Module 2 - Modern Portfolio Theory and Performance Evaluation of Equities Flashcards
Markowitz Portfolio Theory
Markowitz developed a rational system to analyze portfolio choices based on the efficient use of risk. He took the idea that risk (standard deviation) and return levels are important and added the component of how the individual components of a portfolio interact with one another (correlation). The result of Markowitz’s work is the creation of optimal portfolios using means-variance optimization.
Means Variance Optimization
An approach to portfolio creation developed by Markowitz. It utilizes mean returns, standard deviations, and correlations of assets to develop efficient portfolios.
Markowitz’s Assumptions
- Investors are risk averse.
- Investors make investment decisions based on expected return and risk only.
- Investors have homogeneous expectations regarding return and risk for all investment opportunities available in the market.
- Investors have a common one-period investment time horizon.
- Investors have free access to all information relevant to investment decision making.
- There are no transaction costs.
Minimum Variance Frontier
The parabola (chart) that presents all available portfolio options (called the investment opportunity set). There is a minimum and maximum risk level (denoted by standard deviation on the X axis), and a minimum and maximum expected return level (denoted on the Y axis).
The Efficient Frontier
The efficient frontier is the portion of the Minimum Variance Frontier that provides investors with portfolios that are the most efficient from a risk and return standpoint. Portfolios above the efficient frontier are considered unattainable, and the portfolios below the efficient frontier are considered inefficient.
Utility Function/Indifference Curve
A utility function represents an investor’s willingness to accept more risk for a given level of return. An Indifference Curve is a graphical representation of this utility function. A risk averse investor will have a steep indifference curve, indicating the unwillingness to take on more risk to achieve additional returns. A flatter indifference curve generally applies to a risk tolerant investor.
Optimal Portfolio
According to Markowitz’s theory, the optimal portfolio for an individual investor is the point on the efficient frontier with which the investor’s indifference curve intersects.
Capital Market Theory
William Sharpe’s work continuing on Markowitz’s theory. Developed the Capital Asset Pricing Model (CAPM) which consists of the Capital Market Line and the Security Market Line. This model relies on a “market portfolio” to determine asset pricing.
Capital Market Line
The Market is the efficient frontier. Where Rf (risk free rate) intersects with the Y axis. The Y axis is returns and the X axis is the standard deviation. Points along the CML start with riskless assets, then move to a combination of riskless and risky assets, then all risky assets, then all risky assets with leverage. Standard Deviation, not Beta, is used in the CML formula. Rp=Rf + op [Rm-Rf/om]
Security Market Line
Risk/Return relationship for individual portfolios. Beta is used in the SML. The equation for the SML is also used to calculate the required rate of return. Rp=Rf+(Rm-Rf)B
(Rm-Rf) is the market risk premium. (Rm-Rf)B is the security risk premium. The SML is not fixed and will change based on changes in variables that affect the economy (like inflation). These changes will cause a parallel shift in the SML. Whereas an investor’s appetite for risk will cause a steepening (more risk averse) or flattening of the line (less risk averse).
Equilibrium/Disequalibrium
If the markets are in equilibrium, all assets will plot along the SML. If markets are in disequilibrium, you will get inefficiencies. Assets above the SML are underpriced and assets below the SML are overpriced.
Arbitrage Pricing Theory (APT)
Pricing theory that does not rely on a market portfolio, but rather unexpected changes in certain market factors. There are two major categories - sector influences and systematic influences. Four primary factors affect a stock’s return:
-inflation
-industrial production (or changes in GDP)
-risk premiums
-yield curves (interest rates)
