1. FUNDAMENTALS Flashcards

Question

standard deviation of a population or sample

Answer 1

Used when return/growth is compounded arithmetic mean doesnt consider compounding

Answer 2

Arithmetic = average: doesnt take compounding into account but geo does makes sense when one can withdraw funds @ any time so compounding may not be relevant where there is RPI linkage since RPI is arithmetic mean of price changes geometric = takes compounding into account so tends to be more accurate measure for investments (since there is serial correlation) - good for vol investments and LT time horizons

Answer 3

skew and kurtosis can help measure the degree by which returns differ from normal distro Leptokurtosis = more pointed/taller middle with long skinny tails = long tail risk. small prob of v large losses platykurtosis= fewer results @ mean, fatter distro with shorter tails Sharpe uses SD which assumes normal distro but results may show kurtosis

Answer 4

skew and kurtosis can help measure the degree by which returns differ from normal distro skew = measure of asymmetry of distro around mean - normal distro = zero skew negative skew = longer negative tail. positive skew = longer positive tail

Answer 5

often assume in finance that returns are normally distributed = symmetric bell shaped distribution around mean 68 - 95 - 99.7% rule in real life - asset returns often not normally distributed arithmatic mean, median and mode, are all the same and lie at the centre (differences between the median and mean suggest that the distribution is skewed)

Answer 6

determines whether a sequence of data within a given distribution have been derived with a random process or impacted by common variable valuable tool in technical analysis Wald -Wolfowitz = is data randomly generated or has it been impacted by underlying variable Kolmogorov-Smirnov - tests how well results fit normal distro pattern of it they are skewed

Answer 7

- returns should be known with certainty in advance - should be no default risk - should be no reinvestment risk

Answer 8

Highly liquid and convertable to cash Risk of non payment is virtually 0 No reinvestment risk as issued @ discount and redeemed @ par

Answer 9

If inflation rising rapidly in holding period - real return of T bill may be much less than nominal return other options are SONIA, EFRA, SOFR, TONIA

Answer 10

measured from -1 to +1 most effective diversification comes from combining negatively correlated assets observation of correlation doesnt = causation

Answer 11

m = market s= stock

Answer 12

Cov (ra,rb) = Corr(a,b) x SDa x SDb var = SD squared

Answer 13

Cov (ra,rb) = Corr(a,b) x SDa x SDb var = SD squared

Answer 14

Markowitz formula Cov (ra,rb) = Corr(a,b) x SDa x SDb var = SD squared

Answer 15

+ (wc2 x SDc2) + (2wc wb Cov rc,rb) + (2wc wa Cov rc,ra)

Answer 16

= Weighted avg return from each sec included

Answer 17

investing fixed amount @ fixed periods of time regular investment more shares bought when price low and less bought when price high kind of assumes price is going to drop but good in general for volatile investments clients more sensitive to loss than gains - PCA helps this but not showing much conviction in investments achieves lower returns than other stats but with lower vol

Answer 18

BENE - avoids regret if price declines and you have bought at peak - makes investor feel that they have done something clever - satisfies deep seated need to avoid loss - feels instinctively prudent to spread over months vs gamble on large bet DRAWBACKS - price may move up in which case the strategy has eroded returns vs buying in one go - not logical - implies that there will be a fall in price in which case why not wait for this before investing - sub optimal strat - why not invest more when prices are low?

Answer 19

VA = means buying shares such that the portfolio value increases by a fixed amount at fixed intervals of time when prices are low - investor forced to invest more money to bring portfolio value up to set amount. so avg price paid is less than avg price of shares over same period (as with PCA

Answer 20

Spot transactions are immediate currency deals that are settled within two working days. Forward transactions involve currency deals that are agreed for a future date at a rate of exchange fixed now.

Answer 21

Real = (1 +NOM) / (1+ INFL)

Answer 22

Interest rate parity is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.

Answer 23

for foreign clients use domestic rate as this is the rate they are exposed to counter argument = international fisher eq would double count for inflation and UK inflaiton would already be reflected in currency XC rate counter to this is that Fisher is LT but currency may not reflect

Answer 24

(Ri-Rf) = Rt = return on investment - rfr (Rm - Rf) = return on market - rfr sometimes Rmt ei = unexplained residual error: assume = 0

Answer 25

Value at risk (VaR) quantifies potential financial risk for an investment or a portfolio @ specific probability offering a quant estimate of the maximum probable downside over a specified time horizon. VAR = Expected return - (portfolio vol x t-stat for the confidence level)

Answer 26

t stat = no. of SDs from mean % values = % of values within that no. of SDs only concerned with neg tail SO 95% of values = (100-95)/2 + 95 = 97.5% confidence level (2.5% negative tail)

Answer 27

CVAR = arithmetic mean losses below VAR average of the losses if VaR is exceeded provides the mean loss in the remainder of the distribution tail, starting at VaR helps understand how stretched left tail returns may be

Answer 28

vol: doesn't distinguish between positive and negative returns. assumes normal distro (ignores skew, kurtosis, black swan events) VAR: only considers neg events but still assumes normal returns. Cornish-Fischer VAR extends VAR to include skew and kurtosis but ignores higher moments. Historical VAR avoids normal distro by using historical returns but depends on historical data which may be no guide to future

Answer 29

Cash: useful to have emergency fund. May be wise to hold some in variable rate deposits as hedge against rates FI - secure income and negatively correlated to equity markets when rates are low Equtiies: diversified bucket for growth and divi income CIS: can further spread risk across sector, geog, asset class Property: brick and mortar illiquid, property shares can be correlated to equities Unconventional: e.g. coins/art. can diversify but reqs expert knowledge, may not be liquid

Answer 30

FI - can hold different maturities, durations, issues. ALso sovereign, IG, HY, EM bonds. Different currencies and ratings Equities: Can diversify by style (value/growth). Sector, listing geog and revenue exposure, size. Reduce exposure to single sec shocks but also market/sector shocks or style being out of favour

Answer 31

General notion - investors willing to tolerate higher levels of risk will need to be compensated with higher levels of return (a risk premium) see in an asset class e.g. FI and credit spreads or between asset classes e.g. bond vs equity returns

Answer 32

NY ST = real yield + inflation rate

Answer 33

LP = additional compensation used to encourage investments in assets that cannot be easily or quickly converted into cash at fair market value Can be measured as difference in yields between sampled sec and its comparator with same qualities but exhibiting liquidity differences

Answer 34

PURE EXPECTATIONS THEOYR - Slope reflects market expectations on future interest rates LT yields to mat = geometric avg of future ST rates - Upward = ST rates expected to rise, downward = ST rates expected to fall LIQUIDITY PREM THEORY -- additional compensation used to encourage investments in assets that cannot be easily or quickly converted into cash at fair market value ILLIQUIDITY PREM THEORY - states upward bias to pure expectation model - investors require high yield from LT bonds because of increased price vol - assumes investors have shorter term time preferences than borrows SEGMENTED MARKETS THEORY - regards short, med and long parts of curve as separate markets dependent of diff forces of supplu/demand - Instit requirement for long dated gilts depresses long end of market

Answer 35

refers to the excessively high historical outperformance of stocks over Treasury bills, which is difficult to explain Approx 5-8% in US - theoretically should be lower and implies abnormally large risk aversion

Answer 36

John Taylor - 1992 - provides recs on how US Fed should set ST interest rates - 1% change in inflation would require change in rates of >1% Three variables - actual rate of inflation vs target - how far economy is from full employment -what rate of itnerest should be consistent with full employment Rate = real rate + inflation rate + 0.5 x ( rate of inflation - target rate) + 0.5 x (log of real output - log of potential output)