Topic 3 - Critically Evaluate Portfolio Theory Flashcards
What is Capital Market Theory and how does it work?
The risk of holding securities A and B in isolation is given by their respective standard deviation of returns.
However, by combining the same assets in the same two-asset portfolio in different proportions, the portfolio’s standard deviation of return will be lower (assuming that the two assets do not have the same standard deviation) than the weighted average aggregation of the standard deviations of the two individual securities.
Define Diversification?
How can diversification potential be measured?
A reduction in risk for a given level of expected return is known as diversification. Diversification potential of combined securities can be measured using Correlation or Convariance.
What is the difference between systematic and non-systematic risk?
Systematic risk - Market risk that cannot be diversified away. E.g Black Monday - October 19th, 1987
- Domestic and Foreign Policy
- Taxation
- Global Security Threats
- Socio-economic changes
Non-systematic risk - Risk that is associated with a specific stock, which can be diversified away
- Pricing
- Marketing
- Product Type
- Research and development
What is the Capital Asset Pricing Model?
What is it used for?
- Pricing model based on relationship between risk and expected returns.
- It states the expected return on security/portfolio is same as the rate on risk-free security plus the risk premium.
- Risk is defined so allows to establish price to pay for the asset and returns expected.
- If expected returns not met then investment should be avoided.
- Essentially, a financial planner should generate return higher than risk-free based return to jusitfy active management fee that the investor is paying
What are the assumptions of the Capital Asset Pricing Model?
- All market participants borrow and lend at the same risk-free rate;
- All market participants are well-diversified investors & non-systematic risk is diversified away;
- No tax or transaction costs to consider;
- All market participants want a maximum return for minimum risk or at least minimise their losses;
- Market participants have the same expectations about the returns and standard deviations of all assets and act in a rational way.
What are the principles of the Capital Asset Pricing Model?
- Investors want a return in excess of the risk-free rate to allow for systematic risk;
- Systematic risk cant be diversified away, so investors should not expect or require a premium to compensate for it;
- Systematic risk varies between companies, so investors will require a higher return from shares where the systematic risk is greater.
What is the formula for CAPM?
- Risk Free Rate = 3%
- Beta = 1.2%
- Expected Market Return = 9%
Return = Risk Free Rate + Beta ( Expected Market Return - Risk Free Rate)
Return = 3% +1.2% x (9% - 3%) = 10.2%
Order of Calculation = 9% - 3% = 6% x 1.2% = 7.2% + 3% = 10.2%
Can also be used to discount cash flow to determine true cost of the share. However, can also use the arbitrage pricing theory and Multi Factor Models.
Define what a Derivative is?
Financial instrument that derives its value from an underlying value of another asset. Underlying asset can be anything.
What are the uses of derivatives?
What types of derivative strategies are there?
What types of derivatives are there?
Hedge Risk - Wheat Producers and Cereal Manufactuers hedging risk against price fluctuations. Can enter into contract fixing future price at which wheat will be sold such as £12 in 6 months.
Speculating - Motivated by profit and not to mitigate risk.
Derivative Strategies
- short calls
- long calls - Want price to rise. Provides insurance against short positions.
- long puts - Want price to fall
- short puts
Derivative Types:
- Forwards
- Customised contract to buy/sell asset at specified price at specified date. Not standardised or regulated so good for hedging.
- Futures
- Similar to forwards but these are standardised and regulated so can be traded on futures exchange. Often used to speculate on commodiites.
- Options
- Contract that gives the right but not the obligation to buy or sell/ call or put a security
- Swaps
- Exchange of security for another based on different factors.
Correlation Coefficient Limitations
May not be wholly reliable if:
- Data size is small
- Data represents frequent or extreme data outliers
- Correlation is not always causation. The relationship may be coincidental or based on third party or unknown variable.
- Correlation Coefficients are prone to change especially at times of severe economic stress where you will see correlation compression
What is Convariance?
How is it calculated?
Measure relationship of two variables
Standard deviation of 1st share X Standard Deviation of 2nd share X Correlation Coefficient.
- Positive convariance = move in same direction
- Negative convariance = Moved inversely
What is the difference between Correlation and Convariance?
Correlation can take values between +1 and -1
Convariance can take any value.
Therefore Convariance is not too meaningful, it tells whether it is historically positive or negatively correlated. Correlation coefficient tells how positively or negatively correalted tow assets are.
What is Absolute Return and how is it used in evaluation the return on a portfolio?
Measures the return of a portfolio against a risk specturm
What is Beta?
What is the Beta of standard market return?
How is Beta measured and what does it mean for stocks?
- Beta is measure of stock volatility in relation to market.
- Measure known as Beta Coefficient
- Market always has beta of 1.0.
- If stock moves more than the market over time has a beta coefficient of higher than 1.0. Lower than 1 .0 if it moves less.
- As such a Beta with two will return and lose twice as much as the market.
What is Alpha?
How is it calculated?
- Alpha a.k.a Jensen Rational or Jensen’s Alpha
- Referred to as added value of adviser as based on return from their stock selection.
- Alpha = Actual return – CAPM return.
- Measure to assess difference between actual return and expected level based on CAPM
- Indicates whether investment produced higher or lower returns for risk taken.
- Positive Alpha = more desirable than negative alpha
- Negative Alpha indicates underperformance.
- Can use FAMA’s Alpha ‘Decomposition of total return’ which invovles analysing the totalreturn in various components.
- The return from the riskless asset (fixed interest or cash);
- What return the client would expect based on their level of risk (return from client’s risk);
- The return from market timing (the beta that the fund manager has chosen by investing in the market);
- The return from selectivity (return from active security selection).
What is the Sharpe Ratio?
How is it calculated?
Sharpe ratio illustrates how well return from portfolio compared to a risk free asset such as gilts.
Therefore how much investor is compensatesd for the risk taken. Cannot use for individual securities.
Uses historical data. It is defined as the additional return per unit of risk compared with a risk-free investment (T-bills, etc).
Sharpe = (market return – risk-free return) / standard deviation of fund (where standard deviation is the square root of the variance, ie 6). Therefore, Sharpe = (8% – 5%) / 6 = 0.5%.
Higiher sharpe ratio the better. Lower is worse.
