Capital Allocation Line Flashcards
(32 cards)
Standard Deviation?
Measures the dispersion (distance from average) of series of investment returns => Shows variation from the mean
Common measure of inv risk.
Higher SD – higher potential variation of actual ret from expected returns – higher RISK
Capital Mkt Line = CML
= a Capital Allocation Line
= expected returns and risk of ALL combinations of
1. risk free assets (eg US T bills) and
2.. Optimal portfolio of all risky assets Eg common stocks or real estate
T bill are risk free. SD 0
MPT?
Investment thinking is based on MPT
Focus on expected returns , risk and correlation making asset classes for portfolio as whole
Focus on total portfolio risk. Based on efficient diversification also considers tolerance for risk, financial constraints, overall investment strategy objectives etc
Risk.
= dispersion of investment return
Main measure of risk = standard deviation
Coefficient of Variation. Cv
Ratio of standard deviation variation to the mean of a distribution of data
= (SD/Mean return)100. Expressed as percentage
The lower the Cv—-> the better your risk return trade off
= “percentage” standard deviation = relative standard deviation
Coefficient of determination. R Squared
R squared = degree of correlation of fund with the INDE
How reliable is Beta?
Beta coefficient
Measures Volatility of a stock relative in to its INDEX
= tendency of security’s return to respond to swings in mkt
Measures an investment’s return re: whole mkt
Measures volatility of mkt prices of … Mutual fund /individual CS, portfolio of stock… Relative to those in given mkt
An impt measure of investment risk
Nominal Yield
Annual interest or dividends/investment’s par or face value
Interest / par value
Systematic risks
Risk after diversification =undiversifiable risk = beta
Cannot reduce or eliminate by diversifying portfolio
Ex
Interest risk/ Purchasing power risk /Exchange risk/Political risk/tax risk
Unsystematic risk =non mkt risk = firm specific risk
Risk that can be reduced/eliminated by diversification
Eg Financial or credit risk/business risk/ liquidity or marketability risk/investment mgr risk
Marketability risk
Condition under which an investor can find ready mkt if needs to sell an investment in short time.
Liquidity risk.
Condition under which investor can dispose of investment quickly and receive approx the amt put into it
Investment is marketable and has stable price
Liquid investments = Cash Equivalents
Risk Premium
Difference between
- the asset’s expected return and
- risk free asset’s return
Really —> payoff to the investor for selecting riskier asset
Covariance = Correlation
= Number that shows the degree to which the RETURNS of 2 assets move with each other
+ covariance. Move together
- covariance - move in opposite directions
When diversifying you want to AVOID covariance of diversified assets. Would cancel each other
Correlation coefficient
For returns of 2 investments
+1 = they move in same direction Perfect Correlation
-1 —> move in opposite directions Perfectly Negatively correlated
+1 and 0: assets are positively correlated
0 and -1: assets are inversely correlated = negatively correlated
Most assets and asset classes are positively correlated
Bond duration - explain
Used to assess its bond price sensitivity to interest rate risk
NB the longer the maturity of a bond, the more influenced the prices will be by changes in mkt interest rates
Measures price sensitivity to interest risk by multiplying a change in interest rate X number of years left until bond matures
= weighted average maturity of the bond’s cash flows
NB. Interest payments are rec’d earlier than the principal at maturity, a bond’s or bond portfolio’s duration will be less than its maturity ( when the face or par value is payable) or a bond portfolio’s weighted average maturity assuming the bond or bond portfolio pay current coupon interest
Bond convexity
Occurs when there is
an increase in mkt interest rates and
the decline in bond prices
is LESS THAN
the corresponding increase in bond prices for the same amt of decline in mkt interest rates
If Interest increase, (change bond price) < < (change in bond price) if Interest declines
Variance
Distance from the average of returns, including positive gains and neg losses
Efficient Frontier
Graph showing assets w/ lowest possible portfolio variance for the expected return for each possible combination of the assets
Diff combinations from100% bonds to splits between stock and bonds
Eff Frontier seeks to highlight best poss combos of stock and bond investments at lowest risk
Graph = rate of return vs risk (= standard deviation)
EMH Eff Mkt Hypothesis
Stock prices automatically adjust to mkt info
3 Forms
Weak
Semi strong
String form
Current yield
= Interest / current price
If bond selling at discount —YTM > Current Yield
= annual investment income/Investment’s current price
= cash inflows/mkt price
=’how much if I hold for 1 yr
Yield To Maturity. Definition
Anticipated return if hold the bond until it matures
Expressed as annual rate
Need to know
-what all future coupon payments are worth today at present value
- mkt price, par value, coupon interest rate,time to maturity
assume all coupon payments reinvested at same rate as bond’s current yield
YTM for Bond selling at discount
= Annual coupon interest + (discount/nos of years to mat) /
(current mkt price + par value)/2
YTM for Bond selling at a premium
= annual coupon interest - (premium/years to maturity)/
(Current mkt price + par value)/2
