Equity Portfolio Management Flashcards
(159 cards)
1
Q
The economy’s equilibrium level of real interest rates depends on… (Select 1-3)
A) The households’ willingness to save
B) The profitability of investments in PP&E and inventories for companies
C) The government monetary policy
D) The government fiscal and monetary policy
A
A) The households’ willingness to save - as reflected in the supply curve of funds
B) The profitability of investments in PPE and inventories for companies - as reflected in the demand curve of funds
D) The government fiscal AND monetary policy
2
Q
Which of the following is true?
A) Real Interest Rate = Nominal Interest Rate + Expected Rate of Inflation
B) Nominal Interest Rate = Real Interest Rate + Expected Rate of Inflation
C) Nominal Interest Rate = Real Interest Rate - Expected Rate of Inflation
A
B) Nominal Interest Rate = Real Interest Rate + Expected Rate of Inflation
In general, we can only directly observe nominal interest rates; from which, we must infer expected real rates, using inflation forecasts!
3
Q
The equilibrium expected rate of return on any security is the sum of the equilibrium real rate of interest, the expected rate of inflation, and a security-specific risk premium.
TRUE/ FALSE
A
TRUE.
Equilibrium expected return on any security = equilibrium real interest rate + expected inflation + security-specific risk premium.
4
Q
Historical returns on stocks exhibit somewhat more frequent large negative deviations from the mean than would be predicted from a normal distribution. Which of the following can help quantify the deviation from normality? A) skew of the actual distribution B) kurtosis of the actual distribution C) VaR D) lower partial standard deviation (LPSD) of the actual distribution E) A, B, C F) A, C, D G) A, B, D
A
G) A, B, D:
The lower partial standard deviation (LPSD), skew, and kurtosis of the actual distribution quantify the deviation from normality.
Lower partial standard deviation (LPSD): Standard deviation computed using only the portion of the return distribution below a threshold such as the risk-free rate or the sample average.
5
Q
Widely used measures of tail risk are; (i) value at risk (VaR) and (ii) expected shortfall (ES). Which of the following statements are true? Select 1-4
A) VaR measures the loss that will be exceeded with a specified probability such as 1% or 5%.
B) Expected shortfall (ES) measures the expected rate of return conditional on the portfolio falling below a certain value: e.g., 1% ES is the expected value of the outcomes that lie in the bottom 1% of the distribution.
C) ES is always larger than VaR
D) VaR is always higher than ES
A
A) VaR measures the loss that will be exceeded with a specified probability such as 1% or 5%.
B) Expected shortfall (ES) measures the expected rate of return conditional on the portfolio falling below a certain value: e.g., 1% ES is the expected value of the outcomes that lie in the bottom 1% of the distribution.
C) ES is always larger than VaR
6
Q
Risk-free rate is the rate you would earn in risk-free assets. Which of the following options is NOT a risk-free asset?
A) T-bills
B) Money market funds
C) Certificates of Deposits (CD)
D) Yield obtained from bank depositing
E) All of the above options are considered risk-free
A
E) All of the above options are considered risk-free
7
Q
The following statement is NOT true about excess return:
A) Excess return represents the EXPECTED payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset
B) Excess return is the difference in any particular period between the ACTUAL rate of return on a risky asset and the actual risk-free rate.
C) The risk premium is the expected value of the excess return.
D) The standard deviation of the excess return is a measure of its risk.
E) All options are correct
A
WRONG OPTION: A
Excess return represents the ACTUAL payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset. It is the difference in any particular period between the ACTUAL rate of return on a risky asset and the actual risk-free rate.
Meanwhile, the RISK PREMIUM reflects the EXPECTED value of excess return.
8
Q
Following is NOT true about risk-averse investors: Select 1-4
A) they prioritize the safety of principal over the possibility of a higher return on their money
B) they prefer illiquid investments
C) they generally favor municipal and corporate bonds, CDs, and savings accounts
D) they take on additional risk if the excess return is above a certain threshold
A
WRONG OPTIONS: B and D
B) they prefer LIQUID investments. That is, their money can be accessed when needed, regardless of market conditions at the moment.
D) they DONT take on additional risk if the excess return is above a certain threshold, because they would rather be certain not to suffer losses on their principal
9
Q
Following is NOT true about normal distribution:
A) It is completely characterized by two parameters; the mean and SD
B) Investment management is far more tractable when rates of return can be well approximated by the normal distribution
C) the normal distribution is symmetric, i.e., the probability of any positive deviation above the mean is equal to that of a negative deviation of the same magnitude. Absent symmetry, the standard deviation is an incomplete measure of risk.
D) When assets with normally distributed returns are mixed to construct a portfolio, the corresponding portfolio return is not normally distributed.
E) when securities are normally distributed, the statistical relation between returns can be summarized with a single correlation coefficient. Absent normal distribution, such dependence is a complex, multilayered relationship
A
WRONG: D)
When assets with normally distributed returns are mixed to construct a portfolio, the portfolio return IS ALSO NORMALLY DISTRIBUTED.
10
Q
The Fisher equation claims that the real rate of interest is approximately equal to the nominal interest minus inflation rate. Given this, what if inflation rate was to increase from 3% to 5%, how will this affect nominal rate and real rate of interest, given all else equal?
If inflation increases, all else equal, the real interest rate will ____.
If inflation increases, all else equal, the nominal interest rate will ____.
A) Fall, rise
B) Rise, fall
C) Fall, fall
D) Rise, rise
A
CORRECT: A)
If inflation increases, all else equal, the real interest rate will FALL.
If inflation increases, all else equal, the nominal interest rate will RISE.
real=nominal - inflation
nominal= real + inflation
11
Q
Large historical datasets (large sample) is advantageous given a reasonably stable return distribution - why?
A) Assuming that the return distribution remains reasonably stable over the entire history, a longer sample period increases the precision of the estimate of the expected rate of return, since the standard error decreases as the sample size increases.
B) Given a volatile mean that randomly changes y-o-y in the sample, i.e., we are unable to determine the nature of this change, a large sample is still advantageous.
C) A large sample increases the expected return of the portfolio.
A
A) Assuming that the return distribution remains reasonably stable over the entire history, a longer sample period increases the precision of the estimate of the expected rate of return, since the standard error decreases as the sample size increases.
Explanation of B:if we assume that mean of the distribution of returns is changing over time randomly (we are unable to determine the nature of this change), the expected return must be estimated from a more RECENT part of the historical period. In this case, we must determine how far back to go in order to select the relevant sample. Thus, in this case, it is likely a disadvantage to use the entire dataset back to e.g., earlier decades such as 1880.
12
Q
You are considering two alternative two-year investments:
• You can invest in a risky asset with a positive risk premium and returns in each of the two years that will be identically distributed and uncorrelated,
• or you can invest in the risky asset for only one year and then invest the proceeds in a risk-free asset.
Which of the following statements about the first investment alternative (compared with the second) are true?
a. Its two-year risk premium is the same as the second alternative.
b. The standard deviation of its two-year return is the same.
c. Its annualized standard deviation is lower.
d. Its Sharpe ratio is higher.
e. It is relatively more attractive to investors who have lower degrees of risk aversion.
A
c. Its annualized standard deviation is lower - se pp. 9 in exam notes
Let σ=annual st.dev.of the risky investment, and σ1 = st.dev.of the first investment alternative over the two year period. Then, σ1=√2*σ
Therefore, the annualized standard deviation for the first investment alternative is equal to:
σ1 /2 = σ /√2 < σ
13
Q
If businesses become more pessimistic about future demand for their products and decide to reduce their capital spending, the real rate of interest will ______.
If households are induced to save more because of increased uncertainty about their future Social Security benefits, the real rate of interest will ______.
If the Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money, the real rate of interest will ______.
A) rise, fall, rise
B) fall, rise rise
C) fall, fall fall
D) rise, rise rise
A
C)
If businesses become more pessimistic about future demand for their products and decide to
reduce their capital spending, the real rate of interest will FALL.
If households are induced to save more because of increased uncertainty about their future Social Security benefits, the real rate of interest will FALL.
If the Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money, the real rate of interest will FALL.
14
Q
You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.
Which is the safer investment?
A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information
A
B) Inflation-plus CD:
The safer investment will be the inflation-plus CD offering, since the investor will be appropriately compensated for any level of inflation rate to materialize over the next year. That is, the real interest rate that you will receive by investing in the inflation plus CD is 1.5% regardless of inflation.
15
Q
You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.
Can you tell which offers the higher expected return?
A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information
A
C) Depends - cannot be determined based on the given information
The CD without inflation plus offers a higher expected return if the expected inflation rate will be lower than 3.5%. If the expected inflation rate is higher than 3.5%, then the inflation plus CD offers a higher expected return. In conclusion, the expected return on each investment depends on the expected inflation rate.
16
Q
You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.
If you expect the rate of inflation to be 3% over the next year, which is definitely the better investment?
