Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

CFA Level II Derivatives & Portfolio Management > Reading 57 - Portfolio Concepts > Flashcards

Reading 57 - Portfolio Concepts Flashcards

You may prefer our related Brainscape-certified flashcards:
CFA flashcards
1
Q

In general terms, what is mean-variance analysis?

A

Refers to the use of expected returns, variances and covariances of individual investments to analyze the risk-return tradeoff of combinations of these assets

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What are the main assumptions of mean-variance analysis?

**Critical Concept***

A
  1. Investors are risk averse
  2. Statistical inputs (mean returns, variances, covariances) are known
  3. Investors make all portfolio decisions based solely on means, variances and covariances
  4. Investors face no taxes or transaction costs
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

How do you calculate the expected return for a 2 asset portfolio?

**Critical Concept**

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

How do you calculate the variance of a 2 asset portfolio?

**Critical Concept***

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What does the covariance, Cov1,2 measure?

A

It measures the strength of the relationship between the returns earned on assets 1 and 2.

** covariance is unbounded (meaning it ranges from infinity to negative infinity)

***Is not a useful measure of strength, so we use it as part of the calculation for correlation

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

How do you calculate the correlation between 2 assets?

***Critical Concept***

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What is a minimum-variance portfolio?

A

Is a portfolio that has the smallest variance among all portfolios with identical expected returns.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

What is the minimum-variance frontier?

A

Is a graph of the expected return/variance combinations for all minimum-variance portfolios.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What is the global minimum-variance portfolio ?

A

The portfolio with the smallest variance among all possible portfolios

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

For a minimum-variance frontier, what is graphed on the X an Y axis?

A

X Axis : Standard Deviation

Y Axis : Expected Return

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What are the efficient portfolios?

**Critical Concept**

A
  • Minimum risk of all portfolios with the same expected return
  • Maximum expected return for all portfolios with the same risk

******ie —-the one offering the highest expected return for a given level or risk as measured by variance or standard deviation of return****

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

According to Prof Harry Markowitz, what is the efficient frontier?

A

Is a plot of the expected return and risk combinations of all efficient portfolios.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What are the two things that affect portfolio diversification ?

**Critical Concept**

A
  • Correlations between assets
  • Numbers of assets included in the portfolio
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What is the formula to calculate the variance of an equally weighted n - asset portfolio ?

***Critical Concept***

A

σ2i = average variance of all assets in the portfolio

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What happens to the variance of an equally weighted portfolio as n gets larger?

A

It approaches the average covariance.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the variance of a risk-free asset ?

A

0

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What happens to the shape of the efficient frontier after a risk-free asset is added to the portfolio?

A

It changes from a curve to a line

** It becomes linear.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What is the Capital Allocation Line?

**Critical Concept**

A

the risk-return line that lies tangent to the efficient frontier.

***It is the Markowitz’s effecient frontier + Rf

**It describes the expected results of the investor’s decision on how to optimally allocate her capital among risky and risk free assets***

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

How is the reward-to-risk ratio (i.e. Sharpe Ratio ) calculated ?

**Critical Concept**

A

Can be viewed as the expected risk premium for each unit of risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What is the equation to calculate the Capital Allocation Line (CAL) ?

**Critical Concept**

A

**** E(Rt) is the expected return for the market

*** the middle part of the equation is a Sharpe ratio of the market.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

What is the Capital Market Line (CML) ?

**Critical Concept**

A

The capital allocation line in a world in which all investors agree on the expected returms, standard deviations, and correlations of all assets

**** The “homogeneous expectations” assumption

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

Under assumption of the CML, what is the market portfolio?

**Critical Concept**

A
  • The optimal risky portfolio
  • Defined as the portfolio of all marketable assets, weighted in proportion to their relative market values.
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What is the key conclusion of the CML?

A

All investors will make optimal investment decisions by allocating between the risk-free asset and the market portfolio.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

What is the equation for the CML?

**Critical Concept**

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

What are the differences between the CML and CAL ?

**Critical Concept**

A
  • There is only one CML b/c it is developed assuming assuming all investors agree on the expected return, standard deviation and correlations of all assets
  • There is an unlimited number of CALs because one is developed uniquely for each investor
  • The tangency portfolio for the CML is the market portfolio. There is only one market portfolio.
  • The tangency portfolio for the CAL can differ across investors based on their expectations
  • The CML is a special case of the CAL
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

In general terms, what does the CAPM tell us?

**Critical Concept**

A

It provides a way to calculate an asset’s expected return based on its level of systematic (i.e. market related) risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

What are the underlying assumptions of CAPM?

