Portfolio Theory (Lesson 2) Flashcards
What is standard deviation
- measure of risk and variability of returns
- measure of total risk
- determines total risk of an undiversified portfolio
What does a higher standard deviation mean
- higher the riskiness of the investment
What is the percent of +- 1, +- 2, +- 3 standard deviations
- 68%, 95%, 99%
How do you find expected return using probability
- Multiply expected return times probability of return and add them together
What does the Coefficient of Variation tell you
- 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
What is the formula for coefficient of variation
CV= Standard deviation/ Mean Return
When is normal distribution appropriate
- if an investor is considering a range of investment returns
- 68%, 95%, 99%
What is lognormal distriubtion
- not a normal distribution
- Appropriate if an investor is considering a dollar amount or portfolio value at a point in time
What is skewness
- refers to a normal distribution curve shifted to the left or right of the mean return
- Commodity returns tend to be skewed
With positive skewness mode, median, and mean are to the
left
With negative skewness mode, median, and mean are to the
right
What is kurtosis
- 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
What is Leptokurtic kurtosis
- high peak and fat tails (higher chance of extreme events)
What is Platykurtic kurtosis
- Low peak and thin tails (lower chance of extreme events)
What is mean variance optimization
- 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
What are some characteristics of Monte Carlo Simulation
- 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
What is covariance
- the measure of two securities combined and their interactive risk
- How price movements between two securities are related to each other
What does Covariance measure
- Relative risk
Is the formula for Correlation of coefficient on the board sheet
- No but it is the just the covariance formula rearranged to solve for P
What type of measurement is correlation of coefficient
- relative measurement
What does a correlation of +1 mean
- denotes that two assets are perfectly correlated
What does a correlation of 0 mean
- denotes that two assets are completely uncorrelated
What does a correlation of -1 mean
- denotes that two assets are perfectly negatively correlated
When do diversification benefits begin for correlation
less than 1
What is beta a measure of
- Measure of an individual securities volatility relative to that of the market
- Best used to measure the volatility of a diversified portfolio
What type of risk does beta measure systemic or unsystematic
- Systematic
- Greater the beta the greater the systematic risk
What does a beta of 1 mean
- expected to mirror the market terms of direction, return, and fluctuation
Beta can be calculated by the formula on the board sheet or
- dividing the security risk premium by the market risk premium
Which does beta or standard deviation measure risk of a non diversified portfolio
- Standard deviation
What is Coefficient of Determination or R2
- measure of how much return is due to the market or what percentage of a securities return is due to the market
How do you calculate Coefficient of Determination
- by squaring the correlation of coefficient
What does r2 give the investor insight to
- 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
What does the r2 have to be greater than in order for beta to be reliable
0.70
How can the risk of a portfolio be measured
- through determination of the interactivity of the standard deviation and covariance of securities in the portfolio
What is systematic risk
- the lowest level of risk one could expect in a fully diversified portfolio
- Nondiversifiable
- market risk
- economy based risk
What is unsystematic risk
- is the risk that exists in a specific firm or investment that can be eliminated through diversification
- Diversifiable risk
- unique risk
- company specific risk
What are systematic risks
(PRIME)
- Purchasing power
- Reinvestment risk
- Interest rate risk
- Market risk
- Exchange rate risk
What is purchasing power risk
- 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
What is reinvestment rate risk
- risk that an investor will not be able to reinvest at the same rate of return that is currently being received
- Mostly impacts bonds
What is interest rate risk
- 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
What is market risk
- 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
What is exchange rate risk
- is the risk that a change in exchange rates will impact the price of international securities
(Unsystematic Risks)
Accounting Risk
- risk associated with an audit firm being too closely tied to the management of a company
(Unsystematic Risks)
Business Risk
- inherent risk a company faces by operating in a particular industry
- Oil industry is different than tech industry
(Unsystematic Risks)
Country Risk
- risk that a company faces by doing business in a particular country
- unique risks in doing business in Iraq
(Unsystematic Risks)
Default Risk
- risk of a company defaulting on their debt payments
(Unsystematic Risks)
Executive Risk
- risk associated with the moral and ethical character of the management running the company
(Unsystematic Risks)
Financial Risk
- the risk associated with the amount of debt that a company uses
- more debt more risk
(Unsystematic Risks)
Government/Regulation Risk
- 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
What is modern portfolio theory
- 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
What is the efficient frontier
- the curve which illustrates the best possible returns that could be expected from all possible portfolios
What is an efficient portfolio
- Occurs when an investors indifference curve is tangent to the efficient fronteir
What is an indifference curve
- constructed using selections made based on highest level of return given an acceptable level of risk
What is an optimal portfolio
- one selected from all efficient portfolios
- point at which an investors indifference curve is tangent to the efficient frontier
Portfolios above the Efficient frontier are? And Portfolios below are?