A) Conventional CD
B) Inflation-plus CD
C) Depends - cannot be determined based on the given information
A
C) Depends - cannot be determined based on the given information.
All equal:
If the inflation rate is expected to be 3%, then the CD without inflation plus offers the highest expected return of 2%, versus 1.5% in the inflation-plus case.
E(r)_CD(Conventional) > E(r)_CD(Inflation Plus)
→ 2% > 1.5%
BUT, unless the inflation rate of 3% is certain, the conventional CD is yet the riskier option.
Therefore there is not a clearly/ definitely “better” investment of the two.
17
Q
If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year?
A) Yes
B) No
C) Depends
A
B) NO
We CANNOT assume that the entire difference between the risk-free nominal rate (on conventional CDs) of 5% and the real risk-free rate (on inflation-plus CDs) of 1.5% is the expected rate of inflation. Part of the difference is likely a risk premium associated with the uncertainty surrounding the real rate of return on conventional CDs. This implies that the expected rate of inflation is less than 3.5% per year.
18
Q
Which risk is non-diversifiable?
A) Systematic risk
B) Non-systematic risk
A
Systematic risk refers to macroeconomic risks. This is a common factor that affects all security returns. The market factor, m, measures unanticipated developments in the macroeconomy.
The systematic component of a portfolio variance, β_P^2 σ_M^2 depends on the average beta coefficient of the individual securities. This part of the risk depends on portfolio beta and σ_M^2 and will persist regardless of the extent of portfolio diversification. No matter how many stocks are held, their common exposure to the market will result in a positive portfolio beta and be reflected in portfolio systematic risk. I.e., systematic risk is non-diversifiable.
19
Q
Which of the following are examples of common economic factors? I.e., sources of systematic risk. Select 1-4 A) business cycles B) stock repurchase C) interest rates D) cost of natural resources
A
Common economic factors/“Shocks” refers to unexpected changes to macroeconomic variables that cause, simultaneously, correlated shocks in the rates of return on stocks across the entire market.
ANSWER: all options are correct except B
20
Q
A scatter diagram plots returns of one security versus _____.
A) its price
B) returns of another security or benchmark
C) excess return of the same security, relative to the risk-free rate
D) excess return of the same security, relative to market excess return
A
CORRECT: B)
A scatter diagram plots returns of one security versus returns of another security (or benchmark such as a market). Each point represents one PAIR of returns for a given holding period.
21
Q
A regression equation describes the average relationship between a dependent variable and one or more explanatory variables. In this context, residuals captures______
A) Parts of stock returns are not explained by the explanatory variable. They measure the impact of firm-specific events during a particular period.
B) The risks that are non-diversifiable and therefore not captured by the explanatory variables.
A
A regression equation describes the average relationship between a dependent variable and one or more explanatory variables. In this context, residuals capture Parts of stock returns not explained by the explanatory variable. They measure the impact of firm-specific events during a particular period.
A IS CORRECT
22
Q
A security characteristic line (SCL) plots_____
A) the excess return on a security over the risk-free rate as a function of the excess return on the market.
B) the excess return on a security against its price
C) the returns of one security against the return of another security
D) the return of a security against the excess return of the same security relative to the risk-free rate
A
A) IS CORRECT:
A security characteristic line (SCL) plots the excess return on a security over the risk-free rate as a function of the excess return on the market.
23
Q
Following is NOT true about the Information Ratio:
A) It is a version of a reward-to-risk ratio (another example is Sharpe).
B) It divides the alpha of the portfolio by the systematic risk of the portfolio.
C) It quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.
D) All of the above are true
A
WRONG: B & D
B) It divides the alpha of the portfolio by the NON-systematic risk of the portfolio. This is the firm-specific risk of the portfolio, called “tracking error” in the industry - which CAN be diversified away. Thus, IR quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.
IR = α_p/ σ(e_P )
24
Q
What are the advantages of the index model compared to the Markowitz procedure for obtaining an efficiently diversified portfolio? What are its disadvantages?
A
Advantages:
- Reduced number of estimates required – the large number of estimates required for the Markowitz procedure can result in large aggregate estimation errors when implementing the procedure.
- Takes into account specialization of labor in security analysis. An advantage of the index model (relative to Markowitz model) is its simple way of computing covariances across industries.
Disadvantage:
- The index model’s assumption that return residuals are uncorrelated. This assumption will be incorrect if the index omits a significant risk factor.
25
How does the magnitude of firm-specific risk affect the extent to which an active investor will be willing to depart from an indexed portfolio?
A) the higher the firm-specific risk of an asset, the higher the willingness to include a larger weight of this specific asset in an active risky portfolio
B) the higher the firm-specific risk of an asset, the lower the willingness to include a larger weight of this specific asset in an active risky portfolio
CORRECT: B)
the higher the firm-specific risk of an asset, the lower the willingness to include a larger weight of this specific asset in an active risky portfolio.
Other tings equal, w^0 (initial guess of asset weight in active portfolio) is smaller the greater the residual variance of a candidate asset for inclusion in the portfolio (σ^2 (e_Active)). Further, regardless of beta, when w^0 decreases, so does w*(the optimal asset weight in active portfolio).
Therefore, other things equal, the greater the residual variance of an asset, the smaller its position in the optimal risky portfolio. That is, increased firm-specific risk reduces the extent to which an active investor will be willing to depart from an indexed portfolio.
See pp. 28-29 in Exam Notes
26
Why do we call alpha a “nonmarket” return premium?
A) it is the portion of the return premium that is independent of the market performance.
B) it is non-diversifiable and is correlated with the beta of the security
C) The lower the alpha (nonmarket risk), the higher the total risk premium
D) All of the above
CORRECT: A)
The total risk premium is equal to = α + (β * market risk premium)
We call alpha the non-market return premium due to the fact that it is the portion of the return premium that is independent from the market performance. That is, the alpha of an asset is DIVERSIFIABLE; as more and more stocks are added to the portfolio, the firm-specific components tend to cancel out, resulting in ever-smaller nonmarket risk.
27
Why are high-alpha stocks desirable investments for active portfolio managers? Hint: think of the Sharpe Ratio for an optimal risky portfolio
A) A higher alpha entails a lower Sharpe Ratio, which is very desirable for risk-averse investors
B) A higher alpha entails a higher Sharpe Ratio, which is desirable for any active investors - even the risk-averse ones
C) A higher alpha of a security decreases the portfolio alpha, which is desirable for any active investors - even the risk-averse ones
D) None of the options are correct
CORRECT: B) A higher alpha entails a higher Sharpe Ratio, which is desirable for any active investors - even the risk-averse ones.
The Sharpe Ratio:
S_P^2 = S_M^2+[α_A/σ(e_A ) ]^2
Alpha (the numerator in the Sharpe Ratio) is a fixed number that is not affected by the standard deviation of returns (the denominator). Hence, an increase in alpha increases the Sharpe ratio, which indicates a higher reward-to-risk ratio. Since the portfolio alpha is the portfolio-weighted average of the securities’ alphas, then, holding all other parameters fixed, an increase in a security’s alpha results in an increase in the portfolio Sharpe ratio.
28
```
In the index model (excess return), the firm-specific risk is measured by:____
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)
```
B) Firm-specific risk is measured by the residual standard deviation.
The higher the residual standard deviation, the higher the firm-specific risk of the stock according to the index model (excess return) regression of stocks.
29
```
In the index model (excess return), the market risk of a stock is measured by:____
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)
```
A) Market risk is measured by beta, the slope coefficient of the regression. A stock with a larger beta coefficient indicates a larger market risk.
30
```
In the index model (excess return), the fraction of total variance of return explained by the market return is indicated by: ____
A) beta
B) residual standard deviation
C) R^2
D) market risk premium (r_m-r_f)
```
C) In the index model (excess return), the fraction of total variance of return explained by the market return (explained variance) is indicated by R^2. This means that for a larger R^2, the market movement explains a greater fraction of the stock's total return variability.
R_i^2 = (β_i^2 * σ_M^2) / (σ_i^2 ) =
(Explained Variance) / (Total Variance)
31
Under the efficient market hypothesis, given an efficient market, which type of stock price analysis will likely generate the higher (more optimistic) stock price and development hereof?
A) Single-Index model
B) Technical analysis
C) Fundamental analysis (analysis of the underlying value of the firm, e.g., profitability and growth prospects)
D) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, neither should generate excess profits if markets are operating efficiently.
D) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, netiher should generate excess profits if markets are operating efficiently.
32
Which of the following statements from the EMH chapter (11) is NOT true?
A) Technical analysis focuses on stock price patterns and on proxies for buy or sell pressure in the market
B) Fundamental analysis focuses on the determinants of the underlying value of the firm, such as current profitability and growth prospects
C) Evidence for market efficiency is that stock prices follow a random walk with no discernible predictable patterns that investors can exploit
D) Under market efficiency, only new information will move stock prices, and this information is more likely to be good news than bad news.
