Reading #44 - Risk and Return Part 2

Question 1

define the capital market line (CML)

Answer 1

“the optimal CAL for all investors”

Question 2

CML EQUATION E(Rp) =

Answer 2

Rf+ [(E(rm)-Rf)/(stnd market)]stnd dev portfolio

Question 3

what is the y-intercept of the CML, i.e. the slope Formula

Answer 3

(E(rm) - Rf)/stnd market

Question 4

define the market risk premium

Answer 4

“the expected return on the market and the RFR “

Question 5

define passive investment strategy

Answer 5

strategy that believes “market prices are informationally efficient”

Question 6

define unsystematic risk

Answer 6

“risk that is eliminated by diversification”

Question 7

define systematic risk

Answer 7

“risk that remains cannot be diversified away”

Question 8

is equilibrium security returns depend on total risk of portfolio’s systematic risk?

Answer 8

systematic risk because investors “will knot be compensated for bearing risk that can be eliminated at no cost”

Question 9

define return generating models

Answer 9

“used to estimate the expected returns on risky securities based on specific factors”

Question 10

define multifactor models

Answer 10

“use macroeconomic factors to estimate the expected returns on risky securities”

Question 11

define Fama and French Model

Answer 11

“estimated sensitivity of security returns to three factors: firm size, firm book value to market value and return on market portfolio - RFR”

Question 12

define Carhart model

Answer 12

“fama and french plus factor that measures price momentum using prior period returns”

Question 13

define beta

Answer 13

“sensitivity of asset’s return to return on market index in context of the market model”

Question 14

calculate beta of an asset

Answer 14

“cov(investment,mkt)/ stnd dev squared (of mkt)”

Question 15

what is the security characteristic line?

Answer 15

the regression line against the market asset returns - the slope is the same formula to find beta (cog of investment/ stand dev of mkt squared)

Question 16

what is the security market line (SML)

Answer 16

the line that result from relationship between E(r) risk and return for individual assets using covariance

Question 17

define CAPM

Answer 17

“relation between beta (systematic risk) and expected return”

Question 18

assumptions of CAPM:

Answer 18

1. risk aversion 2. utility maximizing investors 3. frictionless markets 4. one period horizon 5. homogeneous expectations 6. divisible assets 7. competitive markets

Question 19

what is the sharpe ratio

Answer 19

measure of “excess returns per until of total portfolio risk”

Question 20

FORMULA sharpe ratio

Answer 20

r(p) - rf/stnd dev of portfolio

Question 21

define m -squared

Answer 21

“produces the same port. rankings as Sharepe ratio but is stated in % terms”

Question 22

formula for m-squared

Answer 22

(rp - rf)(stnd dev mark/stnd dev port)-(rm -rf)

Question 23

what are the two measures that are based on systematic risk?

Answer 23

Treynor measure and Jenson’s alpha

Question 24

what are the two measure that are NOT based on systematic risk?

Answer 24

M squared and sharpe ratio

Question 25

what is Treynor measure based on? slope or % return

Answer 25

based on the slope

Question 26

what is Jenson's alpha based on? slope or % return?

Answer 26

% return - like standard deviation but it lies on SML

Question 27

what is formula for Treynor measure?

Answer 27

(rp - rf)/ beta of portfolio

Question 28

Jenson's alpha formula

Answer 28

Rport - [Rf +beta port(rm-rf)]

Question 29

when is it appropriate to use Treynor and Jenson's alpha?

Answer 29

"when fund uses multiple managers so that the overall fund portfolio is well diversified, i.e. no systematic risk"

Question 30

what is the slope of the SML?

Answer 30

"The slope of the line is given by the market risk premium, the difference between the equity market return and the risk-free rate of interest"

Question 31

what does SML represent?

Answer 31

the CAPM with beta on x axis and return on y axis