What's in our theory toolbox

Question 1

Five steps of portfolio management (4)

Answer 1

• portfolio objectives
• portfolio protection
• portfolio evaluation
• portfolio construction

Question 2

Five building blocks of finance (5)

Answer 2

• Efficient market hypothesis
• portfolio theory
• capital market theory
• option pricing theory
• agency theory

Question 3

Efficient market hypothesis (4)

Answer 3

• impossible to “beat the market”
• stock always trade at fair value
• application include passive vs active management
• index funds and ETF

Question 4

Portfolio theory (2)

Answer 4

• assume investors are risk adverse

- maximize expected return based on given level of market risk along the efficient frontier

Question 5

Diversification effect (1)

Answer 5

• invest in more than one stock, an investor can reap the benefit of diversification, reduce riskiness of portfolio

Question 6

Markowitz optimization in portfolio theory (2)

Answer 6

• maximize portfolio return subject to portfolio risk

- minimize portfolio return subject to portfolio risk

Question 7

Vertical view (2)

Answer 7

• maximum return

- efficient frontier: all the N securities in the market are included

Question 8

Horizontal view (3)

Answer 8

• minimize risk and variance
• remove those below global minimum variance portfolio (not efficient)
• gives complete picture at all return level (easier)

Question 9

N- security portfolio variance (2)

Answer 9

• includes correlation between all pairs

- risk declines as correlation decreases

Question 10

Covariance matrix (1)

Answer 10

• tabular presentation of the pairwise combination of all portfolio component

Question 11

Meaning of three condition (3)

Answer 11

• set target return level
• weights should add up to 100%
• no short selling

Question 12

Capital market theory (3)

Answer 12

• CAPM: relationship between systematic risk and expected return of asset
• APT: describe price where a misprice asset is expected to be
• application include portfolio beta and security selection

Question 13

Option pricing theory (2)

Answer 13

• Black Scholes model: put and call option

- application include pricing option, portfolio protection, and estimating volatility

Question 14

Agency theory (2)

Answer 14

• address problems that arise

- application include fund company vs fund unit holders, shareholder vs fund company, role of regulation

Question 15

Contract theory (3)

Answer 15

• deal with conflict of interest and control future action
• incomplete contract
• informative principle