E) Market efficiency refers to when market prices reflect all currently available information
WRONG: D) Under market efficiency, only new information will move stock prices, and this information is EQUALLY (NOT MORE) likely to be good news than bad news - i.e., prices follow a RANDOM walk.
33
Proponents of the efficient market hypothesis often advocate passive as opposed to active investment strategies.
TRUE/ FALSE
Why?
TRUE
The policy of passive investors is to buy and hold a broad-based market index. They expend resources neither on market research nor on frequent purchase and sale of stocks. Under the belief of complete market efficiency, it should be the case that no investors will be able to generate superior returns, because market prices should IMMEDIATELY reflect and react to new information.
34
Which of the following is NOT true about active versus passive investment?
A) Passive investment is suggested under the strong assumption of market efficiency
B) Management fees are generally higher in passive investment vehicles than active investment vehicles
C) The degree of investment performance transparency for the client is lower under active than passive management
D) Active management entails high costs to personnel to be actively monitoring the market and trading oftentimes aggressively with short time spans, while in passive management, cost-cutting and efficiency are more important
WRONG: B) Management fees are generally higher in ACTIVE (NOT PASSIVE) investment vehicles. This is because active management entails higher costs for the funds (personnel, IT, etc.) and because it targets superior returns for the investors. Correspondingly, fees are higher. (Because of option D)
EXPLANATIONS OF OTHER OPTIONS:
A) Passive investment is suggested under the strong assumption of market efficiency because if an asset manager is confident that it can outsmart and outperform the market (which is only feasible under the absence of complete market efficiency), he/she would pursue an active investment strategy.
C) The degree of investment performance transparency for the client is lower under active than passive management because investors often get an update of the portfolio performance once a month, while you can see the current value of your passive investment holdings whenever preferred.
35
Even if the market is efficient, an important role exists for portfolio management, which can be particularly valuable to investors. Which of the following is not one of such valuable tasks?
A) Portfolio management can be a valuable addition to the buyer in terms of consulting (which is unique from asset managers who simply invest on behalf of the client).
B) Helping the client understand the benefits of diversification, which is crucial even if the market is totally efficient.
C) Portfolio managers can have a crucial impact on clients in helping them understand and determine a level of risk of their portfolio that is appropriate given their risk tolerance.
D) Consulting on tax considerations for the client, which can be very important in order to improve the after-tax rate of return of the portfolio
E) All of the above are tasks that are valuable for investors, carried out by portfolio managers
CORRECT: E) All of the above are tasks that are valuable for investors, carried out by portfolio managers
EXPLANATION OF OPTIONS
B) Helping the client understand the benefits of diversification, which is crucial even if the market is totally efficient. According to the black model (chapter 8) about the combination of active and passive investment, lack of diversification is the price that you have to pay to pursue alpha. If you believe that there is no alpha, it makes no sense to have a small portfolio. The model argues that if there is no alpha, everything should be passive.
36
While no market can be perfectly efficient, in well-functioning markets, anomalies ought to be self-destructing. As market participants learn of profitable trading strategies, their attempts to exploit them should move prices to levels at which abnormal profits are no longer available.
TRUE/ FALSE
TRUE
Abnormal returns: return on a stock beyond what would be predicted by market movements alone. E.g., due to announcement or the release of information of the firm.
37
Predictability of market prices ______ over longer horizons.
A) increases
B) decreases
C) increases or decreases randomly
Predictability of market prices INCREASES (A) over longer horizons.
Research literature from the 80s indicates evidence in favor of predictability with a longer horizon - it is easier to predict e.g., on the yearly or multi-yearly level rather than the daily or weekly level.
38
```
If markets are efficient, what should be the correlation coefficient between stock returns for two non-overlapping time periods?
A) 0
B) 1
C) -1
D) depends
```
If markets are efficient, the correlation coefficient between stock returns for two non-overlapping time periods should be 0 (A).
If this is not the case, one could use returns from one period to predict returns in later periods and make abnormal profits – which should not be possible in an efficient market.
39
Assuming an efficient market:
For Steady Growth Industries that have never missed a dividend payment in its 94-year history, does this make it more attractive to you as a possible purchase for your stock portfolio?
No, the value of dividend predictability would be already reflected in the stock price
40
The momentum effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.
The momentum effect is (B): The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
41
The book-to-market effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.
Book-to-market effect: (A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
42
The Small-firm effect effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.
The Small-firm effect effect is: D) The tendency of investments in stocks of small firms earning abnormal returns.
43
The P/E effect is:
A) The tendency for stocks of firms with high ratios of book-to-market value to generate abnormal returns.
B) The tendency of poorly performing stocks and well-performing stocks in one period to continue that abnormal performance in following periods.
C) The tendency of low P/E stocks to exhibit higher average risk-adjusted returns than high P/E stocks.
D) The tendency of investments in stocks of small firms earning abnormal returns.
P/E effect: C) low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks. I.e., an investor could earn superior returns simply by buying low P/E securities. This is a market anomaly because it is a piece of information that can be used to improve investment performance, (which should not exist in an efficient market). One possible explanation for this effect is that the neglect to take into account the effect of risk.
- Suppose that we have two companies with the same expected earnings and different levels of risk. The riskier stock, in order to command higher returns, would sell at a lower price, causing its P/E ratio to be lower. Therefore, the P/E effect may simply reflect the effect of risk on stock returns.
44
Reversal effect: the tendency of poorly performing stocks and well-performing stocks in one period to experience reversals (a change in the opposite direction) in the following periods.
TRUE/ FALSE
TRUE
45
Neglected-firm effect: investments in stock of less well-known firms have generated abnormal returns.
TRUE/ FALSE
TRUE
46
Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis?
A) The average rate of return is significantly greater than zero.
B) The correlation between the return during a given week and the return during the following week is zero.
C) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall.
D) One could have made higher-than-average capital gains by holding stocks with low dividend yields.
Suppose that, after conducting an analysis of past stock prices, you come up with the following observations. Which would appear to contradict the weak form of the efficient market hypothesis?
C) One could have made superior returns by buying stock after a 10% rise in price and selling after a 10% fall. Buying stocks when prices are rising and selling them at lower prices can by definition not result in superior returns. Investors should always try to buy at a lower cost and sell at a higher price to make profit.
47
Which of the following statements are true if the efficient market hypothesis holds?
a. It implies that future events can be forecast with perfect accuracy.
b. It implies that prices reflect all available information.
c. It implies that security prices change for no discernible reason.
d. It implies that prices do not fluctuate.
b. It implies that prices reflect all available information.
48
Is the following phenomena consistent with of violation of the EMH?
Nearly half of all professionally managed mutual funds are able to outperform the S&P 500 in a typical year.
Consistent – simply based on pure luck, half of all managers should be able to beat the market in any year.
49
Is the following phenomena consistent with of violation of the EMH?
Money managers who outperform the market (on a risk-adjusted basis) in one year are likely to outperform the market in the following year.
Inconsistent – following the notion of random walk, the outperformance in one year should not result in a likely outperformance of the market in the future. This would be the basis of an “easy money” rule: simply invest with last year’s best managers.
50
Is the following phenomena consistent with of violation of the EMH?
Stock prices tend to be predictably more volatile in January than in other months.
Consistent – in contrast to predictable returns, predictable volatility does not convey a means to earn abnormal returns.
51
Is the following phenomena consistent with of violation of the EMH?
Stock prices of companies that announce increased earnings in January tend to outperform the market in February
Inconsistent – under the EMH, abnormal performance ought to occur in January when earnings are announced – not later.
52
Good News, Inc., just announced an increase in its annual earnings, yet its stock price fell. Is there a rational explanation for this phenomenon?
Yes - The market may have estimated even greater increase in earnings. Compared to expectations, the announcement may have been a disappointment.
53
Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?
YES/ NO
NO
Positive CAPM alphas among thinly traded stocks do not necessarily violate the efficient market hypothesis since these higher alphas are actually risk premiums, not market inefficiencies. Less traded stocks entails lower liquidity, which results in investors requiring a higher expected return to compensate for the illiquidity/risk. Thus, a positive alpha reflects the higher risk connected to the stock, and does not necessarily entail a violation of EMH.
54
Which of the following types of information processing errors concerns that investors are slow to update their beliefs and underreact to new information?
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)
C) conservatism: investors are slow to update their beliefs and underreact to new information.
55
Which of the following types of information processing errors concerns: putting too much weight on recent experiences. I.e., wrongfully projecting that recent economic events will be long-lasting and affect future economic conditions, rather than putting focus on observing the historical data for a longer period. This leads to forecasting errors.
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)
A) memory bias
56
If you trade actively as an investor, however, fail to overperform the market, it is a clear example of _____
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)
if you trade actively as an investor, however, fail to overperform the market, it is a clear example of (B) OVERCONFIDENCE.
overconfidence: investors overestimate their abilities and the precision of their forecasts
57
When investors are too quick to infer a pattern or trend from a small sample, which may lead to overreaction by looking at a too small sample and jump to conclusions. E.g., observing a slight positive trend and believing that the economy is booming. This is an example of which type of information processing error?
A) memory bias
B) overconfidence
C) conservatism
D) representativeness (sample size neglect)
This is an example of REPRESENTATIVENESS (SAMPLE SIZE NEGLECT).
Sample size neglect (representativeness bias) is the tendency to believe that a small sample is reliably representative of a broad population and therefore to infer patterns too quickly.
58
Which of the following types of behavioral bias in finance concerns:
presenting data in a way that is suitable to a given objective of the presenter, which can affect investors' decisions.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)
B) framing: when decisions are affected by how choices are described
59
Which of the following types of behavioral bias in finance concerns:
When investors segregate accounts and take risks with their gains that they would not take with their principal.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)
C) mental accounting: when individuals mentally segregate assets into independent accounts rather than viewing them as part of a unified portfolio.
60
Which of the following types of behavioral bias in finance concerns:
A tendency of investors keeping certain stocks for too long because the return is negative. I.e., they are more willing to sell a stock that has increased in value than one which has decreased in value.
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)
D) loss aversion (prospect theory): If an investor makes money, he/she becomes more risk adverse, and if they lose, they are willing to take more risk. This explains why a stock that you hold decreases in value, you are reluctant to sell the stock and make a loss due to the belief that the stock price might bounce back up.
61
```
Investors tend to blame themselves more when an unconventional or risky bet turns out badly rather than if they were to go for a more safe and conventional investment. Due to this preference to avoid regret and self-blame, investors may tend to allocate assets in more conventional investments. This is a case of:
A) regret avoidance
B) framing
C) mental accounting
D) loss aversion (prospect theory)
```
A) regret avoidance
62
Which of the following limits to arbitrage concers:
Even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This risk lies in the intrinsic value and market value taking too long to converge.
A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion
C) Fundamental risk: even if a security is mispriced, it still can be risky to attempt to exploit the mispricing. This risk lies in the intrinsic value and market value taking too long to converge.
"Markets can remain irrational longer than you can remain solvent”. The risk of “waiting” for the market to adjust to equilibrium may not be feasible, and therefore, exploiting arbitrage opportunities can be extremely risky if the time-horizon is limited.
Remember: the case in the Big Short, where the short sellers were waiting for the market to correct (the bubble to burst) - but almost went bankrupt in the meantime
63
Transactions costs and restrictions on short selling can limit arbitrage activity. Especially when it comes to trading single stocks, it is difficult to play against the market. Meanwhile, the cost of short-selling is not cheap, and the activity itself can entail significant risks.
The above description is of which limit to arbitrage?
A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion
B) Implementation costs & cost of short-selling
64
Maybe your model is wrong, and the market value is actually correct. Maybe your calculation of the terminal value of the price is wrong, or the risk premium is mis-estimated, or there are sources of risk that other people have been able to identify that you have not.
The above description is of which limit to arbitrage?
A) Model risk
B) Implementation costs & cost of short-selling
C) Fundamental risk
D) Loss aversion
A) Model risk
65
Behavioral finance concerns models of financial markets that emphasize implications of psychological factors affecting investor behavior.
TRUE/ FALSE
TRUE
66
```
The tendency of investors to hold on to losing investments is referred to as:
A) momentum effect
B) firm-size effect
C) disposition effect
D) reversal effect
```
Disposition effect: The tendency of investors to hold on to losing investments.
This is often a byproduct of risk aversion behavioral bias (prospect theory).
67
Relative strength refers to:
A) The volatiltiy of a security relative to either the market as a whole or its particular industry
B) The extent to which a security has outperformed or underperformed either the market as a whole or its particular industry
C) The pricing of a security relative to other securities in the market as a whole or its particular industry
D) The extent to which movements in the broad market index are reflected widely in movements of individual stock prices.
Relative strength refers to: B) the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry
68
Breadth refers to the extent to which movements in the broad market index are reflected widely in movements of individual stock prices.
This is often measured as the spread between the number of stocks that advanced and declined in price on a given day in the market.
TRUE/ FALSE
TRUE
69
According to the Dow Theory, there are trends in prices, and we can distinguish between the following trends:
- _____: long-term movement of prices, lasting from several months to several years.
- _____: short-term deviations of prices from the underlying trend line and are eliminated by corrections.
- _____: daily fluctuations of little importance
A) Primary trend, Secondary/ intermediate trend, Tertiary/ minor trends
B) Tertiary/ minor trends, Secondary/ intermediate trend, Primary trend
C) Secondary/ intermediate trend, Primary trend, Tertiary/ minor trends
A)
According to the Dow Theory, there are trends in prices, and we can distinguish between the following trends:
- Primary trend: long-term movement of prices, lasting from several months to several years.
- Secondary/ intermediate trend: short-term deviations of prices from the underlying trend line and are eliminated by corrections.
- Tertiary/ minor trends: daily fluctuations of little importance
70
The ratio of trading volume in declining stocks/number of stocks declined, to the volume in advancing stocks/ number of stocks advanced, is referred to as:
Hint: it is used in technical analysis to identify bearish or bullish signals and to measure breadth.
A) Confindence index
B) Trin statistic
C) Put/call ratio
B) The ratio of trading volume in declining stocks/number of stocks declined, to the volume in advancing stocks/ number of stocks advanced, is referred to as: TRIN ratio
Trin = (Trading volume of declining stock/number stocks declining) / (Trading volume of advancing stock/number stocks advancing )
71
Following is NOT true about the Confidence Index:
A) It is the ratio of the average yield on 10 top-rated corporate bonds divided by the average yield on 10 intermediate-grade corporate bonds.
B) The ratio will always be below 1, because higher-rated bonds will offer lower promised yields to maturity.
C) When the confidence index values approach 0, it reflects a bullish signal
D) When the confidence index values approach 1, it reflects a bullish signal
WRONG: C) When the confidence index values approach 0, it reflects a bullish signal.
TRUE: When bond traders are optimistic about the economy, they require smaller default premiums on lower-rated debt – i.e., the low to high rated bond YTM spread goes down, indicating good sentiment. Hence, the confidence index will approach 1 due to the lower spread, indicating a bullish signal.
The lower confidence index values (approaching 0) reflect bearish signal: when bond traders are pessimistic about the economy, they require larger default premiums on lower-rated bonds. This indicates decreased sentiment.
72
Which of the behavioral biases is arguably the one that is to the highest degree linked to technical analysts ability to detect and exploit inefficient market prices through technical analysis?
A) mental accounting
B) regret avoidance
C) prospect theory
D) conservatism bias
E) sample size neglect (representativeness bias)
F) framing
The professor argues that conservatism bias is that one element of behavioral finance that is most closely linked to technical analysis, while the prospect theory may also be to some degree creating room for detection and exploitation of inefficient market prices through technical analysis. The other behavioral elements are too general.
73
______ believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur immediately/ very quickly. Consequently, prices are at fair levels, and active management (stock picking) is very unlikely to result in overperformance above that of a broadly diversified index portfolio.
A) Behavioral finance advocates
B) Efficeint market advocates
(B) Efficeint market advocates believe that publicly available information (and, for advocates of strong-form efficiency, even insider information) is, at any point in time, reflected in securities prices, and that price adjustments to new information occur immediately/ very quickly. Consequently, prices are at fair levels, and active management (stock picking) is very unlikely to result in overperformance above that of a broadly diversified index portfolio.
74
______ identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the literature in this area generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
A) Behavioral finance advocates
B) Efficeint market advocates
(A) Behavioral finance advocates identify a number of investor errors in information processing and decision making that could result in mispricing of securities. However, the literature in this area generally does not provide guidance as to how these investor errors can be exploited to generate excess profits. Therefore, in the absence of any profitable alternatives, even if securities markets are not efficient, the optimal strategy might still be a passive indexing strategy.
75
Jill Davis tells her broker that she does not want to sell her stocks that are below the price she paid for them. She believes that if she just holds on to them a little longer they will recover, at which time she will sell them. Which behavioral characteristic is the basis for Davis’s decision making?
a. Loss aversion.
b. Conservatism.
c. Representativeness.
a. Loss aversion.
76
```
After Polly Shrum sells a stock, she avoids following it in the media. She is afraid that it may subsequently increase in price. Which behavioral characteristic is the basis for Shrum’s decision
making?
a. Fear of regret.
b. Representativeness.
c. Mental accounting.
```
a. Fear of regret: she wants to avoid the feeling of regret from having sold a stock that has increased in value since the sale
77
All of the following actions are consistent with feelings of regret except:
a. Selling losers quickly.
b. Hiring a full-service broker.
c. Holding on to losers too long.
B) Hiring a full-service broker is NOT consistent with feelings of regret, because you will not have any regret since you have delegated the responsibility to a professional.
