Security and Portfolio Analysis AND Portfolio Theory and CAPM Flashcards
what is the expected return of a security
the expected return (mean return) =
A forward looking return - investors expectations - possibility and possible outcomes of each event = probability distribution
How is expected return calculated when returns offered by a stock follow a particular probability distribution?
the expected return (mean) is calculated as a weighted average
How can you measure the risk of a security (uncertainty)
variance and standard deviation
what is realised return
The realised return is the return that actually occurs over a particular time period
What is covariance
Measures the extent to which the returns on two stocks co-move
When calculation portfolio risk and return. What does it mean when you get +1, 0 and -1
+ 1 Perfect positive correlation - risk reduction impossible through diversification
0 No correlation - Risk reduction possible through diversification
-1 Perfect negative correlation - risk reduction impossible through diversification
What is the expected return definition
The expected return on a portfolio id simply a weighted average of the expected returns on the individual securities
What is an efficient portfolio (frontier)
the portfolio that lies on the efficient frontier (it offers the lowest risk for its expected return and the highest expected return for its level of risk)
What is the best risk and return tradeoff
Combinations of the risk-free asset and tangent efficient portfolio TEP
Every investor should invest in the TEP independent of their taste for risk
What are the assumptions for investing between risk-free asset and TEP
Borrowing rate = lending rate
In reality borrowing rate is usually higher than lending
what happens when the interest changes
capital maket line CML and tangent efficient portfolio TEP shift as risk-free interest rate changes
According to research what is the ideal number of securities to gain the most from diversification
10-15
What is market (systematic) risk
the risk that remains in the portfolio
what is unique (unsystematic) risk
the risk that can be eliminated through diversification
How can you measure the contribution of an individual security to the risk of a well diversified portfolio
Beta
What is the difference between beta and s.d.
s.d. measures the total risk of the stock in isolation
Beta measures the market risk of a stock relative to the market portfolio
What is the CAPM
in a competitive market the expected risk premium varies in direct proportion to beta
What can CAPM be used for in practice
- Give an estimate of the expected return on equity
2. Find a discount rate for a new capital investment
Can we fully accept CAPM as a theory
Return does increase with beta, but the difference between the high-beta stocks and low-beta ones is not as great as CAPM predicts
CAPM is concerned with EXPECTED returns but we can only observe ACTUAL returns
Its hard to reject CAPM but empirical research has provided some alternative theories such as arbitrage theory pricing ABT
what are arbitrage pricing theory assumptions
Stock’s return depends on factors and noise
Factors - pervasive macroeconomic influences, not specifies, but possible factors may include GDP, inflation, exchange rates, market and size
Noise - Events that are unique to the company
What are the steps for Fama French Three factor model
- To identify a short-list of macroeconomic factors that could affect stock return
- To estimate the expected risk premium on each of the factors
- To measure the sensitivity of each stock on the factors by regression analysis
WHat is the market factor
return on market indec - risk free interest rate
what is the size factor
return on small-cap stocks - return on large cap stocks
What is book-to-market factor
return on stocks with high BTM ratio - return on stocks with low BTM ratio