**Critical Concept**

A
  1. Investors only need to know expected returns, variances and covariances in order to create optimal portfolios
  2. All investors have the same forecasts of risky assets’ expected returns, variances and covariances
  3. All assets are marketable, and the market for assets is perfectly competitive
  4. Investors are price takers and their buy and sell decisions have no effect on asset prices
  5. Investors can borrow and lend at the risk free rate, unlimited short selling is allowed
  6. There are no frictions to trading, such as taxes or transaction costs
28
Q

What are the 4 implications of CAPM?

**Critical Concept**

A
  1. Systematic risk, measured by beta, is the only risk priced by the market.
  2. The security master line (SML), which is the graph of CAPM, describes the relationship between the expected return and risk for all assets
  3. Because all investors hold the same risky portfolio, the weight on each asset must be equal to the proportion of its market value to the MV of the entire market portfolio
  4. B/c investors have the same expectations and use mean-variance analysis, they all identify the same risky tangency portfolio
29
Q

What is the equation for the Security Master Line (SML) ?

**Critical Concept**

A

**The CAPM equation***

30
Q

What is the formula for calculating beta?

**Critical Concept**

A
31
Q

Assume the correlation of returns between Transport Co and the market portfolio equal 0.80, the standard deviation of Transport Co equals .60 and the standard devaition for the market portfolio equals 0.30.

Calculate the beta for Transport Co.

A
32
Q

How does the SML and CML each measure risk?

A

SML:

Uses systematic risk (non-diversifiable risk)

CML:

Uses standard deviation (total risk)

33
Q

How is the SML and CML applied ?

A

SML:

Tool used to determine the appropriate expected (benchmark) returns for securities

CML:

Tool used to determine the appropriate asset allocation for the investor.

34
Q

What is the definition of the SML and CML ?

A

SML:

Graph of the capital asset pricing model (CAPM)

CML:

Graph of the efficient frontier

35
Q

What does the slope of the SML and CML measure?

A

SML:

Market risk premium

CML:

Market risk premium for each unit of market risk

36
Q

A stock has a beta of 0.75 and an expected return of 13%. The risk free rate is 4%. Calculate the market risk premium and the expected return on the market portfolio.

A
37
Q

A stock has a beta of 2.0. The correlation of the stock’s returns with the market is 0.5 and the variance of the returns on the market portfolio is 0.04. Calculate the variance of returns on the stock.

A
38
Q

Given a Sharpe ratio for the market portfolio of 0.40, calculate the expected return on a stock with a standard deviation of returns of 0.50 and a correlation with the market portfolio returns of 0.60. The risk-free rate is 5% and the standard deviation of the market portfolio returns is 0.25.

A
39
Q

What are the three methods of obtaining inputs to the mean-variance framework?

**Critical Concept**

A
  1. Using historical means, variances and covariances
  2. Estimating betas using the market model
  3. Calculating adjusted betas
40
Q

What is the premise of the market model?

***Critical Concept***

A

***Describes a regresssion relationship between the returns of an asset and the returns on the market portfolio***

That there are just two sources of risk

  1. Unanticipated macroeconomic events (systematic risk)
  2. Firm-specific events (unsystematic risk)
41
Q

What is the equation to calculate the market model?

***Critical Concept***

A
42
Q

What are the 3 assumptions that the market model makes?

**Critical Concept**

A
  1. The expected value of the error term is zero
  2. The errors are uncorrelated with the market return
  3. The firm-specific surprises are uncorrelated across assets
43
Q

If portfolio A has an expected return of 10% and a variance of 0.02 , given a example of the expected returns and variance of portfolio B if they were to be thought of as inefficient?

A

7% expected return

0.04 variance

*** Portfolios are inefficient if they have lower expected returns and higher variances than offer portfolios.

44
Q

What are the three predictions the market model makes?

A
  1. E(R) of Asset i depends only on the expected return on the market portfolio, the sensitvity of returns to the market,ßi and the average return to Asset i when the market return is 0, ài
  2. The variance of the returns of Asset i consists of two components, systematic risk (ßi2σM2) and an unsystematic component related to firm specific events (σè2)
  3. The covariance between any two stocks is calculated as the product of their betas and the variance of the market portfolio
45
Q

Determine the number of statistical inputs needed to derive the efficient frontier comprising 500 assets, using the market model….

A
46
Q

What is the beta instability problem?

A

That the beta derived from the market model is a good estimate of historical relationships but not necessarily a good predictor of future relationships.

47
Q

What are some of the reasons for the instability in the minumum-variance frontier and, therefore, the efficient frontier?