78
```
Investors are slow to update their beliefs when given new evidence. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS
```
A) CONSERVATISM BIAS
79
```
investors are reluctant to bear losses caused by their unconventional decisions. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS
```
B) REGRET AVOIDANCE
80
```
Investors exhibit less risk tolerance in their retirement accounts versus their other stock accounts. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS
```
C) MENTAL ACCOUNTING
81
```
Investors are reluctant to sell stocks with “paper” losses. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS
```
D) DISPOSITION EFFECT: The tendency of investors to hold on to losing investments.
82
```
Investors disregard sample size when forming views about the future from the past. This is an example of:
A) CONSERVATISM BIAS
B) REGRET AVOIDANCE
C) MENTAL ACCOUNTING
D) DISPOSITION EFFECT
E) REPRESENTATIVENESS BIAS
```
E) REPRESENTATIVENESS BIAS
83
Following is NOT true about data mining:
A) refers to sorting through large amounts of historical data to uncover systematic patterns that can be used as the basis of a trading strategy.
B) the risk of data mining includes that historical relationships may break down when fundamental economic conditions change, or that the apparent patterns in the data may be due to pure chance.
C) patterns resulting from data mining may not reflect real relationships that can be counted on to persist in the future.
D) the larger the sample size/ data base, the higher the probability for data mining.
E) all of the above are true
WRONG: D) the SMALLER (not larger) the sample size/ data base, the higher the probability for data mining.
84
Even if prices follow a random walk, they still may not be informationally efficient. Why may this be true, and why does it matter for the efficient allocation of capital in our economy?
Even if prices follow a random walk, the existence of irrational investors combined with the limits to arbitrage by arbitrageurs may allow persistent mispricing to be present (longer term deviation from instic values). This implies that capital will not be allocated efficiently.
85
Calculate the trin ratio for the NASDAQ.
Of the total 2,981 stocks listed on NASDAQ,
• 1,905 advanced
• 896 declined
• 180 unchanged
The trading volume of the shares totaled 1,487,956, of which:
• 1,075,611 advanced
• 388,278 declined
• 24,067 unchanged
Is the trin ratio bullish or bearish?
Trin Ratio=(388,278/896 )/(1,075,611/1,905 )=(433.346)/(564.625)=0.7675
A trin ratio of 0.7675 indicates a BULLISH signal, since it is below 1.
86
Calculate the BREADTH of NYSE using following data?
Of the total 3,182 stocks listed on NYSE,
• 2,070 advanced
• 1,003 declined
• 109 unchanged
The trading volume of the shares totaled 804,628 of which:
• 510,372 advanced
• 283,331 declined
• 10,925 unchanged
Breadth=no.advances-no.declines
Breadth=2,070-1,003=1,067
Since the breadth (spread) is positive, it indicates that a bullish signal. However, in practice, one would not use a one-day measure for the market signal being bullish/bearish.
87
Baa-rated bonds currently yield 6%, while Aa-rated bonds yield 5%. Suppose that due to an increase in the expected inflation rate, the yields on both bonds increase by 1%.
Calculate confidence index before and after the 1% increase in YTM
Would this be interpreted as bullish or bearish by a technical analyst?
Confidence index=(average YTM of top 10 rated corporate bonds)/(average YTM of 10 intermeidate grade corporate bonds)<1
Confidence index_Before=0.05/0.06=0.833
Confidence index_After=0.06/0.07=0.857
The ratio will always be below 1, because higher-rated bonds will offer lower promised yields to maturity. Since the confidence index increases due to the YTM increase in both bonds amid increased expected inflation rate, theoretically it indicates a bullish market. However, the reason for the increase is not improved sentiment in the economy, but rather, increase expected inflation.
88
On day 1, Comp Inc. traded at 19.63, while the industry index was at 50
On day 40, Comp Inc. traded at 28, while the industry index was at 56.1
Does Comp Inc. show relative strength over this period?
Relative strength: the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry.
Relative strengh=difference between (stock_i stock price at time t)/(Industry index at time t) and (stock_i stock price at time T)/(Industry index at time T)
At the beginning of the period, the price of Computers, Inc. divided by the industry index was:
19.63/50=0.393
By the end of the period, it appears that the firm outperformed other firms in its industry:
28/56.1=0.499
Therefore, the overall trend indicates relative strength
89
The cumulativce breadth is calculated by summing the net advances of stock developments (advances - decreases) over the sample period.
TRUE/ FALSE
TRUE
90
Trin stat of 1.068 indicates a bullish/bearish market?
A trin stat of 1.068 is slightly above 1, which signals a slightly bearish market.
Ratios above 1.0 are BEARISH
Ratios below 1.0 are BULLISH.
Trin=(Trading volume of declining stock/number stocks declining)/(Trading volume of advancing stock/number stocks advancing )
91
The "small firm effect" refers to the fact that:
A) investments in stocks of large firms appear to have earned abnormal returns
B) investments in stocks of small firms appear to have earned abnormal returns
C) smaller firms are not as broadly covered by equity analysts, which results in the stock price of such firms not reflecting true value in as large degree as large firms
D) more than one of the options are correct
B) investments in stocks of small firms appear to have earned abnormal returns
92
```
When unsuccessful funds that cease operation stop reporting returns and leave a database, leaving behind only the successful funds, resulting in the best managers being overrepresented in the sample since the worst managers being ignored - it is an example of:
A) Behavioral finance (bias)
B) Benchmark error
C) Survivorship bias
D) None of the above
```
C) Survivorship bias: bias in the average returns of a sample of funds induced by excluding past returns on funds that left the sample because they happened to be unsuccessful. This arises when build a sample from the end of history rather than from the beginning
93
```
Use of an inappropriate proxy for the true market portfolio when testing a theory is referred to as:
A) data interpretation error
B) benchmark bias
C) survivorship bias
D) benchmark error
```
D) benchmark error: Use of an inappropriate/incorrect proxy for the true market portfolio when testing a theory
94
Which of the following is NOT true about the Equity Premium Puzzle?
A) originates from the observation that equity returns exceeded the risk-free rate to an extent that is inconsistent with the covariance of returns with consumption risk and reasonable levels of risk aversion.
B) the equity premium puzzle is the result of applying a full rationality model of investor choice to equity investment.
C) a plausible explanation for the puzzle is survivorship bias
D) a plausible explanation for the puzzle is unexpected capital gain
E) all of the above are correct
E) all of the above are correct
95
Even if the single-factor CCAPM (with a consumption-tracking portfolio used as the index) performs better than the CAPM, it is still possible that the consumption portfolio does not capture the size and growth characteristics captured by the SMB (i.c., small minus big capitalization) and HML (i.e., high minus low book-to-market ratio) factors of the Fama-French three-factor model. Therefore, it is expected that the Fama- French model with consumption provides a better explanation of returns than does the model with consumption alone.
TRUE/ FALSE
TRUE
96
Following is NOT true about the put/call ratio:
A) Calls are options that gives the right to buy: a way to bet on rising prices.
B) Puts are options that gives the right to sell: a way to bet on falling prices.
C) A rising ratio may signal investor pessimism and a coming market decline (bearish market), and vice versa.
D) A rising ratio may signal investor optimistic and a coming market increase (bullish market), and vice versa.
E) Contrarian investors (a person who opposes or rejects popular opinion, especially in stock exchange dealing) see a rising ratio as a buying opportunity.
WRONG: D) A rising ratio may signal investor optimistic and a coming market increase (bullish market), and vice versa.
CORRECT INSTEAD: C) A rising ratio may signal investor pessimism and a coming market decline (bearish market), and vice versa.
97
Which is NOT a hypotheses for the second-pass regression for a one-factor SML?
A) The intercept is zero
B) The slope is equal to the average return on the index portfolio
C) The factor slope coefficient equals the average return on the factor
D) All of the above are correct
WRONG: C) The factor slope coefficient equals the average return on the factor
98
Which is NOT a hypotheses for the second-pass regression for a two-factor SML?
A) The intercept is zero
B) The slope is equal to the average return on the index portfolio
C) The factor slope coefficient equals the average return on the factor
D) All of the above are correct
D) All of the above are correct
99
Concerning the conventional CAPM and CCAPM (consumption CAPM), which of the following statements are NOT true?
A) CCAPM differs from the conventional CAPM in the beta being measured relatively to consumption growth rather than market growth.
B) CCAPM argues that what matters to investors is not their wealth per se, but their lifetime flow of consumption.
C) The conventional CAPM focuses on the covariance of security returns with returns for the market portfolio (which in tracks aggregate wealth), while the consumption-based CAPM focuses on the covariance of security returns with returns for a portfolio that tracks consumption growth.
D) All of the options are correct
D) All of the options are correct
100
Wealth and consumption should be positively correlated and, hence, market volatility and consumption volatility should also be positively correlated. Periods of high market volatility might coincide with periods of high consumption volatility.
Is this statement TRUE/FALSE?
TRUE
101
```
Which of the following is NOT a determinants for stockholding (i.e., whether to hold stocks and how many stocks to hold) according to John Heaton and Debora Lucas (2000)?
