Flashcards in Section 103 Unit 7 Deck (23):
Modern Porfolio Theory (MPT)
Investors consider each investment opportunity as being represented by a probability distribution of expected returns over a specified holding period.
Investors estimate the risk of the portfolio on the basis of the variability (i.e., standard deviation) of returns.
Investors base decisions solely on expected return and risk; therefore, their indifference curves are a function of expected return and the expected variance of returns only. (Note: This assumption is often captured by the concept of mean-variance optimization.)
Investors base their indifference to alternative investments on the maximization of wealth over a specified period, and this indifference diminishes as they get beyond this period.
For a given level of risk, investors prefer higher returns to lower returns.
This curve represents that set of portfolios that has the maximum rate of return for every given level of risk.
Represent the risk-reward trade-off that the investor is willing to make, will cross the efficient frontier in two locations, lie tangent to the efficient frontier, or not intersect the efficient frontier at all. The portfolio that lies at the point of tangency is the optimal portfolio for the investor.
Capital Asset Pricing Model (CAPM)
ri = rf + (rm − rf)βi
ri = the expected return for a stock
rm = the market rate of return
rf = the risk-free rate of return
βi = beta, measures systematic risk of a particular stock
Stock Risk Premium
Is the part of the CAPM model reflected by the following formula: (rm− rf)βi, where rm is the market return, rf is the risk-free return, and βi is the beta coefficient of the stock.
Market Risk Premium
Is the part of the CAPM model reflected by the following formula: rm − rf, where rm is the market return and rf is the risk-free return.
Capital Market Theory
You should note that the CAPM accounts for the impact of systematic risk (as measured by beta) only and does not take into consideration unsystematic risk, which is assumed to have been diversified away.
Security Market Line
depicts the relationship of risk and return for individual efficient portfolios and has the same formula as that for the CAPM.
Mutual Fund Total Return / Mutual Fund Beta
ap = rp - (rf + (rm − rf)βi)
Just rp or average rate of return minus CAPM
The Treynor ratio uses beta in its denominator and, therefore, may be used only to compare the performance of diversified portfolios or stocks that constitute diversified portfolios. Unlike the absolute measure achieved with Jensen’s alpha, the Treynor ratio is a relative performance measure. By itself it has little meaning. Only when used to evaluate an asset’s performance relative to another potential investment or a benchmark does it convey useful information. Treynor ratio, the better the risk-adjusted performance of the asset.
E X A M P L E Assume the same facts and actual return of Portfolio B as in the previous example. However, Portfolio B now has a standard deviation of 6.5%. Accordingly, Portfolio B’s Sharpe ratio is 1.38, calculated as follows: (0.12 – 0.03) ÷ 0.065. If the Sharpe ratio of Portfolio B is higher than the Sharpe ratio of the market, then the manager of Portfolio B has outperformed the market.
Coefficient of Variation (CV)
A computation of the relative measure of total risk (as measured by standard deviation) per unit of expected return and is used to compare investments with varying rates of return and standard deviations
CV = Standard deviation of asset / expected return of asset
Coefficient of Variation VS Covariance
You should be careful not to confuse the coefficient of variation (CV) with the covariance (COV) between two assets. CV is a measure of relative risk per unit of expected return, whereas COV is a measure of how returns on assets move together. The former is used as a cross-check on an investment decision, whereas the latter is the basis for an optimal portfolio diversification.
Three Forms of EMH
The three forms of EMH and which types of market information each considers relevant in attaining above-market rates of return are summarized in the table below.
Form of EMH Relevant Information
Weak -Insider information and credible fundamental analysis
Semistrong -Insider information
Efficent Market Hypothesis (EMH)
suggests that investors are unable to outperform the market on a consistent basis. The fundamental assumption of the theory, which was developed by Eugene Fama of the University of Chicago, is that current stock prices reflect all available information for a company and that prices rapidly (or immediately) adjust to reflect any new information.
Anomalies are unexpected market results or trends that tend to contradict the EMH. In other words, if the EMH is absolutely true in all its forms, it cannot explain these results or trends, reflecting that the market may not be as efficient as the hypothesis stipulates.
Arbitrage Pricing Theory
What if there are other unanticipated factors that explain the expected return of a stock? Those other unanticipated factors are what the arbitrage pricing theory (APT) attempts to quantify.
The limit order is used to sell or buy at a specific price, one that is better, than the market price at the time the order is placed. The price acts as a ceiling for purchases and a floor for sales.
Sells or buys ASAP
Protects the investor from large losses. If the market reaches a certain point, the stop order will turn into a market order.
Stop Limit Order
the stop limit order is similar to a stop order except that it turns into a limit order when triggered. In a stop limit, both the stop order price and the limit order are specified.