Unit 20 Flashcards
One type of Deflation hedge
One type of Interest rate risk hedge
Deflation hedge - Fixed income
Interest rate risk hedge - stagger maturity dates
3 Major Asset Classes (Asset Allocation)?
Diversification?
Asset allocation - Stocks, bonds, cash
Diversification - different companies of common stocks (negatively correlated, etc.)
Active portfolio Mgmt - Sector Rotation
Passive portfolio mgmt - rebalance
Constant ratio plan - constant ratio of stocks to bonds
Constant dollar plan - constant dollar amount in stocks.
Growth vs Value
Growth - stock price at high end of 52 week range. Earnings momentum. High P/E ratio, high price to book ratio with little or no dividends.
Value - bottom of their 52 week price range. Currently operating at a loss. Low P/E ratio or low price to book ratio and dividends offerring a decent yield. Another sign of a value stock is a large cash surplus (rainy day fund)
Stochastic Modeling
Greek for “to aim” or “To guess” A method of financial analysis that attempts to forecast how investment returns on different asset classes very overtime by thousands of simulations to produce probability distributions for various incomes.
Monte Carlo Simulation
Popular form of stochastic modeling that used computer-generated distributions.
Market Cap Ranges - micro, small, mid, large. (Do not confuse with small mid and large investment advisor numbers)
Be careful of long form numbers. What cap size is a company with market capitalization of $5,000,000,000?
Micro-cap: >$300MM
Small-cap: $300MM - $2 Billion
Mid-Cap: $2 bill - $10 bill
Large-Cap:
Minimizing interest rate risk (strategies) (3)
Barbell Strategy - The investor purchases bonds maturing in one or two years and an equal amount maturing in 10 or more years with no bonds in between.
Bullet Strategy - aims at a target. Such as a child’s graduation. If 12 years away from kid going to college, buys bonds maturing in 12 years. 2 years later, buys bonds that mature in 10 years, etc.
Ladders- you buy a ladder all at once. Maturity dates are lined up in a row like a ladder, and mature one by one each year. As the maturities come due, you reinvest into another one with a longer maturity and keep building the ladder. (Relatively easy way to immunize interest rate risk)
CAPM
Measures expected rate of return given the risk.
Measures only systematic risk (market risk)
Modern portfolio theory (MPT)
Focuses on the relationships of all investments in a portfolio. The theory holds that specific risk can be diversified away by building a portfolio of assets whose returns are not correlated.
The theory is that all things being equal the portfolio with the least amount of volatility would be better than the one with a greater amount of volatility
Optimal Portfolio
Goal of investing is to create an optimal portfolio.
One that returns the highest rate of return consistent with the amount of risk and investors willing to take. More return for less risk.
Capital Market Line (CML)
Definition
Equation components
Offshoot of CAPM. Measures risk and reward.
USES STD DEVIATION, not alpha and beta.
- expected return of the portfolio
- risk-free rate
- return on the market
- Standard deviation of the market
- Standard deviation of the portfolio
Efficient frontier
The collection of efficient portfolios that plots A risk return parabola known as the efficient frontier.
Lying on the frontier is being efficient.
Below the curve is not efficient
Above the curve is not possible
2 spots on a curve are equally efficient.
SML - Security Market Line
What is it?
Compute it.
Derived from CML.
Only takes into consideration systematic risk.
Evaluates individual securities for use in a diversified portfolio
Uses beta.
Computed like RF rate equation from before:
(Market Rate - RF Rate) = (A)
(A) x Beta = (AA)
(AA) + RF Rate = SML
So,
((Market Rate - RF Rate) x beta) + RF Rate
Efficient market hypothesis (EMH)
Also known as random walk theory.
Says markets are efficiently priced, there is no way to accurately predict stock prices and a passive strategy is probably the most suitable for investment success.
