Strategic asset allocation

Question 1

Recap: Diversification

• Market risk
• Firm-specific risk

Answer 1

Market risk
•Risk that is attributable to marketwide risk sources and remains even after extensive diversification
•Also called systematic or nondiversifiable

Firm-specific risk
•Risk that can be eliminated by diversification
•Also called diversifiable or nonsystematic

Question 2

Recap: Portfolio diversification

Answer 2

Portfolio risk (variance) depends on the correlation between the returns of the assets in the portfolio

•Covariance and the correlation coefficient provide a measure of the way returns of two assets move together (covary)

Question 3

minimum variance portfolio

Answer 3

The minimum variance portfolio is the portfolio composed of risky assets that has the smallest standard deviation: the portfolio with the least risk

•The amount of possible risk reduction through diversification depends on the correlation:

•If r = +1.0, no risk reduction is possible
•If r = 0, σP may be less than the standard deviation of either component asset
•If r = -1.0, a riskless hedge is possible
The Minimum Variance Portfolio (MVP

Question 4

Capital Asset Pricing Model (CAPM)

Answer 4

• It is the equilibrium model that underlies all modern financial theory
• Derived using principles of diversification with simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin are researchers credited with its development

Question 5

CAPM Assumptions

Answer 5

–Investors aim to maximize economic utilities and have homogenous expectations
•All investors optimize portfolios a la Markowitz
•Investors are price takers and share the same information at the same time
•Investors use identical input list for the efficient frontier
–Same risk-free rate, tangent CAL and risky portfolio
–Market portfolio is aggregation of all risky portfolios and has the same weights
•No frictions: assets are divisible and liquid, no trading costs, taxes, or capital constraints

Question 6

Equilibrium Conditions

Answer 6

•All investors will hold the same portfolio of risky assets – that is the market portfolio
–Market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value.
•All investors hold the combination of the market portfolio and the risk free rate, where the proportions depend on their risk aversion

Question 7

Extensions of the CAPM

Answer 7

Zero beta CAPM: no risk free asset
•Multi-period CAPM
•Consumption based CAPM
•Liquidity CAPM
•...

Question 8

Liquidity and the CAPM

Answer 8

•Liquidity: the ease and speed with which an asset can be sold at fair market value
Illiquidity Premium: discount from fair market value the seller must accept to obtain a quick sale.
–One measure is the bid-ask spread
–As trading costs are higher, the illiquidity discount will be greater.

Question 9

Multifactor models

Answer 9

for security i
ßGDP = Factor sensitivity for GDP
ßIR = Factor sensitivity for Interest Rate
ei = Firm specific events
•The expected return on a security is a sum of
1.The risk-free rate
2.The sensitivity to GDP times the risk premium for bearing GDP risk
3.The sensitivity to interest rate risk times the risk premium for bearing interest rate risk
..iiIRiGDPii
.
ieIRGDPR
iGDPi
iGDPiieIRGDP

iIRiGDPiieIR
eIR
e

Question 10

APT & well-diversified portfolios

Answer 10

RP = E (RP) + bPF + eP
F = some factor

•For a well-diversified portfolio, eP
–approaches zero as the number of securities in the portfolio increases
–and their associated weights decrease

Question 11

APT

Answer 11

• Assumes a well-diversified portfolio, but residual risk is still a factor.
• Does not assume investors are mean-variance optimizers.
• Uses an observable, market index
• Reveals arbitrage opportunities

Question 12

CAPM

Answer 12

• Model is based on an inherently unobservable “market” portfolio.
• Rests on mean-variance efficiency. The actions of many small investors restore CAPM equilibrium.

Question 13

Two-Factor Model

Answer 13

•The multifactor APT is similar to the one-factor case.
•Track with diversified factor portfolios:
–We do not observe factors but can construct portfolios that mimic their behavior
–beta=1 for one of the factors and 0 for all other factors.
•The factor portfolios track a particular source of macroeconomic risk, but are uncorrelated with other sources of risk.
𝑅𝑖=𝐸 𝑅𝑖 +β𝑖1𝐹1+β𝑖2𝐹2+𝑒𝑖

Question 14

Investment styles

Answer 14

Small vs. large cap
Value vs. growth
High vs. low risk
Foreign vs. domestic

Question 15

Measurement Error in Beta

Answer 15

•Problem: if beta in the first stage is measured with error, then the slope coefficient of the second regression equation will be biased downward and the intercept biased upward.
•Solution: construct P with large dispersion of beta. Then, by ranking them, they yield insightful tests of the SML
–Fama and MacBeth procedure
–Using individual assest instead