Section III.A.

Question 1

What are the Key MPT Assumptions?

Answer 1

Normal return distributions
Fixed asset correlations
Investors are rational
Investors are risk-averse
Risk is known and constant
All information is public
No taxes or transactions costs

Question 2

Key Aspects of MPT

Answer 2

• Return vs. Risk
• Mean Variance Optimization (MVO)
• Efficient Frontier
• How portfolios may be constructed
  from this methodology (portfolio
  construction)

Question 3

Return vs. Risk

Answer 3

*Risk measured as standard deviation

*Return (absolute vs. relative)

*Risk adjusted returns

Question 4

Market Risk Premium

Answer 4

Question 5

Mean Variance Optimization - Inputs Necessary?

Answer 5

Security’s expected returns
Expected risk
Expected cross-security correlations

Question 6

Portfolio optimization (including MVO) involves a mathematical procedure called quadratic programming. Which two objectives are considered?

Answer 6

To maximize return and minimize risk

Question 7

What is the Efficient Frontier?

Answer 7

a set of optimal portfolios with the highest expected return for a set (or defined) amount or risk as measured by standard deviation

Question 8

Portfolio Construction

Answer 8

• Theoretically (using MPT as a foundation) it is possible to build efficient portfolios if your primary
  goal is to optimize risk adjusted returns.
• You may maximize returns for a given level of risk or you may minimize risk for a target amount of return.

Question 9

Capital Allocation Line (CAL)

Answer 9

• The CAL is sometimes called the Capital Asset Line
• Defined: this line represents all possible combinations of risk free and risky assets; represents possible returns by taking on different levels of risk
• Different from the Capital Market Line (CML)
• Different from the Securities Market Line (SML)

Question 10

What are the criticisms of MPT?

Answer 10

Challenging MPT Assumptions:

Investment returns are not normally distributed

Asset correlations are not fixed

Investors are not rational

Investors are not exclusively risk-averse

Risk is not known and constant

All information is not publicly known

Taxes and transactions costs are real

Question 11

What is the Sharpe Ratio?

Answer 11

Question 12

What is the “Kinked” CAL?

Answer 12

The so-called “kink” in a Capital Allocation Line indicates that:

a. leverage is being used, and

b. the rate to borrow exceeds the lending rate

Question 13

What are “positive diversification effects”?

Answer 13

Question 14

What is the Brinson Beebower & Hood study?

Answer 14

1986 study of 91 of the largest pension funds

Conclusion: regarding the determinants of portfolio performance:

– Asset allocation is the primary determinant of a portfolio’s return variability
–Security selection and market timing played only a minor role in portfolio performance

Question 15

What is the Black-Litterman Model?

Answer 15

Question 16

What is Efficient Market Hypothesis (EMH)?

Answer 16

*EMH says stock prices already reflect all available information

• A forecast about favorable future performance leads to favorable current performance, as market
  participants rush to trade on new information.
  –Result: Prices change until expected returns are exactly commensurate with risk.

Question 17

What are the versions of EMH?

Answer 17

• Weak
• Semi-strong
• Strong

Question 18

What is the “Weak Form” of EMH?

Answer 18

*claims that past price movements and volume do not impact prices

• technical analysis is not beneficial
• fundamental analysis can add value

Question 19

What is the “Semi-Strong Form” of EMH?

Answer 19

• claims all public information is reflected in a stock’s current price
• states that neither technical nor fundamental analysis can add value

Question 20

What is the “Strong Form” of EMH?

Answer 20

• claims all public and private
  information is reflected in a stock’s current price
• states that not even insider information can add value (i.e., produce outperformance)

Question 21

What is Fundamental Analysis?

Answer 21

using economic and accounting information to predict stock prices

– Try to find firms that are better than everyone else’s estimate.
– Try to find poorly run firms that are not as bad as the market thinks.
– Semi strong form efficiency and fundamental analysis

Question 22

What is CAPM?

Answer 22

• a theoretical model that attempts to explain the relationship between risk and expected return
• the model holds that investors should be compensated for both the time value of money and risk taken
• the CAPM formula allows one to calculate the expected return of an asset = (risk free rate) +
  (market risk premium times the beta of the asset)

Question 23

What is Systematic (Market Risk)?

Answer 23

• also called “market risk” and “non
  diversifiable risk”
• systematic risk is the inherent risk that comes from having exposure to the overall market
• MPT suggests that systematic risk cannot be mitigated through diversification

Question 24

What is Non-Systematic (Idiosyncratic) Risk?

