Flash Cards
(16 cards)
What is Modern Portfolio Theory
Modern Portfolio Theory is a financial framework that helps investors build an optimal portfolio by balancing risk and return. The key idea is that diversification can reduce risk while maximising expected returns.
MPT graph
x axis risk, y axis return - positive correlation
Common behavioural finance biases
Overconfidence Bias - Investors overestimate their knowledge
Loss Aversion - investors tend to feel the pain of losses more intensely than the pleasure of gains
Herding Behavior - Investors tend to follow the actions of the majority
Representativeness Bias - Investors judge probabilities based on past patterns
Home Bias - Investors prefer domestic stocks over foreign ones, reducing diversification benefits
Portfolio Management process
Planning - Assessing investor profile
Asset Allocation - Determining optimal mix. Considering diversification
Security Selection - Choosing specific securities
Portfolio Execution - implementing the investment strategy
CAPM model
E(Ri)=Rf+βi⋅(E(Rm)−Rf)
The CAPM model is a fundamental financial model that describes the relationship between the expected return of an asset and its risk. It is widely used in portfolio management and investment analysis to determine the required return on an investment, considering systematic risk.
CAPM model advantages
The CAPM formula is straightforward and requires only a few inputs: risk-free rate, market return, and beta.
helps investment decision making by determining whether an asset is overvalued, undervalued, or fairly priced.
The model assumes a positive correlation between risk and return, meaning investors should earn higher returns for taking more risk.
CAPM model disadvantages
CAPM assumes beta (systematic risk) is the only relevant risk factor, but stock prices are influenced by multiple risks (e.g., economic, political, liquidity risks).
CAPM assumes that markets are perfectly efficient, meaning all investors have equal access to information and react rationally.
Loss aversion, overconfidence, and herd behavior can lead to pricing anomalies.
Sharpe Ratio definition and formula
The Sharpe Ratio measures the risk-adjusted return of an investment portfolio by comparing the excess return to its total risk.
(portfolio return - risk free rate) / Standard deviation of portfolio returns
Sharpe Ratio Usage and Limitations
Usage
Helps investors assess whether an investment’s returns are due to smart investment decisions or excessive risk.
A higher Sharpe Ratio indicates a better risk-adjusted return.
Commonly used in portfolio management and hedge funds.
Limitations
Uses total risk (standard deviation), which includes both systematic and unsystematic risk.
May not work well for investments with non-normal return distributions (e.g., hedge funds, options strategies).
Treynor Ratio definition and Formula
The Treynor Ratio measures the excess return per unit of systematic risk (beta). Unlike the Sharpe Ratio, it only considers risk related to market fluctuations.
(portfolio return - risk free rate) / Portfolio Beta
Treynor Ratio Usage and Limitations
Usage
Suitable for well-diversified portfolios because it ignores unsystematic risk.
Helps in comparing funds with similar exposure to systematic risk.
A higher Treynor Ratio indicates better risk-adjusted performance relative to market risk.
Limitations
Not useful for evaluating portfolios with high unsystematic risk.
Requires an accurate estimation of beta, which can change over time.
Jensen’s Measure definition and Formula
Jensen’s Alpha evaluates a portfolio’s ability to generate excess returns beyond those predicted by the Capital Asset Pricing Model (CAPM).
Rp−[Rf+βp(Rm−Rf)]
Jensen’s Measure Usage and Limitations
Usage
Measures the skill of active portfolio managers.
A positive alpha suggests the portfolio added value beyond market expectations.
Often used in mutual fund and hedge fund evaluation.
Limitations
Depends on CAPM assumptions, which may not always hold.
Relies on an accurate beta estimate.
Information Ratio definition and formula
The Information Ratio (IR) evaluates the consistency of a portfolio manager’s returns relative to a benchmark. It measures how much excess return (alpha) is generated per unit of tracking error (active risk).
(Portfolio return - Benchmark return) / tracking error
Information Ratio Usage and Limitations
Usage
Measures the effectiveness of active management.
A higher Information Ratio suggests more consistent active returns.
Used in fund manager evaluations and portfolio comparisons.
Limitations
A low IR suggests high variability in excess returns.
Not useful for passive portfolios that closely track the market.
List 8 key financial institutions involved in the global economy
International Monetary Fund (IMF) – Provides financial assistance, economic surveillance, and policy advice to countries to promote global financial stability.
World Bank – Offers financial and technical assistance to developing countries for economic development and poverty reduction.
Bank for International Settlements (BIS) – Serves as a bank for central banks, promoting financial and monetary stability worldwide.
Federal Reserve System (The Fed, USA) – The central bank of the United States, responsible for monetary policy, financial stability, and regulating banks.
European Central Bank (ECB) – Manages the euro and monetary policy for the Eurozone, ensuring price stability and financial security.
Asian Development Bank (ADB) – Provides loans, grants, and technical assistance to promote economic development in Asia and the Pacific.
International Finance Corporation (IFC) – A part of the World Bank Group, it focuses on private sector investment in emerging markets.
Securities and Exchange Commission (SEC, USA) – Regulates securities markets to protect investors and ensure fair, efficient, and orderly markets.