- Above: Unattainable
- Below: Inefficient
If an investor is risk adverse their indifference curves will be
- very steep
- More return for a little bit of risk added
If an investor is risk seeking their indifference curves will be
- relatively flat
- investor will not require a significant amount of return to take on more risk
What is the Capital Market Line
- the macro aspect of the CAPM
- specifies the relationship between risk and return in all possible portfolios
A portfolios return should be ___ the Capital market line
- On the CML
A Portfolio below the Capital market lines is
- inefficient
Is the Capital Market Line used to measure the performance of a single security
No
What measure of risk does the Capital Market Line use
- Standard deviation
Where does the CML intersect the y axis
- the risk free rate
Before the CML touches the efficient frontier the investor is said to have a security allocation made up of
- optimal portfolio mix and is lending a portion of uninvested assets at the risk free rate
At the optimal portfolio the investor is
- fully invested in that portfolio
- does not lend anything at the risk free rate or borrow at that rate
To the right of the optimal portfolio the investor is said to have
- borrowed at the risk free rate to fully invest all capital and borrowed funds in the portfolio
The Capital Asset pricing model calculates the relationship of
- risk and return of an individual security
- use Beta as its measure of risk
What is the CAPM often referred to as
- Security Market Line
What is (rm - rf) of the CAPM formula
- considered the market risk premium
- how much an investor should be compensated to take on a market portfolio verse the risk free asset
What does the CAPM and SML assume an investor should earn
- A rate of return at least equal to the risk free rate of return
What measure of risk does the SML use
- Beta
If a portfolio provides a return above the SML it would be considered
- undervalued and should be purchased
If a portfolio provides a return below the SML it would be considered
- Overvalued and should not be purchased
What does the information ratio measure
- the excess return and the consistency provided by a fund manager relative to a bench mark
What type of measure is the Information ratio, is higher or lower better, and what type of risk measure does it use
- Relative risk adjusted performance measure
- Higher the better
- Standard deviation
What type of risk measure does Treynor index use
- Beta
Is a higher or lower Treynor ratio better
- Higher
What does the Treynor Index measure
- how much return was achieved for each unit of risk
Does the Treynor index indicate whether a portfolio has outperformed or underperformed the market
- No
What does the Sharpe Index provide
- a measure of portfolio performance using a risk adjusted measure that standardizes returns for their variability
What does Sharpe Index measure
- reward to total variability, or total risk
Is a higher or lower Sharpe ratio good
- Higher
- means more return was provided for each unit of risk
Does the Sharpe ratio measure a portfolios managers performance against that of the market
- No
Can Jensens Alpha be used by itself as a measurement
- Yes
What does Jensen Alpha do
- 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
Is a higher or lower alpha good
- Higher the better
- zero is also good
When is the only time alpha will equal the amount the fund beat the market
- if the beta is 1
How do you calculate r-squared
- Square correlation
Is the below performance measure relative or absolute
Sharpe
Treynor
Alpha
Information ratio
- Sharpe: Relative
- Treynor: Relative
- Alpha: Absolute
- Information Ratio: Relative