A
  1. The statstical input (means,variances, covariances) are unknown and must be forecast
  2. Statistical inputs forecasts derived from historical sample estimates often change over time -> causing the efficient frontier to change over time
  3. Small changes in the statistical inputs can cause large changes in the efficient frontier►unreasonable large short positions and overly frequent rebalancing.
48
Q

What are the 3 kinds of Multifactor models?

**Critical Concept**

A
  1. Fundamental Factor Models
  2. Macroeconomic factor models
  3. Statistical factor models
49
Q

What is the formula for a fundamental factor model?

A
50
Q

What is the formula to calculate Standardized Sensitivities which are used in Fundamental Factor Models?

Use P/E as the fundamental factor

A
51
Q

The P/E for Stock i is 15.20, the average P/E for all stocks is 11.90, and the standard devation of P/E ratios is 6.30. Calculate the standardized sensitivity of Stock i to the P/E factor…

A
52
Q

What are the 4 key differences the Macroeconomic Factor Model vs the Fundamental Factor Model ?

A
  1. Sensitivities
  2. Interpretation of factors
  3. Number of factors
  4. Intercept term
53
Q

The Arbitrage Pricing Theory (APT) refers to an asset pricing theory that assumes these 3 things:

**Critical Concept**

A
  1. Returns are derived from a multifactor model
  2. Unsystematic risk can be completely diversified away
  3. No arbitrage opportunities exist
54
Q

An investment firm employs a two-factor APT model. The risk-free rate equals 5%. Determine the expected return for the Invest fund using the following data:

**Critical Concept**

A
55
Q

What is the Active Return and how is it calculated ?

A

Equals the difference in returns between a managed portfolio and its benchmark

Active return = RP - RB

56
Q

What is Active Risk and how is it calculated?

**Critical Concept**

A

***Is the standard deviation of active returns

57
Q

Active risk of a portfolio can be seperated into these two components…..

A
  1. Active factor risk : risk from portfolio’s factor sensitivitis vs the benchmark’s sensitivities to the same set of factors.
  2. Active specific risk : Risk from devations of the portfolio’s individual asset weightings vs the benchmark’s individual asset weightings
58
Q

Describe what the Information Ratio is and how is it calculated?

**Critical Concept**

A

** Shows a manager’s consistency in generating active return

We standardize average active return by dividing it by its standard deviation.

59
Q

Is a low or high information ratio (IR) desired.

What does an ir of 0.27 indicate?

A

Higher is better.

0.27 means the manager earned about 27 bp of active return per unit of active risk

60
Q

Given that t-bills currently pay 5%, if you can chose only one of the below funds to add to you portfolio, which one would it be?

Fund A : e(r) = 12%, variance = 0.0256

Fund B : e(r) = 9%, variance = 0.0196

Fund C : e(r) = 8%, variance = 0.0172

A
61
Q

Explain in a quick sentence what each of these 5 things are:

  1. Minimum Variance Frontier
  2. Efficient Frontier
  3. Capital Allocation Line (CAL)
  4. Capital Market Line (CML)
  5. Security Market Line (SML)

**Critical Concept**

A
  • Minimum Variance Frontier - a graph of the expected return/variance combinations for all minimum variance portfolios
  • Efficient Frontier - Plot of expected return & risk combinations of all efficient portfolios, all of which lie on the upper portion of the minimum variance frontier
  • Capital Allocation Line - describes the combinations of expected return and standard deviation of return available to an investor from combining her optimal portfolio of risky assets with the risk-free asset.
  • Capital Market Line - is a kind of CAL, where all investors agree on 1 market portfolio & investors make optimal investment decisions by allocating between the RF rate and the market portfolio
  • Security Market Line - a graph of the CAPM equation, which describes the relationship between expected return and systematic risk
62
Q

Calculate the variance of this equally weighted portfolio:

100 assets

avg variance = 0.15

avg covariance = 0.09

**Critical Concept**

A
63
Q

If you currently own a portfolio, what do you need to consider before adding an additional security to your portfolio?

A

***Whether the Sharpe Ratio after the addition is greater than the Sharpe Ratio of the portfolio prior to the addition****

64
Q

Why do adjusted betas predict future betas better than historical betas do?

A

B/c betas are, on average, mean reverting

65
Q

What are the 2 reasons why Multifactor models have gained importance of the practical business of portfolio management?

A
  1. They explain asset returns better than the market model does
  2. The provide a more detailed analysis of the risk than a single factor model does.

CFA Level II Derivatives & Portfolio Management (10 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions