L5 - Portfolio Theory Flashcards
(15 cards)
What is the main idea behind the CAPM
It describes the expected return to any asset as a linear function of its beta
How is the market risk premium calculated in CAPM?
(Rm - Rf)
Explain the diversification logic in portfolio theory
Reducing risk by investing in a variety of assets, benefits increase as correlation between assets decreases
How does correlation affect portfolio risk?
As correlation moves from perfect positive to perfect negative, diversification benefits increase, reducing risk
What does Jensen’s alpha measure?
Difference between what a portfolio actually earned and what it should have earned based on its beta and the market return
Explain the purpose of the Capital Allocation Line (CAL)
Describes the optimal expected return and standard deviation combinations available from combining risky assets with a risk-free asset
What is the Capital Market Line and how does it relate to the CAL?
CML is a special case of the CAL where all investors hold the same risky portfolio (the market portfolio)
What is the Sharpe Ratio and what does it measure?
Its the slope of the CAL and measures the excess return per unit of risk. Higher Sharpe ratio is better
What does the Security Market Line represent?
Graphical depiction of the CAPM
According to the Markowitz decision rule, when should an investor choose Asset A over Asset B?
When A has a higher or equal mean return and smaller standard deviation than B, or when A has a strictly larger mean return and the same standard deviation as B
Describe the Fama-French Three Factor Model
It uses beta, size (SMB), and value (HML) to explain asset returns
What do the factors SMB and HML represent in the Fama-French Model
SMB: (Small Minus Big) Difference in returns between small and large stocks
HML: (High Minus Low) Difference in returns between value and growth stocks
Explain the Carhart Four Factor Model
It extends the Fama-French Model by adding a momentum factor (UMD)
How can benchmarks be used to evaluate portfolio performance?
By comparing the portfolio’s performance to similar portfolios or market indexes with the same constraints
What is the formula for Beta
B = Covariance of asset and market / Variance of market
