MIDTERM 2

Question 1

Expected return

Answer 1

expected return = anticipated outcome
mean = average
median = middle number in series
mode = most common return

Question 2

Expected Return (single asset)

Answer 2

sum of the individual weighted scenario returns

Question 3

Mean

Answer 3

distance less-than-the-average and greater-than-the-average are the same. describes the point of “central tendency”; however, it does not describe the dispersion of results around that point

Question 4

Variance

Answer 4

describes the dispersion around the mean

variance = sum of the squared individual dispersions around the mean times the probability

risk is defined as the chance that the expected return will not be realized, variance or dispersion of actual returns around the expected return is how risk is usually quantified

Question 5

Standard Deviation

Answer 5

square root of variance, normalizes the dispersion of a normal distribution around the mean
allows for a direct comparison of the standard deviation with the mean because same “un-squared” units of observation

Question 6

Measure of Dispersion

Answer 6

spread of data, reference to the measure of central tendency, variance of sample = sum squared differences / (N-1)

Question 7

Semi-Variance (downside risk)

Answer 7

risk includes observations that deviate from mean; however, investors are not concerned about out-performance
-only measures dispersion for data points that fall below the mean (threshold)
- most relevant when distribution exhibits skewness
-semi-standard deviation is square root of semi-variance

Question 8

Coefficient of Variation

Answer 8

relative risk-to-return statistic
- CV = standard deviation/mean return
- lower CV preferred
- used to compare to securities

Question 9

Moments of a Probability Distributions

Answer 9

1st moment = mean
2nd moment = variance/stdev
3rd moment = skewness
4th moment = kurtosis

Question 10

Normal Distribution

Answer 10

standard deviation normalized dispersion around mean
- 68.26% is +- 1 std dev
- 95.44% is +- 2 std dev
- 99.74% is +- 3 std dev

Question 11

Skewness

Answer 11

cubed dispersions: distributions with different means, medians, and modes, one tail will be longer than the other

Question 12

Kurtosis

Answer 12

raise dispersion to 4th power, answers how much of the distribution is in the tail

Question 13

Expected Return (two-asset portfolio)

Answer 13

expected return = sum of the weighted returns of the assets

Question 14

Variance (two-asset portfolio)

Answer 14

variance of a 2-asset portfolio is NOT simply the weighted average of the individual asset deviations because variance of a 2-asset portfolio depends on how the assets move relative to one another (covariance)

Question 15

Covariance

Answer 15

describes how two assets move relative to each other, key to the power of diversification

Question 16

Standard Deviation (two-asset portfolio)

Answer 16

creates a 2x2 matrix, can increase to any NxN size

Question 17

Correlation Coefficient

Answer 17

adds clarity about the strength of the relationships by normalizing the co-movement between 1 and -1.

statistical relationship between returns, which describes the direction of the linear relationship and magnitude of move.

adding any two securities with correlation coefficient less than perfect +1 will dampen volatility

Question 18

Coefficient of Determination

Answer 18

correlation coefficient squared, measures the proportion of asset a’s price movement that is explained by asset b

Question 19

Practical Applications of R^2

Answer 19

-identifying appropriate benchmark
- benchmark tracking
- active management
- risk relative to benchmark

Question 20

Asset Allocation

Answer 20

you could hold a risky-asset component and a risk-free component in your portfolio

Question 21

Adding Risk-free Security

Answer 21

adding a risk-free security will bring down the standard-deviation and decreases portfolio volatility

Question 22

Mean-variance Portfolio Theory

Answer 22

assuming mean variance is sufficient to describe the market minimization techniques (calculus) can be used to determine portfolio combinations that offer lowest level of risk for a given level of return

Question 23

Efficient Frontier

Answer 23

describes highest return combinations for a given level of risk, any portfolio lying on the efficient frontier has the optimal return to variability payoff.

an efficient frontier can be generated for any set of assets and constraints given assets 1) expected return 2) standard deviation 3) correlation coefficients

Question 24

Capital Allocation Line

Answer 24

adding a risk-free asset with a risky portfolio increases the risk-return profile in every case but one and that is the point of tangency

once a risk-free asset is introduced the slope represents the constant reward to variability profile. there can be numerous CALs (one for each risky asset) and the investor just decides what allocation to make between the portfolio and the risk-free rate

Question 25

Slope = reward to variability ratio

Answer 25

slope (rise over run) describes the amount of extra return for each unit of additional risk

Question 26

Sharpe Ratio

Answer 26

the reward-to-variability (slope of the CAL) is referred to as the Sharpe Ratio, additional units of return for additional units of risk

Question 27

Risk Theory

Answer 27

Risk lover (A < 0) Risk Neutral (A=0) Risk Averse (A > 0) risk averse investors demand a higher level of return to hold a higher level of risk, risk neutral investors focused just on expected return

Question 28

Utility Theory

Answer 28

suggests that risk-averse investors compare risky assets based on their expected utility (welfare), not on nominal return

Question 29

Indifference Curve

Answer 29

graphically depicts the unique preferences for individuals in terms of risk and reward. every point along the curve depicts the same risk/return ratio: therefore, the investor is indifferent about any combination (same level of utility)

Question 30

Capital Market Line (CML)

Answer 30

CML is a special case of the capital allocation line. rather than unique portfolio, everyone holds the same risk portfolio = broad domestic stock market index, only decision is about allocation between risky asset (market index) and risk-free asset