A) Net worht
B) Market volatility
C) Relative business
D) Age
```
WRONG: B) Market volatility is NOT a determinant for stockholding.
According to John Heaton and Debora Lucas (2000), significant explanatory variables for stockholding include:
• Net worth: wealthier people hold a larger proportion of stocks.
• Relative business: if you are a business man owning a company, you are less likely to hold stocks, because you are already running risk by running company - i.e., you are not incentivized to increase the risk of your portfolio by adding single stocks.
• Age of respondents: there is a positive coefficient, indicating that the older you are, the more likely you are to hold stocks.
102
```
Which two ways are most commonly utilized when measuring Average Portfolio Return:
A) time-weighted (average) returns
B) internal rate of return
C) dollar/ money- weighted returns
D) risk-adjusted return
E) CAPM
```
A) time-weighted (average) returns
| C) dollar/ money- weighted returns
103
```
When measuring risk-adjusted portfolio performance, which measure is most appropriate if the given portfolio under evaluation represents the entire investment fund of the investor (total investor wealth)?
A) Sharpe ratio
B) Treynor measure
C) Jensen's Alpha
D) Information Ratio
```
A) Sharpe is the most appropriate performance measure when the portfolio represents the entire investment fund of the investor.
104
```
When measuring risk-adjusted portfolio performance, which measure is most appropriate when the portfolio under evaluation represents the active portfolio to be optimally mixed with the passive portfolio?
A) Sharpe ratio
B) Treynor measure
C) Jensen's Alpha
D) Information Ratio
```
D) Information Ratio is most approriate when measuring a portfolio that represents the active portfolio to be optimally mixed with the passive portfolio.
105
When measuring risk-adjusted portfolio performance, which measure is most appropriate when the portfolio is one of many combined into a larger investment fund - i.e., if the portfolio represents one sub portfolio of many owned by the investor? Choose 1-4
A) Sharpe ratio
B) Treynor measure
C) Jensen's Alpha
D) Information Ratio
If the portfolio is one of many combined into a larger investment fund, use the (C) Jensen’s alpha or (B) Treynor measure. The Treynor measure is appealing because it weighs excess returns against systematic risk. On the other hand, Jensen’s alpha makes inference easier.
106
The evaluation process of portfolio returns is commonly very "noisy". Therefore, even if the return distribution is stable with a constant mean and variance, many observations and long sample periods are required to eliminate the effect of the “luck of the draw” from the evaluation process.
TRUE/FALSE
TRUE
Think of the example with S&P 500 index compared to the The Markowill Group performance (page 90 in lecture notes). Here, we looked at the difference in relative performance of the Markowill group across horizons (quarter, 1Y, 3Y & 5Y).
107
Following statement is NOT true about market timing:
A) involves movement of asset allocation e.g., (stocks or fixed income securities) and cash, so that the proportion of stocks in your portfolio changes tactically over time
B) entails active investment pursuing stock pricing
C) is mostly pursued by advocates of the efficient market hypothesis
D) actively managed portfolios (which is the case with market timing) make it difficult to assess performance, since it leads to shifting mean and risk, and an ever-changing portfolio beta
WRONG: C) is mostly pursued by advocates of the efficient market hypothesis
Strong belief of EMH entails lack of belief in the ability to beat the market. Therefore, such investors would not attempt to pursue market timing.
108
```
The difference between the return on a managed portfolio and that of a benchmark portfolio against which the manager is evaluated is referred to as:
A) market timing
B) tracking error
C) bogey
D) comparison universe
```
B) Tracking error: The difference between the return on a managed portfolio and that of a benchmark portfolio against which the manager is evaluated
109
```
Asset allocation in which the investment in the market is increased if one forecasts that the market will outperform T-bills. This is active investing, and is referred to as:
A) market timing
B) tracking error
C) bogey
D) comparison universe
```
A) Market timing: Asset allocation in which the investment in the market is increased if one forecasts that the market will outperform T-bills. This is active investing.
• Market timer: An investor who speculates on broad market moves rather than on specific securities.
110
```
An average (often a geometric average) of the period-by-period holding-period returns of an investment, which is calculated as the product of the return for each period to the power of 1/n, is referred to as:
A) time-weighted average
B) tracking error
C) dollar-weighted average
D) comparison universe
```
A) time-weighted average
111
The internal rate of return on an investment is also referred to as:
A) time-weighted average
B) tracking error
C) dollar-weighted average rate of return
D) comparison universe
C) dollar-weighted average rate of return = IRR
112
A set of money managers employing similar investment styles and risk characteristics, used as a benchmark for assessing the relative performance of a portfolio manager, is referred to as _____:
A) time-weighted average
B) tracking error
C) dollar-weighted average rate of return
D) comparison universe
D) comparison universe
Comparing a portfolio’s return with the returns on a comparison universe is the simplest and most popular way to adjust returns for risk.
113
```
The reward-to-volatility ratio; ratio of excess return to portfolio standard deviation is referred to as:
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio
```
D) Sharpe ratio: the reward-to-volatility ratio; ratio of excess return to portfolio standard deviation
114
```
______ expresses the ratio of the average excess return of the portfolio in respect to the weighted average beta of the portfolio (systematic risk). This indicates the average return in respect to systematic of total risk. The measure gives us the slope of the SML, going through the origin to the specific portfolio we are measuring.
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio
```
A) Treynor’s measure: ratio of average excess return of portfolio to the weighted average portfolio beta. This tells us the average return in respect to systematic of total risk
115
_____ is the relation of the specific point relative to SML. If ____ is positive, the manager under evaluation is overperforming the market, and the point would be above the SML.
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio
B) Jensen's alpha: the alpha of an investment, which tells us whether the given portfolio manager is overperforming the market. (If alpha is positive: yes; if alpha is negative: no)
116
```
______ is a version of a reward-to-risk ratio, which divides the alpha of the portfolio by the nonsystematic/ firm-specific risk of the portfolio. This ratio quantifies the trade-off between alpha and diversifiable risk, and it measures abnormal return per unit of risk that in principle could be diversified away by holding a market.
A) Treynor’s measure
B) Jensen's alpha
C) Information ratio
D) Sharpe ratio
```
Information ratio: Ratio of alpha to the standard deviation of diversifiable risk (firm-specific risk). It measures abnormal return (relative to market) per unit of risk that in principle could be diversified away by holding a market. This difference between the return on the portfolio and that of a benchmark portfolio against which the manager is evaluated is called "tracking error".
117
The return an investment manager is compared to for performance evaluation i referred to as a _____. It typically refers to a specific benchmark that is set by the fund company as a close comparison for the fund itself.
A) market timing
B) tracking error
C) bogey
D) information ratio
C) bogey
118
In terms of “forward looking” statistics, the arithmetic average is the better estimate of expected rate of return (compared to geometric average return).
TRUE/FALSE
TRUE: In terms of “forward looking” statistics, the ARITHMETIC AVERAGE is the better estimate of expected rate of return (compared to geometric average return).
119
When computing the parameter of average return, we always use _____, while we use the ____ when computing the increase in wealth.
A) Arithmetric average return; geometric average return
B) Geometric average return; arithmetric average return
This is important!!!
When computing the parameter of average return, we always use ARITHMETRIC AVERAGE RETURN, while we use the GEOMETRIC AVERAGE RETURN when computing the increase in wealth.
120
The time weighted return differs from money-weighted return in that it puts equal weight on each period, while the money-weighted return puts a different weight on periods on the basis of the in- and outflows during each period.
TRUE/ FALSE
TRUE
121
The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.
TRUE/ FALSE
TRUE: The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.
122
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If we are evaluating portfolios that will be invested alongside with an index portfolio (i.e., neither portfolio A or B will make up the investor’s total wealth allocated in not risk-free investments), we can utilize which measure? Select 1-4
A) Jensen’s alpha
B) Sharpe ratio
C) Information ratio
D) Treynor measure
```
A) Jensen’s alpha & D) Treynor measure.
If the portfolio under evaluation is one of many combined into a larger investment fund, we may use Jensen’s alpha or Treynor measure. The Treynor measure is appealing because it weighs excess returns against systematic risk. On the other hand, Jensen’s alpha makes inference easier.
123
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If the portfolio under evaluation is to represent the entire risky investment of the investor’s wealth (everything beyond risk-free investments), which measure of performance is most appropriate? Select 1-4
A) Jensen’s alpha
B) Sharpe ratio
C) Information ratio
D) Treynor measure
```
B) Sharpe ratio
If the portfolio under evaluation represents the entire risky investment, i.e., if investor is considering allocating capital in asset/portfolio A or B, and the given decision would completely change the total volatility profile of the investor’s wealth, then we use the Sharpe measure.
124
If the alpha (jensen's aplha) of portfolio A (under consideration) is equal to 1.4%, while the expected return on portfolio A is equal to 12%, which of the statements are then NOT true?
