaulting on their debt payments
47
Q

(Unsystematic Risks)

Executive Risk

A
  • risk associated with the moral and ethical character of the management running the company
48
Q

(Unsystematic Risks)

Financial Risk

A
  • the risk associated with the amount of debt that a company uses
  • more debt more risk
49
Q

(Unsystematic Risks)

Government/Regulation Risk

A
  • risk that tariffs or restrictions may be placed on an industry or firm that may impact the firms ability to effectively compete in an industry
50
Q

What is modern portfolio theory

A
  • The acceptance by an investor of a given level of risk while maximizing expected return objectives
  • Investors seek the highest return attainable at any level of risk
  • Investors want the lowest level of risk at any level of return
  • Assumption is that investors are risk adverse
51
Q

What is the efficient frontier

A
  • the curve which illustrates the best possible returns that could be expected from all possible portfolios
52
Q

What is an efficient portfolio

A
  • Occurs when an investors indifference curve is tangent to the efficient fronteir
53
Q

What is an indifference curve

A
  • constructed using selections made based on highest level of return given an acceptable level of risk
54
Q

What is an optimal portfolio

A
  • one selected from all efficient portfolios
  • point at which an investors indifference curve is tangent to the efficient frontier
55
Q

Portfolios above the Efficient frontier are? And Portfolios below are?

A
  • Above: Unattainable
  • Below: Inefficient
56
Q

If an investor is risk adverse their indifference curves will be

A
  • very steep
  • More return for a little bit of risk added
57
Q

If an investor is risk seeking their indifference curves will be

A
  • relatively flat
  • investor will not require a significant amount of return to take on more risk
58
Q

What is the Capital Market Line

A
  • the macro aspect of the CAPM
  • specifies the relationship between risk and return in all possible portfolios
59
Q

A portfolios return should be ___ the Capital market line

A
  • On the CML
60
Q

A Portfolio below the Capital market lines is

A
  • inefficient
61
Q

Is the Capital Market Line used to measure the performance of a single security

A

No

62
Q

What measure of risk does the Capital Market Line use

A
  • Standard deviation
63
Q

Where does the CML intersect the y axis

A
  • the risk free rate
64
Q

Before the CML touches the efficient frontier the investor is said to have a security allocation made up of

A
  • optimal portfolio mix and is lending a portion of uninvested assets at the risk free rate
65
Q

At the optimal portfolio the investor is

A
  • fully invested in that portfolio
  • does not lend anything at the risk free rate or borrow at that rate
66
Q

To the right of the optimal portfolio the investor is said to have

A
  • borrowed at the risk free rate to fully invest all capital and borrowed funds in the portfolio
67
Q

The Capital Asset pricing model calculates the relationship of

A
  • risk and return of an individual security
  • use Beta as its measure of risk
68
Q

What is the CAPM often referred to as

A
  • Security Market Line
69
Q

What is (rm - rf) of the CAPM formula

A
  • considered the market risk premium
  • how much an investor should be compensated to take on a market portfolio verse the risk free asset
70
Q

What does the CAPM and SML assume an investor should earn

A
  • A rate of return at least equal to the risk free rate of return
71
Q

What measure of risk does the SML use

A
  • Beta
72
Q

If a portfolio provides a return above the SML it would be considered

A
  • undervalued and should be purchased
73
Q

If a portfolio provides a return below the SML it would be considered

A
  • Overvalued and should not be purchased
74
Q

What does the information ratio measure

A
  • the excess return and the consistency provided by a fund manager relative to a bench mark
75
Q

What type of measure is the Information ratio, is higher or lower better, and what type of risk measure does it use

A
  • Relative risk adjusted performance measure
  • Higher the better
  • Standard deviation
76
Q

What type of risk measure does Treynor index use

A
  • Beta
77
Q

Is a higher or lower Treynor ratio better

A
  • Higher
78
Q

What does the Treynor Index measure

A
  • how much return was achieved for each unit of risk
79
Q

Does the Treynor index indicate whether a portfolio has outperformed or underperformed the market

A
  • No
80
Q

What does the Sharpe Index provide

A
  • a measure of portfolio performance using a risk adjusted measure that standardizes returns for their variability
81
Q

What does Sharpe Index measure

A
  • reward to total variability, or total risk
82
Q

Is a higher or lower Sharpe ratio good

A
  • Higher
  • means more return was provided for each unit of risk
83
Q

Does the Sharpe ratio measure a portfolios managers performance against that of the market

A
  • No
84
Q

Can Jensens Alpha be used by itself as a measurement

A
  • Yes
85
Q

What does Jensen Alpha do

A
  • capable of distinguishing a managers performance relative to that of the market and determining differences between realized or actual returns and required returns as specified by CAPM
86
Q

Is a higher or lower alpha good

A
  • Higher the better
  • zero is also good
87
Q

When is the only time alpha will equal the amount the fund beat the market

A
  • if the beta is 1
88
Q

How do you calculate r-squared

A
  • Square correlation
89
Q

Is the below performance measure relative or absolute

Sharpe

Treynor

Alpha

Information ratio

A
  • Sharpe: Relative
  • Treynor: Relative
  • Alpha: Absolute
  • Information Ratio: Relative

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