Risks, Std Deviation, Investment Theories Flashcards
What is risk and how is it measured?
- Risk = Volatility
The two main measures are: - Standard deviation (MPT)]
- BETA (CAPM)
Describe what standard devaition is.
- Measure of volatility
- Shows how widely the actual annual return on an investment varies around the expected return
- Low standard deviation = investment stays close to it’s expected return
- High standard deviation = returns fluctuate widely
- Greater the standard deviation the more volatile and risky the investment.
Explain the x axis for standard deviation
- One standard deviation away from the mean in either direction on the horizontal axis (the red area) accounts for around 68% of the returns
- Two standard deviations away from the mean (the red and green areas) account for roughly 95% of the returns
- Three standard deviations (the red, green and blue areas) account for about 99% of the returns
How do you calculate the standard deviation?
- Calculate the mean return
- Subtract mean from perforamnce and square root the results
- Calculat mean of all the results to get the variance
- SD = square root of variance
Describe what is meant by beta?
- Beta is used to measure the volatility of an investment compared to the market average
- If an investment moves exactly in line with the market, then it will have a Beta of 1 Beta of 0.8 means that in investment rises and falls at a slower rate than the market, hence is less volatile and hence is less volatile – less risky.
- If an investment has a beta of 1.2 then it is higher risk and you would expect a higher reward in return.
- The higher the Beta, the higher the risk, in comparison to the market
Describe what is meant by correlation
- Correlation is a number between +1 and -1.
- The most effective diversification comes from combining investments that are negatively correlated.
To reduce risk further, how also could you diversify?
- Asset classes
- Equities within asset classes, large / small, industries, sectors, blue chip / aim
- Geographical – UK / overseas.
What are the key assumptions to the modern portfolio tehory?
Key assumption:-
* Investors risk averse……
* choose a less risky investment…
* of two offering same return
Illustrate and describe the efficent frontier
Explain the Capital Asset Pricing Model (CAPM)
- Calculates expected return which investor should receive for given level of
- risk
- Assumes investors are well diversified - no specific / unsystematic risk
Introduces new concepts:
* Risk free rate of return
* Market return.
- An individual security’s sensitivity to systematic risk is referred to as it’s Beta (β) - The market, by definition, has a Beta of 1.
What is the CAPM formula?
ERi = Rf + [ßi(Rm- Rf )]
ERi = Expected return to the investment/portfolio
Rf = Risk free rate of return
ßi = Beta of the investment/portfolio
Rm = Return of the market
Expected Return = Risk free return + (Beta x (Expected market return – Risk free return {TB}))
What are the assumptions of the CAPM model?
- Investors are rational and risk averse
- Investors make decisions on risk and return alone
- All investors have the same holding period
- Market has many buyers and sellers
- No one individual can affect the market price
- There are no taxes, costs or restrictions on shorting
- Information is free and simultaneously available to all
- Unlimited funds can be borrowed or lent by all investors at the risk-free rate.
In the AF4 exam, you might be given the expected return of the share / fund and be expected to calculate the market return instead……
{ERi– Rf } + Rf = Rm
ßi
Explain the arbitarge pricing theory
- CAPM is a single factor model – price is solely dependent on the security’s relationship to the market measured by beta
- APT states risk premium is based on a number of independent factors i.e. multi factor
- Can be market or industry related
- Can include macroeconomic variables e.g. Interest rates, inflation, industrial production
- Each factor taken into account and extent risk will affect that security.
- PROBLEM? – have all relevant factors been included!
What are the main limitations of CAPM?
- Studies have shown that not all non-systematic risk can be eliminated through diversification
- Betas are historic and can be unreliable
- Two academics, Eugene Fama and Kenneth French studied the historic return on US stocks to that expected under CAPM and found no relation.