A) Portfolio A would allow the investor to gain additional 1.4% of return
B) The required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio A is met and exceeded
C) The required return in order for the investor to allocate assets in portfolio A is equal to 1.4%
D) the required return in order for the investor to allocate assets in portfolio A is equal to 10.6%
WRONG: C) The required return in order for the investor to allocate assets in portfolio A is equal to 1.4%
INSTEAD: D) the required return in order for the investor to allocate assets in portfolio A is equal to 10.6%:
Expected return - jensen's alpha = required return for the investor:
12% - 1.4% = 10.6%
125
If the alpha (jensen's aplha) of portfolio B (under consideration) is equal to -0.2%, while the expected return on portfolio B is equal to 16%, which of the statements are then TRUE?
A) Portfolio B would allow the investor to gain additional 0.2% of return
B) The required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio B is met and exceeded - therefore, portfolio B would be a good investment
C) The required return in order for the investor to allocate assets in portfolio B is equal to 16.2%
D) the required return in order for the investor to allocate assets in portfolio B is equal to 0.2%
CORRECT: C) The required return in order for the investor to allocate assets in portfolio B is equal to 16.2%
All other answers are wrong.
Portfolio B would NOT allow the investor to meet the required return: with the negative alpha, it means that the investor’s required return in order to compensate for taking on the systematic risk connected to allocating funds in portfolio B is NOT met by its expected return of 16%. In this case, the investor would in fact require: 16%+0.2%=16.2%. Thus, he/she should not invest in portfolio B.
126
Graphically, the alpha(intecept) indicates ______ , while the coefficient multiplying square (convex/ concave curve) indicates the _____
A) stock-picking ability; market timing
B) market timing; stock picking ability
Graphically, the alpha(intecept) indicates STOCK-PICKING ABILITY , while the coefficient multiplying square (convex/ concave curve) indicates the MARKET TIMING.
The higher the alpha(intercept), the better the stock-picking ability of an asset manager.
127
A _____ curve entails good market timing - i.e., a good time to buy stocks, and a ____ curve entails poor market timing - i.e., a bad time to buy stocks
A) convex
B) concave
A CONVEX curve entails good market timing - i.e., a good time to buy stocks, and a CONCAVE curve entails poor market timing - i.e., a bad time to buy stocks
128
Following is NOT true about Roll’s critique to testing CAPM using first- and second pass regressions.
A) Roll suggests that the problem begins with the market index, which is not the theoretical portfolio against which the second pass regression should hold. Instead, one should use the return of a zero-beta stock portfolio as a proxy for risk free rate.
B) According to Roll, even if the relationship is valid with respect to the true (unknown) index, we may not find it. As a result, the second pass relationship may be meaningless.
C) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low
D) According to Roll, we would need also data on the individual investors’ wealth. Not knowing the true composition of the market portfolio makes the CAPM untestable.
WRONG: C) Roll suggests that the CAPM is not testable in any circumstances if R^2 is too low. This is not part of Roll's critique. Instead, Roll argues that due to lack of data on market portfolio composition, i.e., the wealth of the investor, CAPM is untestable. Instead, one should use a portfolio of zero-beta stocks as the theoretical portfolio against which the second pass regression should hold. This zero-beta portfolio return would be a substitute for the risk free rate.
129
Following is NOT true about measurement error in CAPM test:
A) In reality, we cannot observe the true beta nor expected return, which we in turn need to estimate. By construct, an estimation entails some degree of measurement error.
B) If it was possible to observe the true beta, and the true expected return, it would be very easy to test for the CAPM due to no measurement error.
C) The effect of measurement errors can be reduced by looking at portfolios rather than individual securities, since the latter case, e.g., a high-beta security is more likely to be affected by a positive measurement error. Instead, in a portfolio of e.g., 50 stocks, it is more likely that a positive measurement error is offset by a negative measurement error in another stock. The basket is more stable than the individual components.
D) All options are correct
D) All options are correct
130
Following is NOT true about bubbles:
A) The price of stocks can be explained on the basis of fundamentals such as expectations of dividends discounted by an appropriate discount rate, reflecting the time value of money and risk. Bubbles, however, to some extent, represent deviations from fundamental market efficiencies.
B) Bubbles is an extra component of the price that simply depends on the expectations that the price is moving up in the coming period. I.e., in the presence of a bubble, prices appear to differ from intrinsic values. It is suggested that the price of a stock in the market is equal to the sum of the fundamental value and the bubble (if there is one)
C) Bubbles are difficult to predict and exploit. We only know the price of the stock, not the actual value. Thus, we cannot determine accurately the size of the bubble, and it is difficult to determine whether there is a bubble, and if yes, how big.
D) Bubbles are easier to spot right before they burst
E) Bubbles are easier to spot after they burst
WRONG: D) Bubbles are easier to spot right before they burst.
INSTEAD: E) Bubbles are easier to spot after they burst
131
Following is NOT trues about Technical analysis:
A) uses prices and volume information to predict stock price patterns and to proxy buy or sell pressure in the market.
B) is always more optimistic in predicting future stock prices than fundamental analysis provided that market is efficient
C) If we were able to show that technical analysis was actually successful in predicting stock prices, we would provide the results of a weak form of market efficiency, since we would be able to predict prices simply on the basis on past prices and volume.
D) All of the above are true
WRONG: B) Both technical analysis (B) and fundamental analysis (C) are based on public information, and thus, neither should generate excess profits if markets are operating efficiently.
132
Following is NOT true about a "market neutral" investment strategy for hedge funds:
A) A market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio, because such fund is not a diversified portfolio.
B) The term “market neutral” refers to a portfolio position designed to exploit relative mispricing within a market but which is hedged to avoid taking a stance on the direction of the broad market.
C) Market neutral means that beta is equal to 0, and that the investment is risk free
D) A market neutral HF can be thought of as an possible approach for the investor to add alpha to a more passive investment position such as an index mutual fund.
WRONG: C) Market neutral means that beta is equal to 0, and that the investment is risk free
Market-neutral: A strategy designed to exploit relative mispricing within a market but which is hedged to avoid taking a stance on the direction of the broad market.
133
Which of the following is NOT a reason for why it is harder to assess the performance of a hedge fund portfolio manager than that of a typical mutual fund manager?
A) Backfill bias: bias in the average returns of a sample of funds induced by including past returns on funds that entered the sample only if they happened to be successful. Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good. This leads overstatement of the returns relative to what has actually materialized.
B) HFs tend to invest more in illiquid assets - so apparent positive alpha investments may be a compensation for illiquidity
C) HFs' valuation of illiquid assets may be questionable (e.g., due to side pockets)
D) Survivorship bias: bias in the average returns of a sample of funds induced by excluding past returns on funds that left the sample because they happened to be unsuccessful. This arises when build a sample from the end of history rather than from the beginning.
E) All of the options are reasons that make HF managers' performance more difficult to assess
E) All of the options are reasons that make HF managers' performance more difficult to assess
134
Which of the following is most accurate in describing the problems of survivorship bias and backfill bias in the performance evaluation of hedge funds?
a. Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.
b. Survivorship bias and backfill bias both result in downwardly biased hedge fund index returns.
c. Survivorship bias results in upwardly biased hedge fund index returns, but backfill bias results in downwardly biased hedge fund index returns.
a. Survivorship bias and backfill bias both result in upwardly biased hedge fund index returns.
135
Which of the following would be the most appropriate benchmark to use for hedge fund evaluation?
a. A multifactor model
b. The S&P 500
c. The risk-free rate
b. The S&P 500: In the US, most HFs are benchmarked against the S&P 500, and it is said that the performance of the HF is good if it outperforms the S&P 500
136
With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:
a. Both the extra layer of fees and the higher liquidity offered.
b. No reason; funds of funds earn returns that are equal to those of individual hedge funds.
c. The extra layer of fees only.
C) The extra layer of fees only - FoF is not more liquid than direct investment in HFs.
Funds of funds invest in various best-performing hedge funds based on performance evaluation. For this “filtering service”, the fund managers of a fund-of-funds charge an extra layer of fees. This will decrease the net return for investors in FoF relative to direct investments in HFs.
137
Which of the following hedge fund types is most likely to have a return that is closest to risk-free?
a. A market-neutral hedge fund.
b. An event-driven hedge fund.
c. A long/short hedge fund.
A) A market neutral HF uses a combination of long and short positions on assets to avoid risk and maximize returns. Thus, return can be said to closely mimic the risk-free market rate.
138
Statistical arbitrage is not true arbitrage, because it does not involve establishing risk-free positions based on security mispricing. Statistical arbitrage is essentially a portfolio of risky bets. The hedge fund takes a large number of small positions based on apparent small, temporary market inefficiencies, relying on the probability that the expected return for the totality of these bets is positive.
