Principles of Investment Risk - 2 Flashcards
What does the efficient market hypothesis suggest?
All publicly available and relevant information about a particular security is reflected in the price and this is the security’s fair value
What are the 3 versions/forms of EMH?
- Weak form – the market price of shares currently reflects all relevant information implied in historic share prices.
- Semi-strong form – weak form + all publicly available relevant information. Share prices will react to news and adjust to a new level.
- Strong form – this assumes that the market price of a share currently takes into account all publicly and privately available relevant information.
How is the validity of EMH questioned?
just because information on a share is available, that does not mean that it will have been discovered (or taken into account) by an investor
What are the 2 main points of Modern Portfolio Theory?
- It assumes that rational investors will demand a higher rate of return to invest in a riskier asset than they will to invest in a less risky asset.
- The cornerstone of MPT is that diversifying a portfolio by adding investments that do not behave in the same way reduces its overall risk, even if those investments individually are higher risk.
What is the CAPM?
The expected return on a security or portfolio equals the rate on a risk-free security plus a risk premium, and that, if the expected return does not meet or beat this required return, then the investment should not be undertaken.
What is the CAPM formula?
Expected Rate of Return = RF + β(RM − RF)
What is the Arbitrage Pricing Theory (APT)
Adopts a multi-factor asset price model which:
- seeks to capture exactly what factors determine security price movements by conducting regression analysis
- applies a separate risk premium to each identified factor
- applies a separate beta to each of these risk premiums, depending on a security’s sensitivity to each of these factors.
Examples of factors used in the APT?
- anticipated changes in inflation,
- interest rates,
- exchange rates,
- market indices,
- yield spread between investment-grade and non-investment-grade bonds.
What are the 3 categories of multi factor models?
- Macroeconomic models which look to compare the returns achieved by a security against factors such as employment statistics, inflation and interest rates.
- Fundamental models, which compare the returns against underlying factors such as earnings, eg, company profits or dividend ratio, when assessing equities.
- Statistical models which compare the performance of a range of different securities based on the statistics for each individual security.
What is the Fama-French Three-Factor Model? and the 3 factors used?
Analyze stocks based on:
- Company size – the outperformance of small companies relative to larger companies, referred to as ‘small minus big’ (SMB).
- Book-to-market values – the outperformance of high versus low book-to-market value companies, referred to as ‘high minus low’ (HML). In other words, value companies beat growth companies.
- Excess returns on the market – in other words, the portfolio’s return above the risk-free rate (r f ). This compensates investors for the additional volatility of returns over and above the risk-free rate.
What additional factor does the Carhart Four-Factor Model add?
price momentum factor (MOM) - taking the average return of stocks with the best performance over the previous year minus the average return of stocks in the same period with the worst returns.
What are Confirmation and Hindsight bias?
- Confirmation Bias – confirmation bias suggests that an investor is more likely to look for information that supports their original idea about an investment rather than seek out information that contradicts it.
- Hindsight Bias – hindsight bias tends to occur in situations if a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact the event could not reasonably have been predicted.
What are Prospect and Regret Theories?
- Prospect theory – this theory says people respond differently to equivalent situations, depending on whether it is presented in the context of a loss or a gain. Most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.
- Regret theory – people’s emotional reaction to having made an error of judgement. Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a poor investment decision and the embarrassment of reporting the loss
What is Immunisation of liability-driven investing (LDI)?
- Interest rate hedging using swaps and derivatives
- It involves matching the duration of assets and liabilities, thus minimising the impact of interest rates on a portfolio’s net worth over time.
What are the 3 stages of Top Down investing?
- Asset allocation
- Sector selection
- Security selection
