Lecture 1 - Risk & Return

Question 1

What is portfolio management?

Answer 1

Determining the mix of assets to hold in a portfolio

Question 2

Asset Classes

Answer 2

• Stocks
• Bonds
• Cash
• Real Estate

Question 3

Non-Traditional Asset Classes

Answer 3

• Options, Derivatives, Futures
• Commodities
• Hedge Funds, Private Equity

Question 4

What is a 60/40 portfolio?

Answer 4

• 60% Equities
• 40% Bonds

Question 5

Portfolio Strategies

Answer 5

Active & Passive

Question 6

Active Portfolio Manager Goal

Answer 6

Beat an index

Question 7

Passive Portfolio Manager Goal

Answer 7

Maintain index return

Question 8

Factors Influencing Interest Rates

Answer 8

• Supply
• Demand
• Government’s Net Supply/Demand
• Expected Rate of Inflation

Question 9

Correlation between interest rates & fund supply

Answer 9

• As interest rates increase, fund supply increases because people are willing to lend money due to high interest rates

Question 10

Correlation between interest rates & fund demand

Answer 10

• As interest rates increase, fund demand decrease because borrowing becomes more expensive

Question 11

Nominal interest rate = ?

Answer 11

R

Question 12

Real interest rate approximation formula = ?

Answer 12

r = R - i, where i = inflation

Question 13

Real Interest Rate Formula = ?

Answer 13

r = (R - i)/(1 + i) - 1

Question 14

HPR Meaning

Answer 14

Holding Period Return

Question 15

HPR Formula #1 = ?

Answer 15

HPR = (P1 - P0 + D1)/P0

Question 16

HPR Formula #2 = ?

Answer 16

HPR can either be nominal or real so you would use the nominal/real interest rate formula

Question 17

Expected Return Formula

Answer 17

E(r) = Σ p(s)r(s)

Question 18

Variance (VAR) Formula

Answer 18

σ^2 = Σ p(s) x [r(s) - E(r)]^2

Question 19

Variance (VAR) Formula if no probabilities are given

Answer 19

σ^2 = 1/n Σ [r(s) - r (mean)]^2

Question 20

Standard Deviation (STD) Formula

Answer 20

√σ^2

Question 21

Excess Return

Answer 21

The difference in between the actual rate of return on an asset and the actual risk-free rate

Question 22

Risk Premium

Answer 22

The difference between the expected HPR on a risky asset and the risk-free rate

Question 23

Sharpe Ratio

Answer 23

Sharpe Ratio = (Expected Portfolio Return - Risk Free Rate)/Standard Deviation of Portfolio

Question 24

Risk Measures

Answer 24

• Value at Risk (VaR)
• Expected Shortfall (ES)
• Lower Partial Standard Deviation (LPSD)
• Sortino Ratio

Question 25

Value at Risk (VaR)

Answer 25

Measure of downside risk. The loss that will be incurred in the event of an extreme price change.

Question 26

Expected Shortfall

Answer 26

The expected loss on a security conditional on returns being in the left tail of the probability distribution.

Question 27

Another term known as expected shortfall is.....

Answer 27

Conditional Tail Expectation

Question 28

Lower Partial Standard Deviation

Answer 28

Uses only negative deviations from the risk-free return

Question 29

Sortino Ratio

Answer 29

Sortino Ratio = (Expected Portfolio Return - Risk Free Rate)/LPSD

Question 30

Intrinsic Value

Answer 30

Value calculated for equities using a specific model

Question 31

Market Price

Answer 31

Current price of the stock

Question 32

IV > MP means?

Answer 32

Buy

Question 33

IV < MP means?

Answer 33

Sell or Short

Question 34

IV = MP means?

Answer 34

Hold or fairly priced

Question 35

Three Cases of DDM

Answer 35

1) No Growth DDM 2) Constant Growth DDM 3) Multi-Stage DDM

Question 36

No Growth DDM Formula

Answer 36

P0 = DIV1/r Note* DIV can also be EPS

Question 37

Constant Growth DDM is also known as the........

Answer 37

Gordon Growth Model

Question 38

Constant Growth DDM only works when?

Answer 38

r > g

Question 39

Constant Growth DDM Formula

Answer 39

P0 = DIV1/r-g or P0 = DIV0 (1 + g)/r-g

Question 40

If the dividend is just paid for constant growth DDM, what formula do you use?

Answer 40

P0 = DIV0 (1 + g)/r-g

Question 41

If the dividend is paid at the end of the year or is next years dividend for constant growth DDM, what formula do you use?

Answer 41

P0 = DIV1/r-g

Question 42

What is the current price of a 7% coupon bond, paying semi-annually with 3 years to maturity, if market interest rates are 5%? The face value of the bond is $1000.

Answer 42

I/Y = 5%/2 = 2.5% PMT = $1000/2 x (0.07) = $35 n = 3 x 2 = 6 FV = 1000 CPT PV = $1055.08

Question 43

What would your rate of return be if you purchase a 5-year bond paying an 8% coupon at $1,035 and sell it one year later when its yield to maturity drops to 6.2%? Assume the coupons are semi-annual and not reinvested.

Answer 43

Step 1: Find PV PMT = 1000 x 8% = 80/2 = $40 FV = 1000 n = 4 x 2 = 8 i = 6.2%/2 = 3.1% CPT PV = -$1062.91 Step 2: Find Rate of Return over holding period Rate of Return = (Coupon Interest + Price Change) / Initial Price Rate of Return = ($40 x 2 + ($1,062.91 - $1,035)) / $1,035 = 10.4262% Step 3: Find Annual Rate of Return Since there is a one year holding period, EAR = 10.4262%

Question 44

What was your one-year rate of return if you purchased a bond in 2022 at a 2% YTM and then sold it one year later when YTM increased to 4%? Assume a 2% coupon (paid semi-annually, 10 years to maturity (at purchase), par value $1000.

Answer 44

Step 1: Find PV FV = 1000 PMT = (2% x 1000)/2 = $10 N = 20 i/y = 2%/2 = 1% CPT PV = -$1,000 Step 2: Find selling price after one year FV = 1000 PMT = $10 N=18 i/y=2% CPT PV = -$850 Step 3: Find HPR HPR = (Ending Price - Begin Price + CFs)/Beginning Price HPR = (850 - 1000 + 20)/1000 = -13%

Question 45

Briefly explain why the 60/40 portfolio often has performed well for investors historically

Answer 45

Historically, stocks and bonds have proven to have a negative correlation. Combining assets with negative correlations provide portfolio managers with the best risk-return combinations.

Question 46

Why didn't bonds help the 60/40 portfolio as a "diversifying" asset class in 2022

Answer 46

Since central banks cut interest rates to support the economy. When banks ease policy, bond yields drop and bond prices rise