TRUE/ FALSE
TRUE
139
A hedge fund with net asset value of $62 per share currently has a high water mark of $66. Which of the following statements are TRUE? Choose 1-4
A) The incentive fee is less valuable if the high-water mark is $67 rather than $66
B) The current incentive fee paid out to the HF is higher now than if the HWM were at $67
C) The incentive fee is more valuable if the high-water mark is $67 rather than $66
D) The current incentive fee paid out to the HF is lower now than if the HWM were at $67
CORRECT: A) The incentive fee is LESS valuable if the high-water mark is $67 rather than $66. With a HWM of $67, the NAV of the fund must reach $67 before the HF can assess the incentive fee. The HWM for a HF is equivalent to the exercise price of a call option on an asset with a current market value equal to the NAV of the fund - I.E., IF EXERCISE PRICE OF CALL OPTION IS HIGHER, THE CALL OPTION VALUE IS LOWER.
NOTE: the HF will not be paid any incentive fees since the NAV is lower than both $67 and $66 (HWM). Thus, B and D are both wrong.
140
A security market line (SML) plots:
A) the returns of one security against the return of another security: a pair of returns
B) the excess return on a security over the risk-free rate as a function of the excess return on the market over the risk-free rate.
C) the expected return of the asset against the systematic risk
D) the excess return on a security against its price
C) the expected return of the asset against the systematic risk
The SML is a graphical representation of the expected return–beta (systematic risk) relationship.
141
_____ level is an upper price level for a security or commodity that is repeatedly reached but not exceeded due to resistance from the market.
A) Resistance
B) Support
C) Momentum
D) Abnormal
A) RESISTANCE level is an upper price level for a security or commodity that is repeatedly reached but not exceeded due to resistance from the market.
Example: stock XYZ is traded for several months at a price of $72 and then declined to $65. If the stock eventually begins to increase in price, $72 will be considered a resistance level, because investors who bought originally at $72 will be eager to sell their shares as soon as they can break even on their investment. Therefore, at prices near $72, a wave of selling pressure will occur. Such activity imparts a type of “memory” to the market that allows past price history to influence current stock prospects.
142
____ levels refer to the price level that an asset does not fall below for a period of time.
A) Resistance
B) Support
C) Momentum
D) Abnormal
Support levels refer to the price level that an asset does not fall below for a period of time. It is the opposite of resistance level.
It indicates e.g., that if a stock is bought at a price of 65, and afterward increases to 72. Eventually, if the stock price again declines, a wave of buying investors will happen as the price falls to 65 (the support level).
143
Cumulative abnormal return (CAR) is the total abnormal return for the period surrounding an announcement or the release of information.
TRUE/ FALSE
TRUE
144
Anomalies: patterns of returns that seem to contradict the efficient market hypothesis.
TRUE/ FALSE
TRUE
145
Jagannathan and Wang study shows two important deficiencies in tests of the single-index model. Which are not part of these two?
A) A human capital factor may be important in explaining returns. The study proves that the model including the human capital factor performs better than the CAPM
B) The study finds that beta is actually cyclical and changes over time depending on the market activity and the state of the economy - therefore, the CAPM and the index model, where we assume constant beta - are suboptimal.
C) if human capital factor and dynamic beta are incorporated in explaining expected returns, anomalies such as the size and book-to-market effects are mitigated
D) Net worth is a significant explanatory variable: wealthier people hold a larger proportion of stocks.
WRONG: D) Net worth is a significant explanatory variable: wealthier people hold a larger proportion of stocks. This is found in a study by John Heaton and Debora Lucas.
The other options correctly sum up Jagannathan and Wang's study.
146
According to John Heaton and Debora Lucas (2000), which of the following are determinants for stock holding? I.e., determinants that affect the attractiveness of holding stocks. Select 1-4:
A) Net worth: wealthier people hold a larger proportion of stocks
B) Relative business: if you are a businessman owning a company, you are less likely to hold liquid stocks because you are not incentivized to increase the risk of your portfolio by adding single stocks
C) Age of respondent: the older you are, the more likely you are to hold stocks
D) Investment experience: if you are a very experienced trader, the chances of holding stocks relative to market index is higher
A) Net worth: wealthier people hold a larger proportion of stocks
B) Relative business: if you are a businessman owning a company, you are less likely to hold liquid stocks because you are not incentivized to increase the risk of your portfolio by adding single stocks
C) Age of respondent: the older you are, the more likely you are to hold stocks
147
The consumption-based asset pricing model (CCAPM) is exactly like the regular CAPM, but differs in the beta being measured relatively to consumption growth rather than market. It implies that what matters to investors is not their wealth per se, but their lifetime flow of consumption. Given this framework, the generalization of the standard CAPM is that instead of measuring systematic risk based on the covariance of returns with the market return (a measure that focuses only on wealth), we are better off using the covariance of returns with aggregate/ economywide consumption.
TRUE/ FALSE
TRUE
148
How does variance (standard deviation) of portfolio return affect the geometric mean and arimethic mean?
The higher the dispersion (standard deviation), the lower the geometric mean is relative to the aritmetci mean - the larger the difference between the two.
The arithmetic average is always greater than or equal to the geometric average; the greater the dispersion, the greater the difference – i.e., the higher the arithmetic average relative to geometric average.
149
Exchange rate risk imparts an extra source of uncertainty to investments denominated in foreign currencies. Much of that risk can be hedged in foreign exchange futures or forward markets, but a perfect hedge is not feasible unless the FOREIGN CURRENCY RATE OF RETURN is known.
TRUE/ FALSE
TRUE
150
Interest rate parity relationship is the relation between spot and forward exchange rates and foreign and domestic interest rates that rules out arbitrage opportunities.
TRUE/ FALSE
TRUE
151
In terms of hedge funds strategies, which of the following options refers to:
Bets on particular mispricing across two or more SECURITIES, with extraneous sources of risk such as general market exposure hedged away.
A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage
Pure plays: Bets on particular mispricing across two or more securities, with extraneous sources of risk such as general market exposure hedged away
152
In terms of hedge funds strategies, which of the following options refers to:
Bets that one sector or another will outperform other sectors. I.e., directional funds take a stance on the performance of broad market sectors, NO HEDGING.
A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage
B) directional strategy
153
In terms of hedge funds strategies, which of the following options refers to:
Exploiting temporary misalignments (mispricing) in relative valuation across SECTORS – this entails buying one type of security and selling another. Such hedge funds establish market-neutral positions on relative mispricing. However, even these hedged positions still present idiosyncratic risk.
A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage
C) nondirectional strategy
154
In terms of hedge funds strategies, which of the following options refers to:
The use of quantitative systems to uncover many perceived misalignments in relative pricing and ensure profits by averaging over all of these small bets. It often uses datamining methods to uncover past patterns that form the basis for the investment positions.
A) pure play
B) directional strategy
C) nondirectional strategy
D) statistical arbitrage
D) statistical arbitrage
155
A strategy in which a hedge fund invests in positive alpha positions, then hedge the systematic risk of that investment (you short the market) in order to isolate its alpha, and, finally, establish market exposure to desired market sectors by using passive indexes such as mutual funds or ETFs.
This strategy is referred to as?
Portable alpha
The idea is to transfer alpha from the sector where you find it to the asset class in which you ultimately establish exposure. You hedge against fall in the market and target absolute returns: if market goes up, you get alpha as return, and if market goes down, you still get alpha as return.
156
In the context of hedge fund styles/strategies, a hedged investing in convertible securities, typically long convertible bonds and short stock. I.e., you buy the equities and the bond convertibles issued by the same company.
This is referred to as:
A) Convertible arbitrage
B) Dedicated short bias
C) Event-driven
D) (Equity) market neutral
A) Convertible arbitrage: a hedged investing in convertible securities, typically long convertible bonds and short stock. I.e., you buy the equities and the bond convertibles issued by the same company.
This is referred to as:
157
(Equity) Market neutral DOES NOT refer to when hedge funds:
A) Commonly uses long/short hedges
B) Typically controls for industry, sector, size, and other exposures, and establishes market-neutral positions designed to exploit some market inefficiency (relative mispricing).
C) Commonly involves leverage.
D) Net short position, usually in equities, as opposed to pure short exposure.
E) Hedged to avoid taking a stance on the direction of the broad market.
WRONG: D) Net short position, usually in equities, as opposed to pure short exposure - this is a "dedicated short bias" strategy.
158
Following is NOT true about the event-driven hedge fund strategy:
A) Attempts to profit from situations such as mergers, acquisitions, restructuring, bankruptcy, or reorganization
B) It is a market-neutral strategy
C) No anticipation, and action is taken first after the announcement of the corporate event.
WRONG: B) It is a market-neutral strategy
159
A market-neutral hedge fund would NOT be a good candidate for an investor’s entire retirement portfolio, because such fund is not a diversified portfolio. The term “market neutral” refers to a portfolio position with respect to specified market inefficiency.
However, there could be a role for a market-neutral hedge fund in the investor’s overall portfolio; the market-neutral HF can be thought of as an approach for the investor to add alpha to a more passive investment position such as an index mutual fund.
TRUE/ FALSE
TRUE
