PM Flashcards
(61 cards)
What is the relationship between risk and return across major asset classes?
Back:
There is a tradeoff between risk and return:
Small-cap stocks have the highest returns but also the highest risk.
Treasury bills (T-bills) have the lowest returns and lowest risk.
Other asset classes fall in between, with bonds having lower returns and risk than equities.
How do large-cap and small-cap stocks compare in terms of risk and return?
Back:
Small-cap stocks: Higher average return (12.1%) but greater risk (31.7% standard deviation).
Large-cap stocks: Lower average return (10.2%) with lower risk (19.8% standard deviation).
Small-cap stocks offer higher potential rewards but come with greater volatility.
How do bonds compare to equities in risk and return?
Back:
Long-term corporate bonds: 6.1% return, 8.3% standard deviation.
Long-term government bonds: 5.5% return, 9.9% standard deviation.
Equities have higher returns and higher risk, while bonds offer more stability but lower returns.
What is the impact of inflation on asset class returns?
Back:
Inflation averaged 2.9% (1926–2017).
Real returns (adjusted for inflation) were lower than nominal returns.
Example: Large-cap stocks had a real return of 7.3%, while T-bills had only 0.5%.
Inflation risk must be considered in portfolio construction.
Why is liquidity important when selecting investments?
Back:
Liquidity affects pricing and expected returns.
Infrequently traded assets (e.g., emerging markets, low-quality corporate bonds) may have higher risk due to liquidity constraints.
Less liquid assets may experience larger price swings during market stress.
How do skewness and kurtosis affect investment returns?
Back:
Returns are not normally distributed.
Negative skew: Greater downside risk.
Excess kurtosis: More frequent extreme gains/losses.
These factors should be considered when evaluating investments.
What is risk aversion, and how does it affect investment choices?
Back:
A risk-averse investor dislikes risk and prefers lower-risk investments when expected returns are equal.
Financial models assume all investors are risk-averse.
A risk-averse investor will only take on more risk if compensated with higher expected returns.
How do risk-seeking and risk-neutral investors differ from risk-averse investors?
Back:
Risk-seeking investors prefer more risk to less and may choose riskier investments even without higher returns.
Risk-neutral investors are indifferent to risk and will focus only on expected returns.
Risk-averse investors require additional return to compensate for extra risk.
What are indifference curves, and how do they relate to risk aversion?
Back:
Indifference curves represent combinations of risk (standard deviation) and return that give an investor the same level of utility.
More risk-averse investors have steeper indifference curves, requiring higher returns for additional risk.
Less risk-averse investors have flatter curves and accept more risk for a given return.
What is the capital allocation line (CAL), and how is it constructed?
Back:
CAL represents the risk-return tradeoff from combining a risky asset portfolio with a risk-free asset.
Expected return: E(Rportfolio) = WA E(RA) + WB Rf (where Rf = risk-free rate).
Standard deviation: σportfolio = WA σA (because risk-free assets have zero standard deviation).
The CAL is a straight line showing possible portfolio risk-return combinations.
What is the two-fund separation theorem?
Back:
All investors will hold a combination of the risk-free asset and an optimal risky portfolio.
The mix depends on risk aversion:
More risk-averse investors hold more of the risk-free asset.
Less risk-averse investors hold more of the risky portfolio.
The optimal portfolio is found at the tangency point between an investor’s indifference curve and the CAL.
How does risk aversion affect portfolio selection along the capital allocation line?
Back:
More risk-averse investors choose a portfolio with a higher proportion of risk-free assets.
Less risk-averse investors select a portfolio with more exposure to the risky asset.
The investor’s optimal portfolio maximizes expected utility, balancing risk and return.
Which of the following statements about risk-averse investors is most accurate? A risk-averse investor:
A)
seeks out the investment with minimum risk, while return is not a major consideration.
B)
will take additional investment risk if sufficiently compensated for this risk.
Correct Answer
C)
avoids participating in global equity markets.
Explanation
Risk-averse investors are generally willing to invest in risky investments, if the expected return of the investment is sufficient to reward the investor for taking on this risk. Participants in securities markets are generally assumed to be risk-averse investors. (Module 83.2, LOS 83.b)
What happens to portfolio risk when asset returns are perfectly positively correlated (ρ = +1)?
Back:
The portfolio’s standard deviation is a weighted average of the individual assets’ standard deviations.
No risk reduction occurs because the assets move perfectly together.
Formula: σportfolio = w1σ1 + w2σ2
What is the effect of adding assets with low or negative correlation to a portfolio?
Back:
Lower correlation means greater diversification benefits.
If ρ = 0, portfolio risk is reduced compared to individual asset risks.
If ρ < 0, portfolio risk is further reduced and can even be eliminated with the right weights.
How does diversification impact portfolio risk?
Back:
Diversification reduces portfolio risk unless assets are perfectly correlated (ρ = +1).
The lower the correlation, the greater the risk reduction.
This principle explains why investors diversify across stocks, bonds, real estate, and international assets.
Why do investors seek assets with low or negative correlation?
Back:
To reduce portfolio risk while maintaining expected return.
Drives investment in bonds, foreign stocks, real estate, commodities, etc.
If assets were perfectly negatively correlated (ρ = -1), a risk-free portfolio could be created.
📌 Concept: Capital Allocation Line (CAL)
💡 Definition: The CAL represents all possible combinations of a risk-free asset and a risky portfolio, showing risk-return trade-offs.
✅ Key Takeaway: The optimal CAL maximizes investor utility by offering the best possible risk-return combinations.
📌 Concept: Role of Borrowing and Lending in Portfolio Construction
💡 Explanation: Investors can move beyond the market portfolio by:
Lending (risk-free asset investment) → Less risk, lower return.
Borrowing (leveraged risky portfolio) → More risk, higher return.
✅ Key Takeaway: Investors can customize their risk exposure by adjusting their mix of the risk-free asset and the market portfolio.
📌 Concept: Passive vs. Active Portfolio Management
💡 Explanation:
Passive investors hold the market portfolio and allocate between it and a risk-free asset.
Active investors try to outperform by overweighting undervalued securities and underweighting overvalued ones.
✅ Key Takeaway: Passive investing follows the market portfolio, while active investing seeks to exploit mispricings.
📌 Concept: Risk-Return Tradeoff in Combining Risk-Free and Risky Assets
💡 Graphical Representation: A straight line from the risk-free rate through the risky asset portfolio on a risk-return graph.
✅ Key Takeaway: Adding a risk-free asset to a risky portfolio improves the risk-return profile, allowing investors to achieve an optimal balance.
Q: What are the key assumptions of CAPM?
A:
Risk Aversion – Investors require higher returns for higher risk.
Utility Maximization – Investors choose portfolios maximizing expected utility.
Frictionless Markets – No taxes, transaction costs, or trading restrictions.
One-Period Horizon – All investors share the same investment time horizon.
Homogeneous Expectations – Investors have the same return and risk expectations.
Divisible Assets – Assets can be infinitely divided.
Competitive Markets – Investors are price takers.
Q: What is the Security Market Line (SML), and how does it differ from the Capital Market Line (CML)?
A:
SML: Graphs expected return vs. beta (systematic risk). All correctly priced securities lie on the SML.
CML: Graphs expected return vs. total risk (standard deviation). Only efficient portfolios lie on the CML.
Q: How can CAPM be used to identify mispriced securities?
A:
Stock plots below SML: Overvalued (expected return < required return).
Stock plots above SML: Undervalued (expected return > required return).
Stock plots on SML: Properly valued (expected return = required return).
Trading Strategy: Short overvalued stocks and buy undervalued stocks.
