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RSM336 > Week 7: asset allocation and international investing > Flashcards

Week 7: asset allocation and international investing Flashcards

1
Q

4 steps to asset allocation:

A
  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
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2
Q

How to determine the opt portfolio of risky assets

A

Select the P that has the highest sharpe ratio

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3
Q

What is the sharpe ratio

A

reward to risk ratio, measure the risk-adjusted return

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4
Q

Portfolio is tangent to

A

capital allocation line

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5
Q

What is the CAL slope and y intercept

A

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

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6
Q

Separation property

A

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

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7
Q

Tangency is the same for:

A

all investors

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8
Q

Risk averse investors hold:

A

more risk free and some tangency portfolio

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9
Q

Risk-seeking investors will hold:

A

Only tangency portfolio and use leverage to increase return

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10
Q

What does the seperation property imply?

A
  • all investors have the same portfolio of risky assets
  • combine with risk free to achieve the acceptable overall level of risk for each investor
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11
Q

Problems with MVO

A
  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
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12
Q

Issues with utility fnc

A

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

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13
Q

Prospect theory

A
  • 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
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14
Q

Fear of regret

A

Causes to sell winners soon and hold on losers

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15
Q

Loss aversion

A

Dont want to realize paper losses

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16
Q

Anchoring

A

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

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17
Q

recency effect

A

give more weight to current events

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18
Q

confirmation bias

A

give more weight to info that confirms our own opinions

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19
Q

herding

A

like to follow the crowd, dont want to miss out

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20
Q

overconfidence bias

A

success leads to overconfidence

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21
Q

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

A

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

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22
Q

what is the second method for forecasting market return

A

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

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23
Q

What is running regression cons

A

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

24
Q

The market P/E is a weighted avg of

A

the P/E ratio in the index

25
Q

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

A

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

26
Q

trailing P/E

A

based on past EPS
P0/E0

27
Q

forward P/E

A

Based on future forecast
P0/E1

28
Q

Dividend yield

A

D/P
percentage of dividend of price

29
Q

Why do P/E ratios predict future returns

A
  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)
30
Q

Dogs of the Dow

A

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

31
Q

Why is using historical avg bad for forecasting Sd and corr

A

because covariance and corr arent stable

32
Q

what is the obj of MVO

A

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

33
Q

assets that are not perfectly corr improve:

A

diversification

34
Q

benefit of global diversification

A

reducing portfolio risk by combining assets with corr < 1

35
Q

Why does US have to most corr with the world

A

Bc they take up the majority

36
Q

Canada and which country has similar corr

A

US

37
Q

Why include foreign stocks in your portfolio

A
  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
38
Q

Include foreign stocks to improve the

A

efficient frontier (same return for lower risk bc diversification)

39
Q

In a crisis, what happens to the correlation

A

corr increases and coverts to 1 -> no diversification benefit

40
Q

Risks of global investing

A
  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
41
Q

What is currency risk

A

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

42
Q

2 components of returns and risk for local investors

A
  1. return of foreign mark (eg. stock)
  2. change in foregin currency (e. us dollar)
43
Q

Local investors benefit if foreign investment :

A

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

44
Q

Techniques for international investing

A
  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
45
Q

American Depositary receipts

A

-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

46
Q

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

A

the also the covariance

47
Q

risk of stock has two components

A
  1. systematic (market) risk
  2. Non-systematic (firm-specific, idiosyncratic) risk
48
Q

Which components of risk can be eliminated

A

Non systematic can be eliminated by diversifying

49
Q

If p (corr) = 1

A

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

50
Q

If p (corr) = -1

A

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

51
Q

If p = 0

A

the securities are uncorrelated
has diversification benefit

52
Q

Distribution of returns shape

A

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

53
Q

what is the most volatile fixed income?

A

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

54
Q

What is the portfolio management process?

A
  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
55
Q

what is IPS

A

RSM336 (3 decks)

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