Week 7: asset allocation and international investing

Question 1

4 steps to asset allocation:

Answer 1

1. define the portfolio opp set
2. forecast the inputs for each asset class (Expected return, sd or variance, covariance)
3. cal the optimal risky portfolio
4. allocate funds between the risky portfolio and the risk free asset based on investor risk tolerance

Question 2

How to determine the opt portfolio of risky assets

Answer 2

Select the P that has the highest sharpe ratio

Question 3

What is the sharpe ratio

Answer 3

reward to risk ratio, measure the risk-adjusted return

Question 4

Portfolio is tangent to

Answer 4

capital allocation line

Question 5

What is the CAL slope and y intercept

Answer 5

Y intercept: risk-free asset return
slope: sharpe ratio

Question 6

Separation property

Answer 6

separate the portfolio optimization process into two tasks:
1. find the tangency portfolio (with highest sharpe ratio)
2. find the combo of P and risk-free asset based on investor’s utility

Question 7

Tangency is the same for:

Answer 7

all investors

Question 8

Risk averse investors hold:

Answer 8

more risk free and some tangency portfolio

Question 9

Risk-seeking investors will hold:

Answer 9

Only tangency portfolio and use leverage to increase return

Question 10

What does the seperation property imply?

Answer 10

• all investors have the same portfolio of risky assets
• combine with risk free to achieve the acceptable overall level of risk for each investor

Question 11

Problems with MVO

Answer 11

1. difficult to determine an investors utility function
2. assumes investors only care about mean and variance (risk = variance but investors might have different risk objective)
3. the success of MVO depends on the quality of inputs
4. Corr arent stable and rises in times of crisis
5. MVO assumes normal distribution of returns
6. optimization often generates a concentrate portfolio and high allocation to alternative asset classes

Question 12

Issues with utility fnc

Answer 12

Decision making in risky conditions creates results not consistent with concave utility fnc

Question 13

Prospect theory

Answer 13

• Changes in wealth affect willingness to take risk -> S shape utility function
• people underweight probable outcomes compared to certain outcomes
• with gains, more risk-averse
• with loss, more risk-seeking
• people are more sensitive to gains/ losses than to level of wealth

Question 14

Fear of regret

Answer 14

Causes to sell winners soon and hold on losers

Question 15

Loss aversion

Answer 15

Dont want to realize paper losses

Question 16

Anchoring

Answer 16

Focus on what stock P should be eg. stock P should be this so don’t want to sell

Question 17

recency effect

Answer 17

give more weight to current events

Question 18

confirmation bias

Answer 18

give more weight to info that confirms our own opinions

Question 19

herding

Answer 19

like to follow the crowd, dont want to miss out

Question 20

overconfidence bias

Answer 20

success leads to overconfidence

Question 21

why is avg past returns not a good way to forecast market returns

Answer 21

Only reasonable if the Er for stock market is constant
Does not consider current economic and financial conditions

Question 22

what is the second method for forecasting market return

Answer 22

use specific variables and run a predictive regression eg. divi yield, PE. interest rate, credit spread, cyclically adjusted PE

Question 23

What is running regression cons

Answer 23

best model has low Rsquare, not very accurate at predicting the actual value

Question 24

The market P/E is a weighted avg of

Answer 24

the P/E ratio in the index

Question 25

A higher multiple means what about investors future expectations and future price

Answer 25

higher P/E means higher expectation for future earning, bidding up the stocks price

Question 26

trailing P/E

Answer 26

based on past EPS P0/E0

Question 27

forward P/E

Answer 27

Based on future forecast P0/E1

Question 28

Dividend yield

Answer 28

D/P percentage of dividend of price

Question 29

Why do P/E ratios predict future returns

Answer 29

1. P/e reflect optimism concerning future growth prospect 2. investors overreact to earning news and perceived changes in risk 3. stock might be overpriced (high P/E) or underpriced (low P/E)

Question 30

Dogs of the Dow

Answer 30

Takes the 10 lowest in the Dow index and hold for a year

Question 31

Why is using historical avg bad for forecasting Sd and corr

Answer 31

because covariance and corr arent stable

Question 32

what is the obj of MVO

Answer 32

want to obtain the highest possible return given our tolerance for risk

Question 33

assets that are not perfectly corr improve:

Answer 33

diversification

Question 34

benefit of global diversification

Answer 34

reducing portfolio risk by combining assets with corr < 1

Question 35

Why does US have to most corr with the world

Answer 35

Bc they take up the majority

Question 36

Canada and which country has similar corr

Answer 36

US

Question 37

Why include foreign stocks in your portfolio

Answer 37

1. offer diversification opportunity - lower corr with home market 2. investments in developing regions may provide superior returns 3. access investment opportunities not available in the domestic market

Question 38

Include foreign stocks to improve the

Answer 38

efficient frontier (same return for lower risk bc diversification)

Question 39

In a crisis, what happens to the correlation

Answer 39

corr increases and coverts to 1 -> no diversification benefit

Question 40

Risks of global investing

Answer 40

1. political risk variables (government stability, corruption, military, religious tensions) 2. financial risk variables (foreign debt, exchange rate stability, liquidity) 3. economic risk variables (GDP, inflation, budget balance) 4. currency risk

Question 41

What is currency risk

Answer 41

a foreign investment is investing in foreign asset and its currency (exposure risk(

Question 42

2 components of returns and risk for local investors

Answer 42

1. return of foreign mark (eg. stock) 2. change in foregin currency (e. us dollar)

Question 43

Local investors benefit if foreign investment :

Answer 43

increases in stock market price increases in the value of foreign currency (appreciation of foreign, depreciation of home $)

Question 44

Techniques for international investing

Answer 44

1. direct purchase of overseas securities 2. ETF (unhedged d ETF carry currency risk and market risk vs hedged WTD eliminate currency risk) 3. American Depositary receipts 4. country or regional mutual funds

Question 45

American Depositary receipts

Answer 45

-trading on NYSE for foreign companies (nokia, honda toyota, etc) - want to be accessible (convenience) to US investors - fraction of the stock in US $ - still has currency risk bc economic tied

Question 46

Portfolio risk is simply not the weighted ag of the risk of assets, but

Answer 46

the also the covariance

Question 47

risk of stock has two components

Answer 47

1. systematic (market) risk 2. Non-systematic (firm-specific, idiosyncratic) risk

Question 48

Which components of risk can be eliminated

Answer 48

Non systematic can be eliminated by diversifying

Question 49

If p (corr) = 1

Answer 49

the securities would be perfectly positively corr and there will be no diversification

Question 50

If p (corr) = -1

Answer 50

he securities would be perfectly negatively correlated and offer a perfect hedge

Question 51

If p = 0

Answer 51

the securities are uncorrelated has diversification benefit

Question 52

Distribution of returns shape

Answer 52

have fat tails ( higher probability of big losses than estimated by normal distribution

Question 53

what is the most volatile fixed income?

Answer 53

Zero government coupon bond bc has very high price volatility but zero risk for investor

Question 54

What is the portfolio management process?

Answer 54

1. identify investor's objective and constraint using IPS 2. asset allocation to achieve long term objective and constraint 3. security selection 4. measure portfolio performance

Question 55

what is IPS