Investment Theory

Question 1

Modern Portfolio Theory (MPT)

Answer 1

• enables investor to classify, estimate, control nature and amount of expected risk and return
• seeks to quantify relationship between risk and return
• determines relationships among individual securities that make up portfolio as a whole

Question 2

4 Basic steps of MPT

Answer 2

1. security valuation: describing a universe of assets in terms of expected return and expected risk
2. asset allocation decision: determining how assets are to be distributed among classes of investment such as stocks/ bonds
3. portfolio optimization: reconciling risk and return in selecting the securities to be included, best return for given level of risk
4. performance measurement: dividing each stocks performance (risk) into market related (systematic) and industry (residual) classification

Question 3

Capital market line (CML)

Answer 3

• expresses macro aspect of MPT
• specifies relationship of risk and return on a portfolio rather than one investment
• tangent to efficient frontier at point B
• new efficient frontier
• shows relationship between variability of returns and risks of all possible portfolios

Question 4

What CML reveals

Answer 4

• expected return on fully diversified portfolio
• diversified portfolio should fall somewhere on CML
• individual securities and inefficient portfolios fall below CML
• cannot be used to evaluate performance of single security to portfolio lacking diversification
• Rf is risk free return (100% t bills)

Question 5

Efficient frontier

Answer 5

• lowest portfolio risk for given level of expected return
• highest level of expected return for given level of risk
• any point on efficient frontier is attainable and efficient

Question 6

Efficient frontier - Inefficient (attainable)

Answer 6

• points below line are attainable but inefficient
• carry too much risk relative to expected return or too little return relative to risk they carry

Question 7

Efficient frontier - not feasible (unattainable)

Answer 7

• portfolios above boundary are not feasible and cannot function under model
• low risk and high returns

Question 8

Optimal portfolio

Answer 8

• efficient frontier gives set of optimal portfolios
  -indifference curves must be considered to select risk/return combo that will satisfy investor preferences
• indifference curves cannot intersect
• point where indifference curve intersects efficient frontier is optimal portfolio for particular investor

Question 9

risk tolerance of investors

Answer 9

• different investors have different indifference curves
  risk adverse: steep curve, large return needed to assume more risk
  risk tolerant: curve flat, modest amount of return needed to bear additional risk

Question 10

Security market line (SML)

Answer 10

• at micro level
• can be used to evaluate any asset (individual security or portfolio)
• doesnt matter if portfolio is diversified or not
  ri = rf + (rm - rf) Bi
• if markets are in equilibrium all assets plot along SML. expected return = required rate of return
• points above line are undervalued

Question 11

Market risk premium

Answer 11

in required rate of return formula, the term (Erm - rf) is the market risk premium
- the term (Erm - rf) B is the stock risk premium

Question 12

Efficient market hypothesis (EMH)

Answer 12

• suggests that investors cannot expect to outperform the market consistently on a risk adjusted basis
• security pricing reflects all know information and enables stock price change rapidly
• random walk: price changes are unpredictable
• charting has no value with this theory
• good for passive investors

Question 13

3 forms of EMH

Answer 13

1. strong form: stock prices fully reflect all information, both public and private.
   - insider info, fundamental, technical analysis not expected to improve
2. Semi strong form: all publicly know information is fully reflected in stock prices
   - only insider info can improve results
3. Weak form: historical data is already reflected in current stock prices and no use to predict future prices
   - fundamental analysis may improve results, not technical

Question 14

Anomalies

Answer 14

• exception to rule or model
• P/E effect: stocks with low ratio perform better than high
• small firm effect: stock of small firms outperform stocks of large firms
• January effect: stocks decline at the end of the year and rebound in January
• neglected firm effect: stocks from firms not commonly studied outperform stocks with considerable attention from analysts
• value line phenomenon: stocks rated 1 by value line investment survey outperform those ranked 5