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Old CFA A Most Important Concepts per Study Session > Study Session 18 - Portfolio Management > Flashcards

Study Session 18 - Portfolio Management Flashcards

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1
Q

What are the main assumptions of mean-variance analysis?

A
  1. Investors are risk averse
  2. Statistical inputs (mean returns, variances, covariances) are known
  3. Investors make all portfolio decisions based solely on means, variances and covariances
  4. Investors face no taxes or transaction costs
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2
Q

How do you calculate the expected return for a 2 asset portfolio?

A
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3
Q

How do you calculate the variance of a 2 asset portfolio?

A
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4
Q

How do you calculate the correlation between 2 assets?

A
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5
Q

What are the efficient portfolios ?

A
  • Minimum risk of all portfolios with the same expected return
  • Maximum expected return for all portfolios with the same risk
             \*\*\*\*\*\*ie ----the one offering the highest expected return for a given level or risk as measured by variance or standard deviation of return\*\*\*\*
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6
Q

What are the two things that affect portfolio diversification ?

A
  • Correlations between assets
  • Numbers of assets included in the portfolio
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7
Q

What is the formula to calculate the variance of an equally weighted n - asset portfolio ?

A

σ2i = average variance of all assets in the portfolio

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8
Q

What is the** Capital Allocation Line **?

A

the risk-return line that lies tangent to the efficient frontier.

***It is the Markowitz’s effecient frontier + Rf

**It describes the expected results of the investor’s decision on how to optimally allocate her capital among risky and risk free assets***

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9
Q

How is the reward-to-risk ratio (i.e. Sharpe Ratio ) calculated ?

A

Can be viewed as the expected risk premium for each unit of risk

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10
Q

What is the equation to calculate the Capital Allocation Line (CAL) ?

A

**** E(Rt) is the expected return for the market

*** the middle part of the equation is a Sharpe ratio of the market.

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11
Q

What is the Capital Market Line (CML) ?

A

The capital allocation line in a world in which all investors agree on the expected returms, standard deviations, and correlations of all assets

**** The “homogeneous expectations” assumption

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12
Q

Under assumption of the CML, what is the market portfolio?

A
  • The optimal risky portfolio
  • Defined as the portfolio of all marketable assets, weighted in proportion to their relative market values.
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13
Q

What is the equation for the CML?

A
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14
Q

What are the differences between the CML and CAL ?

A
  • There is only one CML b/c it is developed assuming assuming all investors agree on the expected return, standard deviation and correlations of all assets
  • There is an unlimited number of CALs because one is developed uniquely for each investor
  • The tangency portfolio for the CML is the market portfolio. There is only one market portfolio.
    The tangency portfolio for the CAL can differ across investors based on their expectations
  • The CML is a special case of the CAL
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15
Q

In general terms, what does the CAPM tell us?

A

It provides a way to calculate an asset’s expected return based on its level of systematic (i.e. market related) risk

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16
Q

What are the underlying assumptions of CAPM?

A
  1. Investors only need to know expected returns, variances and covariances in order to create optimal portfolios
  2. All investors have the same forecasts of risky assets’ expected returns, variances and covariances
  3. All assets are marketable, and the market for assets is perfectly competitive
  4. Investors are price takers and their buy and sell decisions have no effect on asset prices
  5. Investors can borrow and lend at the risk free rate, unlimited short selling is allowed
  6. There are no frictions to trading, such as taxes or transaction costs
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17
Q

What are the 4 implications of CAPM?

A
  1. Systematic risk, measured by beta, is the only risk priced by the market.
  2. The security master line (SML), which is the graph of CAPM, describes the relationship between the expected return and risk for all assets
  3. Because all investors hold the same risky portfolio, the weight on each asset must be equal to the proportion of its market value to the MV of the entire market portfolio
  4. B/c investors have the same expectations and use mean-variance analysis, they all identify the same risky tangency portfolio
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18
Q

What is the equation for the Security Master Line (SML) ?

A

**The CAPM equation***

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19
Q

What is the formula for calculating beta?

A
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20
Q

What are the three methods of obtaining inputs to the mean-variance framework?

A
  1. Using historical means, variances and covariances
  2. Estimating betas using the market model
  3. Calculating adjusted betas
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21
Q

What is the premise of the market model ?

A

***Describes a regresssion relationship between the returns of an asset and the returns on the market portfolio***

That there are just two sources of risk

  1. Unanticipated macroeconomic events (systematic risk)
  2. Firm-specific events (unsystematic risk)
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22
Q

What is the equation to calculate the market model?

A
23
Q

What are the 3 assumptions that the market model makes?

A
  1. The expected value of the error term is zero
  2. The errors are uncorrelated with the market return
  3. The firm-specific surprises are uncorrelated across assets
24
Q

What are the 3 kinds of Multifactor models?

