Risk Free Returns / Measures

Question 1

Why does risk adjusted return matter?

Answer 1

Investors are risk averse, and therefore given same return, they will take portfolio with less risk

Question 2

To be considered a risk free asset, what two conditions must be met

Answer 2

1) No Default Risk
2) No reinvestment risk

Question 3

What is most commonly used as a risk free asset / rate

Answer 3

3 Month T Bill Yield

Question 4

What does the Sharpe Ratio do?

Answer 4

Calculates return in terms of the risk taken to generate the return.

Expected return per unit of risk.

Question 5

What is the formula for the sharpe ratio?

Answer 5

(Rp-Rf)/Sd

Question 6

What is better, a higher or lower sharpe ratio?

Answer 6

Higher is better - denotes that there is less volatility to withstand

More return per unit of risk

Question 7

What is Jensen’s Alpha?

Answer 7

Measures performance against a benchmark return (CAPM)

Measures whether a portfolio generates excess return vs its expected performance

Question 8

What can Jensen’s alpha be used to do?

Answer 8

See where a portfolio falls on the SML

can be in-line, above or below

Question 9

What is the formula for Jensen’s alpha?

Answer 9

Rp-(Rf+B(eRm-Rf)

Rp is actual portfolio return (the rest of the expression calculates the expected CAPM return)

Question 10

What ratio is similar to the Sharpe Ratio?

Answer 10

The Information Ratio (IR)

Question 11

What is the information ratio?

Answer 11

Measures the return on a portfolio vs benchmark and takes into account risk taken to achieve those returns

measures the skill of a manager

Question 12

What is for formula for the Information Ratio?

Answer 12

IR = (Ra - Rb) / (SDa - SDb) (tracking error)

Where a is portfolio and b is benchmark

Question 13

What is active share?

Answer 13

measures similarity between fund and benchmark

Question 14

What does an active share of 0% show?

Answer 14

Identical to benchmark (e.g. fund is a tracker)

Question 15

What does an active share of 100% show?

Answer 15

No holdings in common between fund and benchmark

Question 16

Why is active share useful?

Answer 16

1) Can identify if a manager is benchmark hugging and charging too much
2) Can identify how accurately a tracker is tracking

Question 17

What is the Treynor Ratio?

Answer 17

Measures how much excess return is generated for each point of risk taken

Question 18

What is the Treynor Ratio sometimes known as?

Answer 18

Reward to Volatility ratio

Question 19

What is the formula for the Treynor Ratio

Answer 19

TA = (Ra - Rf) / Ba

Where a is the portfolio / fund

Question 20

What is the Sortino Ratio

Answer 20

A variation on the Sharpe ratio - that only accounts for downside volatility

as upside volatility is a benefit to an investor

Question 21

Give 4 reasons why tracking error is unlikely to ever be 0

assuming a full duplication approach

Answer 21

1) Transaction Costs
2) Timing when stocks enter / leave index
3) Round-lot purchases (can only be bought in 100s = slight mismatch)
4) Restrictions on foreign ownership

Question 22

Pros / Uses of Sharpe ratio?

Answer 22

1) Easy to communicate
2) Easy for clients to understand
3) Suitable for portfolios that aren’t fully diversified

Question 23

Use of Treynor Ratio?

Answer 23

1) Measuring returns across different sectors
2) Clients with multiple portfolios
3) clients with diversified holdings (no idiosyncratic risk)

Question 24

Pros of Treynor Ratio

Answer 24

1) Simple to calculate
2) Focus on systematic risk makes it useful for diversified portfolios

Question 25

Cons of Treynor Ratio?

Answer 25

1) Limited use for non-diversified portfolio
2) Linked to capital market theory and SML

Question 26

Pros of Jensen’s Alpha

Answer 26

1) Can be adapted to multi-factor models
2) Most rigourous risk-adjusted return

Question 27

Cons of Jensen’s Alpha

Answer 27

1) Difficult to calculate (requires regression)
2) Relies on CAPM assumptions

Question 28

Pros of Information Ratio

Answer 28

1) Direct comparison to benchmark
2) Simple to calculate / explain
3) allows a manager’s consistency to be measured

Question 29

Cons of Information Ratio

Answer 29

1) Can be difficult to interpret
2) Assumes portfolio and benchmark have similar levels of systematic risk