Question 31

Beta

Answer 31

measures systematic risk, describes the sensitivity of an asset's return to the market, appropriate when considering a security for inclusion in a diversified portfolio beta = (correlation of asset to market * risk of asset)/risk of market quantifies an individual security's price sensitivity to market's price movement Beta>1: greater sensitivity to market price changes Beta=1: security exhibits the same volatility as the market Beta<1: security has less sensitivity to market price changes slope of the linear regression scaling describes stock's exposure to marker risk

Question 32

Significance of beta

Answer 32

when adding a security to a portfolio, you are not concerned about the total risk, rather the amount of systematic risk that the asset will add to the portfolio. adding a security with a higher beta will increase overall portfolio

Question 33

Security Market Line (SML)

Answer 33

Capital asset pricing model, beta replaces standard deviation as a measure of risk Expected return = Rfree + [betasecurity*(Rmarket-Rfree)] Rmarket-Rfree=market premium slope of SML describes the proper theoretical pricing of financial assets

Question 34

Significance of SML

Answer 34

slope represents the market risk premium, recognizes that with portfolios you are concerned about the amount of systematic risk that the asset will add to the portfolio, suggests that theoretical pricing of securities is linked to the beta

Question 35

CAPM versus APT

Answer 35

capital asset pricing model: single factor model, pricing higher expected return required to hold higher expected risk arbitrage pricing model, multi-factor model focused security's sensitivity to various macroeconomic variables

Question 36

Factor Models

Answer 36

build factor models fro projecting stock return - macroeconomic data - fundamental data - statistical realized return of asset = expected return + beta sensitivity to the different firm specific characteristics

Question 37

Determinants of Portfolio Performance

Answer 37

asset allocation: 91% of portfolio performance is based on the asset allocation decision other determinants: security selection, market timing, other factors

Question 38

Impact of Individual Factors on Asset Allocation

Answer 38

variables influencing the asset allocation decision: tolerance for risk, financial need and return objective, time horizon, financial capacity, investment knowledge, investing experience, preferences and constraints

Question 39

Assessing Risk Tolerance

Answer 39

risk tolerance cannot be measured with complete accuracy - attitude - financial capacity - knowledge - propensity

Question 40

Challenges with Portfolio Optimization for Individuals

Answer 40

challenges include multiple life goals, several forms of individual taxes, liquidity needs, behavioral issues, income needs from investment portfolio

Question 41

Life Cycle Investment Strategy

Answer 41

wealth = financial wealth + human capital wealth - greater the human capital the greater focus on growth investments - lower the human capital the more you focus on income-producing investments equity allocation = 100 - age

Question 42

Other Approaches: 60/40 & Risk-return

Answer 42

60/40 adjustment: start from 60% growth and 40% income mix. risk-return bucket approach: categorize based on individual factors - conservative investor (50/50) - moderate (60/40) - assertive (70/30) - aggressive (80/20)

Question 43

Strategic vs tactical allocation

Answer 43

strategic: establishing a long-term target strategic allocation, portfolio monitoring and periodic rebalancing to maintain target mix tactical: overweighting of asset categories based on projected performance, minimum and maximum allocations might be established

Question 44

Portfolio Rebalancing

Answer 44

- application of buying high and buying low -rules: fixed-percentage threshold rule, percent variance from threshold, calendar, after major market event

Question 45

Sector vs Industry

Answer 45

sector: broader economic groupings that include multiple industries (energy, real estate, utilities) industry: group of companies with the same business activity (banking, defense)

Question 46

Diversifying by Investment Style

Answer 46

value investing: invest in companies that are underpriced or under-recognized growth investing: invest in companies that are growing at faster rates than overall market

Question 47

Diversifying Concentrated Portfolios

Answer 47

concentrated portfolio positions occur when an individual or small number of securities represent a large percentage of the overall portfolio - negative implications: lower risk-return profile, higher volatility impacts compounded growth, financial vulnerability

Question 48

utility vs prospect theory

Answer 48

utility describes how decisions under uncertainty should be made prospect theory describes how decisions are actually made

Question 49

prospect theory

Answer 49

focus on loss or gain, change in wealth is reset to a reference point, more pain associated with losses

Question 50

loss aversion

Answer 50

tendency for risk-averse investors to place greater value on avoiding losses than acquiring gains

Question 51

Fast/slow brain

Answer 51

system 1 - fast, automatic unconscious thinking system 2 - slow, conscious reasoning and thought reptilian brain = caveman brain

Question 52

anchoring

Answer 52

decision makers begin from a reference point and then adjust

Question 53

representativeness

Answer 53

decision based on finding commonality between current situation and a prior experience, law of small numbers

Question 54

availability

Answer 54

decision based on available data

Question 55

affect

Answer 55

attitude impacts the decision

Question 56

hyperbolic discounting

Answer 56

tendency to overvalue immediate rewards at the expense of long-term goals

Question 57

mental accounting

Answer 57

assigning subjective value or emotional label to money based on its source

Question 58

availability vs selective recall

Answer 58

availability bias: reliance on recent data selective recall: tendency to overweight recent information and successful trading experiences

Question 59

Cascading

Answer 59

make own assessment, observe actions of group, despite private contradictions, follow the group

Question 60

regret avoidance

Answer 60

make decisions that allow them to avoid the pain of monetary loss and loss of self-esteem inaction: refusing to admit that the investment was a mistake results in tendency to hold losers in hope they recover indecision: fear of loss can cause investor to remaining in cash equivalents for too long a period

Question 61

ambiguity aversion

Answer 61

make a decision that favors the familiar