Answer 24

• also called “diversifiable” or “unsystematic risk “
• this risk refers to factors that may affect one asset or investment but not another
• MPT suggests that this risk may be mitigated through diversification

Question 25

What is the Security Market Line (SML)?

Answer 25

* the SML is a graphical expression of the CAPM * the slope of the SML represents the market risk premium

Question 26

What does the SML look like Graphically?

Answer 26

Question 27

What is Arbitrage Pricing Theory (APT)?

Answer 27

* seeks to explain security returns beyond the usual metrics by introducing risk factors such as expected return, sector and systematic factors * while far more expansive than CAPM given the flexibility of the model, it is limited in accuracy because it cannot measure unanticipated changes in the variables

Question 28

What are Arbitrage Pricing Theory Assumptions?

Answer 28

* Does not require an expected market return. * Uses the asset’s expected return and the risk premium of a number of macro economic factors. * Arbitrageurs use APT to buy underpriced assets and short those that are overvalued.

Question 29

APT and CAPM?

Answer 29

APT * Equilibrium means no arbitrage opportunities. * APT equilibrium is quickly restored even if only a few investors recognize an arbitrage opportunity. * The expected return beta relationship can be derived without using the true CAPM * Model is based on an inherently unobservable “market” * Rests on mean variance efficiency. The actions of many small investors restore CAPM equilibrium. * CAPM describes equilibrium for all assets.

Question 30

APT Application

Answer 30

Challenges MPT - Can’t predict asset returns using the relationship between the same asset and many common risk factors - Predicts asset returns through a linear combination of many different independent macro economic variables

Question 31

APT Model

Answer 31

* APT applies to well diversified portfolios and not necessarily to individual stocks. * With APT it is possible for some individual stocks to be mispriced not lie on the SML. * APT can be extended to multifactor models.

Question 32

Fama-French Three Factor Model

Answer 32

* Market (aka: equity) premium * Size and book to market ratios explain returns on securities. * High book to market firms experience higher returns (value * Smaller firms experience higher returns.

Question 33

What is Momentum: a Fourth Factor?

Answer 33

* The original Fama French model augmented with a momentum factor has become a common four factor model used to evaluate abnormal performance of a stock portfolio. * Winners minus losers (WML) winners/losers based on past returns.

Question 34

Optimal Portfolios and Non Normal Returns

Answer 34

* Fat tailed distributions can result in extreme values of VaR (value at risk) and ES (expected shortfall) and encourage smaller allocations to the risky portfolio. * If other portfolios provide sufficiently better VaR and ES values than the mean variance efficient portfolio, we may prefer these when faced with fat tailed distributions.

Question 35

The Minimum Variance Portfolio?

Answer 35

* The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk. * When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets. * When correlation is -1, the standard deviation of the minimum variance portfolio is zero.

Question 36

What are we looking for with Minimum Variance Portfolio?

Answer 36

What we're looking for is the mix of assets that provides the smallest variance or standard deviation. In the case of two assets that are perfectly negatively correlated (i.e., Corr Coeff = - 1), we know that the standard deviation of the minimum variance portfolio is zero. In other words, because these two assets are perfectly negatively correlated, we can combine A & B in the right mix such that there is no variance and a fixed return (i.e., risk free return) is provided. (Page 628)

Question 37

What is Semi-Variance (downside deviation)?

Answer 37

* a measurement of dispersion measures data that is below the mean or target value of a data set * considered a better measurement of downside risk * semi variance is the average of the squared deviations of all values less than the average or mean

Question 38

What is Value-at-Risk (VaR)?

Answer 38

* Defined: – VaR is a measure of risk that quantifies potential loss (e.g., $1 million), the probability of the potential loss (e.g., 3%), and the time frame for potential loss (e.g., three months) * Assumes market to market pricing, no trading, and normal market conditions. * A measure of loss most frequently associated with extreme negative returns * VaR is the quantile of a distribution below which lies q % of the possible values of that distribution – The 5% VaR , commonly estimated in practice, is the return at the 5 th percentile when returns are sorted from high to low

Question 39

What is Expected Shortfall (ES)?

Answer 39

* Also called conditional tail expectation (CTE) * More conservative measure of downside risk than VaR – VaR takes the highest return from the worst cases – ES takes an average return of the worst cases

Question 40

What is Sortino Ratio?

Answer 40

* a risk adjusted measure of return that uses downside volatility (semi standard deviation) to measure risk * unlike the Sharpe ratio, Sortino only uses negative returns in the calculation to measure downside risk * considered a more effective way to than other ratios to measure high volatility portfolios