A
  1. Fundamental Factor Models
  2. Macroeconomic factor models
  3. Statistical factor models
25
Q

The Arbitrage Pricing Theory (APT) refers to an asset pricing theory that assumes these 3 things:

A
  1. Returns are derived from a multifactor model
  2. Unsystematic risk can be completely diversified away
  3. No arbitrage opportunities exist
26
Q

An investment firm employs a two-factor APT model. The risk-free rate equals 5%. Determine the expected return for the Invest fund using the following data:

A
27
Q

What is Active Risk and how is it calculated?

A

***Is the standard deviation of active returns

28
Q

Describe what the Information Ratio is and how is it calculated?

A

** Shows a manager’s consistency in generating active return

We standardize average active return by dividing it by its standard deviation.

29
Q

Explain in a quick sentence what each of these 5 things are:

  1. Minimum Variance Frontier
  2. Efficient Frontier
  3. Capital Allocation Line (CAL)
  4. Capital Market Line (CML)
  5. Security Market Line (SML)
A
  • Minimum Variance Frontier - a graph of the expected return/variance combinations for all minimum variance portfolios
  • Efficient Frontier - Plot of expected return & risk combinations of all efficient portfolios, all of which lie on the upper portion of the minimum variance frontier
  • Capital Allocation Line - describes the combinations of expected return and standard deviation of return available to an investor from combining her optimal portfolio of risky assets with the risk-free asset.
  • Capital Market Line - is a kind of CAL, where all investors agree on 1 market portfolio & investors make optimal investment decisions by allocating between the RF rate and the market portfolio
  • Security Market Line - a graph of the CAPM equation, which describes the relationship between expected return and systematic risk
30
Q

Calculate the variance of this equally weighted portfolio:

100 assets

avg variance = 0.15

avg covariance = 0.09

A
31
Q

Define what alpha (residual return) is ……

A

The return of a portfolio in excess of its benchmark (adjusted for risk difference between the portfolio and benchmark)

***i.e. excess risk adjusted return

32
Q

In general terms, what is the information ratio?

A

Is a ratio of (annualized) residual return to (annualized) residual risk.

33
Q

How is the information ratio calculated?

A

**The notion of success is captured and quantified by the IR. The IR says how good you think you are***

34
Q

Since the information ratio can be viewed as a budget constraint, what is the only way a manager can increase their active return?

A

By increasing residual risk

a = IR * w

35
Q

Define what **Value Added **is ….

A

A metric that measures the tradeoff between active return and active risk

36
Q

What is the formula to calculate Value Added if given the residual return?

A

**** Return and risk figures should be in % form, not decimal**

37
Q

What is the formula to derive the implied level of risk aversion when given information ratio and optimal level of residual risk?

A
38
Q
A
39
Q

How can Value Added (VA) be calculated if given the information ratio and level of risk aversion?

A
40
Q

How can Value Added (VA) be calculated if given the information ratio and the optimal level of residual risk?

A
41
Q

How do you calculate Value Added when given the follow pieces of information?

A
42
Q

What does the Information coefficient (IC) measure?

A

A manager’s forecasting accuracy.

Is measured as the correlation of a manager’s forecasts with actual outcomes.

43
Q

What is **Breadth (BR) **?

A

The number of independent forecasts of exceptional return per yr that the manager makes.

44
Q

The fundamental law of active management says the formula to calculate the information ratio is what?

A
45
Q

How do you calculate the optimal level of residual risk given the information coefficient (IC),risk aversion and breadth?

A
46
Q

How do you calculate the Value Added given the information coefficient (IC) and breadth?

A
47
Q

Given the number of bets made by a manager, how can the information coefficient (IC) be calculated?

A
48
Q

Explain the importance of the portfolio perspective…..

A

That investors, analysts, and porfolio managers should analyze the risk-return tradeoff of the portfolio as a whole, not the risk-return tradeoff of the individual investments in the portfolio.

49
Q

What are the steps of the portfolio management process?

A
  1. Planning
  2. Execution
  3. Feedback
50
Q

What are investment objectives?

A

Specific and measurable desired performance outcomes

**The two types are risk and return**

51
Q

What are risk objectives?

A

Those factors associated with an investor’s willingness and ability to take risk.

Risk tolerance means ability to accept risk

Risk aversion means an unwillingness to take risk

52
Q

What are the 5 main investment constraints?

A
  1. Liquidity constraints
  2. Time horizon constraints
  3. Tax constraints
  4. Legal and regulatory factors
  5. Unique circumstances
53
Q

Diversification can reduce:

A) systematic risk.
B) macroeconomic risks.
C) unsystematic risk.

A

Old CFA A Most Important Concepts per Study Session (6 decks)

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