Topic 1 - Review

Question 1

Beta formula

Answer 1

= Covariance / Mkt Vol^2

or = covariance * sd of risk free return / sd of market return

Question 2

Expected return formula

Answer 2

= (Beta)(expected mkt return – RFR) + RFR

Question 3

Sharpe ratio formula

Answer 3

= (Expected return – RFR) / StD
= risk premium of asset / asset volatility

• how much expected return combo gives for given level of risk
• slope of line denoting the combo of risk-less rate and risky security

Question 4

Modern Portfolio theory

Answer 4

for risky assets, maximize return for a given level of risk, OR minimize risk for a given level of return

• does NOT say that with risk, you can expect return
• creates efficient frontier/mean-variance frontier (frontier of risky assets)
• gives specific way of putting assets into portfolios that theoretically minimizes risk/maximizes reward

Question 5

why is Beta, expected return, and sharpe ratio important for impact investing?

Answer 5

bc we consider all investments would be part of a diversified portfolio

Question 6

distribution of returns

Answer 6

characterize shape of distribution of returns with:

• expected value (central tendency, mean/ave)
• SD or variance (dispersion)
• skewness (asymmetry)
• kurtosis (how heavy tails are relative to center)

Question 7

standard deviation

Answer 7

dispersion; how spread-out the distribution is
shows volatility, deviation
square root of variance
higher SD = higher expected return
higher volatility impacts downside more

Question 8

compound annual rate of return????

Answer 8

downside negative returns strongly impact what you end up holding; its a fxn of volatility drag

volatility = higher volatility impacts downside more
Ex. start $100, lose 50%, gain 50% =
arithmetic ave is 0 and you’re holding 75 cents on the dollar

Ex. start $100, lose 10%, gain 10%=
arithmetic ave is still 0 and you’re holding 99 cents on the dollar

Question 9

average annual return

Answer 9

simple arithmetic average

helps us estimate expectations

Question 10

MVP

Answer 10

minimum variance portfolio

on frontier of risky assets (furthest most to the left portfolio, before frontier goes convex)

Question 11

capital allocation lines

Answer 11

• risky asset + riskless T bill
• we like higher slopes of CAL (indicates higher Sharpe ratio; maximizing sharpe ratio makes it tangent to the efficient frontier)
• Capital market line = most optimal CAL; optimal location for investments

Question 12

riskless asset

Answer 12

no asset is truly risk free, but use ST T bill
(90 day T-Bill; Fed funds overnight rate)
return you can get with theoretically no risk

Question 13

beta

Answer 13

• market/systematic exposure and a measure of market risk of an investment, related to corr to market
• expected mvmt in an investment vs market
• most investors pay too much for beta that’s too high
• how much variation in the market contributes to variation in an asset’s return

Question 14

alpha

Answer 14

• value-added accounting for market/systematic risk (holding risk constant, how much do you outperform market)
• for PM, a measure of investment skill
• pure alpha has v high Sharpe ratio
• most long only managers have negative alphas (destroying value) bc of fees

Question 15

active mgmt seeks…

passive mgmt seeks…

Answer 15

alpha (bc ascribed to skill of manager)

beta of some portfolio like S&P500

Question 16

Brinson, Hood, Beebower (Determinants of portfolio performance)

Answer 16

explained concept of diversification; asset class selection and diversification are key to optimal returns of a portfolio

important for impact investing bc for some assets in impact investing, you can get additional risk exposures for additional diversification in an otherwise well-diversified portfolio

• investment policy drives largest portion of risk
• timing and selection on ave actually destroyed value
• asset class selection (beta selection) drives performance