Portfolio Theory

Question 1

What is modern portfolio theory?

Answer 1

MPT is based on the use of diversification to reduce risk. The number of assets required for diversification depends on the correlation between assets. The goal is to put together optimal portfolios - referred to as the mean-variance optimization.

Mean-variance optimization requires we look at the returns (mean), the standard deviation (the variance) and the correlation between each asset.

Question 2

What is efficient frontier?

Answer 2

A curved parabola plotted on a x-y risk return graph. Portfolios on the curve are said to be efficient with portfolios above and below the curve to either be too risky or unattainably efficient for low risk.

Question 3

What are indifference curves?

Answer 3

These are curves on the x-y risk reward graph which represent the risk-reward tradeoff that the investor is willing to take. These curves are tangent to the efficient frontier and where they cross the efficient frontier at a single point, is where the optimal portfolio is.

Question 4

What are the considerations for constructing an efficient MPT?

Answer 4

Diversification: be careful not to over-diversify. Should only take 10-15 large cap, 20-30 small cap
Overlap: holding many stocks risks holding many of the same stocks (mutual funds)
Correlation: holding similarly correlated stocks does not mitigate risk when the market moves

Question 5

What is the mean-variance optimization approach?

Answer 5

An efficient portfolio. Investors are trying to maximize the return (mean), for any level of risk (variance).

Question 6

All portfolios on the efficient frontier are, efficient. But not all portfolios are on the efficient frontier are optimal. Explain.

Answer 6

It comes down to the level of risk an individual is willing to take. The optimal portfolio is both on the efficient frontier and at the level of risk the investor is willing to take.

Question 7

What is capital market theory (CMT)?

Answer 7

A continuation of efficient frontier using a market portfolio made entirely of risk (systematic and unsystematic). That market portfolio is plotted along with the risk-free rate, A straight line, known as the Capital Market Line (CML) is drawn between the two which then marks the new efficient frontier.

Question 8

What is the Capital Asset Pricing Model (CAPM)?

Answer 8

ri = rf + (rm – rf)βi

Allows the investor to determine an asset’s expected rate of return, in a form of risk-adjustment that allows the investor to see how much risk they should assume for such a return.

Question 9

What are the two components of the CAPM formula?

Answer 9

The stock risk premium: the inducement necessary to entice the individual to invest
(rm− rf)βi

The market risk premium: the incentive required for the individual to invest in the securities market in general
rm− rf

Question 10

What does the Capital Market Line (CML) represent?

Answer 10

It expands on the efficient frontier to state that every portfolio can at least start with the risk free return. From there, with more risk, it can move directly to point M (the apogee of the efficient frontier), and can continue in a straight line to point A, which uses margin and the most risk to get the most returns.

Question 11

What is the security market line (SML)?

Answer 11

The depiction of the relationship between risk and reward for individual efficient portfolios which has the same formula as CAPM. Assuming the market is in equilibrium, all assets should plot along this axis, moving from the risk free rate, up and to the right.

Question 12

Along SML, how would one expect to see asset plots that are over and under valued?

Answer 12

Over valued would be to the right of the line, under valued would be to the left.

Question 13

How does the slope of the line change with inflation and investor risk levels?

Answer 13

With inflation, all rates change. All other things being equal, the slope of the line parallels the old line

With investor risk levels, (rm - rf), the slope of the line will either steepen for risk aversion or flatten for risk acceptance.

Question 14

What is Arbitrage Pricing Theory (APT)?

Answer 14

As CAPM uses Beta as a single factor effecting stock prices, APT uses multiple factors such as inflation, GDP, risk premiums, and yield curves to determine expected return rates.

ri = a0 + b1F1 + b2F2 + . . . + bnFn + e

b1 = sensitivity of the expected return
F1 = unfactored risk
a0 = risk free return

Question 15

What is efficient market hypothesis?

Answer 15

Suggests that investors cannot beat the market. If prices move in a completely random motion, then any strategies to take advantage of price movements, are useless

Question 16

What is a random walk hypothesis?

Answer 16

States that future prices are random and do not follow any reestablished trend or path. Stock prices to this point have incorporated all information and have been priced appropriately.

Question 17

What is relevant information in the weak form of EMH?

Answer 17

Insider information and credible fundamental analysis

Question 18

What is relevant information in the semi strong form of EMH?

Answer 18

Insider trading

Question 19

What is relevant information in the strong form of EMH?

Answer 19

There is none

Question 20

What are stock market anomalies?

Answer 20

Behaviors that contradict the randomness of EMH. Some of the more prevalent anomalies are the January effect, weekend effect, low P/E effect, size effect.

Question 21

Which type of analysis can be used in the weak form of EMH?

Answer 21

Fundamental (Technical CANNOT be used at all)

Question 22

What is stochastic modeling?

Answer 22

A method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes

Question 23

What is a Monte Carlo simulation?

Answer 23

A popular form of stochastic modeling

Question 24

What is an investment policy statement?

Answer 24

Defines (client for the manager)

• the client’s objectives
• the asset allocation policy
• management procedures
• communication procedures

Question 25

What is rotational investing?

Answer 25

The practice of moving in and out of various investment industries over the course of the business cycle to take advantage of when each industry does well based on their place in the business cycle (i.e. houses and cars do well at the bottom to mid cycle)

Question 26

What is sensitivity analysis?

Answer 26

Used to evaluate the risk associated with a given investment and assesses the impact of different variables on an investment’s returns.

Question 27

What is asset allocation?

Answer 27

The process of apportioning an investors wealth among different countries and asset classes for investment purposes. It is the primary determinate of a portfolio’s total return.

Question 28

What is strategic asset allocation?

Answer 28

A determination of an appropriate allocation based on the long-term financial goals of the client. Ex: lifecycle funds that change with the age of the client based on risk tolerance, but are not responsive to market conditions.

Question 29

What is a tactical asset allocation?

Answer 29

A continuous adjustment to the asset allocation based on market conditions in an attempt to take advantage.

Question 30

What is the core and satellite investment strategy?

Answer 30

Use of a core of funds which invests in broad market indices (FI, equities, intl) and satellite funds which invest in higher-risk investments to attempt to get the high return.

Question 31

What is the value and growth investing strategy?

Answer 31

Both sides of the P/E coin. Value investing (price) assumes that the current P/E ratio is below its natural level and an efficient market will recognize this, driving the price up. Growth looks for companies that have a significant ability to develop products with a minimum of competition.

Question 32

What is a black swan event?

Answer 32

An unpredictable event that has potentially severe consequences and is beyond what constitutes as normal market volatility.

Question 33

What are endogenous risks?

Answer 33

Risks to the market due to individual investors following the behaviors of others (i.e. loss of confidence leads to mass sell-off).

Question 34

What are exogenous risks?

Answer 34

Non-financial catastrophes such as weather events, terrorist attacks, COVID, that can negatively impact the market.

Question 35

What is incremental change?

Answer 35

Change in either the market or personal financial situation (10% raise for instance) that should be watched, but not necessarily acted on.

Question 36

What is a discontinuous change?

Answer 36

Represents a radical departure from a current trend or pattern, such as a shift from economic expansion to recession, or a sudden increase in wealth or loss of job. Requires reassessment