Security and Portfolio Analysis AND Portfolio Theory and CAPM

Question 1

what is the expected return of a security

Answer 1

the expected return (mean return) =
A forward looking return - investors expectations - possibility and possible outcomes of each event = probability distribution

Question 2

How is expected return calculated when returns offered by a stock follow a particular probability distribution?

Answer 2

the expected return (mean) is calculated as a weighted average

Question 3

How can you measure the risk of a security (uncertainty)

Answer 3

variance and standard deviation

Question 4

what is realised return

Answer 4

The realised return is the return that actually occurs over a particular time period

Question 5

What is covariance

Answer 5

Measures the extent to which the returns on two stocks co-move

Question 6

When calculation portfolio risk and return. What does it mean when you get +1, 0 and -1

Answer 6

+ 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

Question 7

What is the expected return definition

Answer 7

The expected return on a portfolio id simply a weighted average of the expected returns on the individual securities

Question 8

What is an efficient portfolio (frontier)

Answer 8

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)

Question 9

What is the best risk and return tradeoff

Answer 9

Combinations of the risk-free asset and tangent efficient portfolio TEP

Every investor should invest in the TEP independent of their taste for risk

Question 10

What are the assumptions for investing between risk-free asset and TEP

Answer 10

Borrowing rate = lending rate

In reality borrowing rate is usually higher than lending

Question 11

what happens when the interest changes

Answer 11

capital maket line CML and tangent efficient portfolio TEP shift as risk-free interest rate changes

Question 12

According to research what is the ideal number of securities to gain the most from diversification

Answer 12

10-15

Question 13

What is market (systematic) risk

Answer 13

the risk that remains in the portfolio

Question 14

what is unique (unsystematic) risk

Answer 14

the risk that can be eliminated through diversification

Question 15

How can you measure the contribution of an individual security to the risk of a well diversified portfolio

Answer 15

Beta

Question 16

What is the difference between beta and s.d.

Answer 16

s.d. measures the total risk of the stock in isolation

Beta measures the market risk of a stock relative to the market portfolio

Question 17

What is the CAPM

Answer 17

in a competitive market the expected risk premium varies in direct proportion to beta

Question 18

What can CAPM be used for in practice

Answer 18

1. Give an estimate of the expected return on equity

2. Find a discount rate for a new capital investment

Question 19

Can we fully accept CAPM as a theory

Answer 19

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

Question 20

what are arbitrage pricing theory assumptions

Answer 20

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

Question 21

What are the steps for Fama French Three factor model

Answer 21

1. To identify a short-list of macroeconomic factors that could affect stock return
2. To estimate the expected risk premium on each of the factors
3. To measure the sensitivity of each stock on the factors by regression analysis

Question 22

WHat is the market factor

Answer 22

return on market indec - risk free interest rate

Question 23

what is the size factor

Answer 23

return on small-cap stocks - return on large cap stocks

Question 24

What is book-to-market factor

Answer 24

return on stocks with high BTM ratio - return on stocks with low BTM ratio