Investment Management Exam 2
how to calculate portfolio risk
(Weight asset 1)^2(std dev asset 1)^2 + (Weight asset 2)^2(std dev asset 2)^2 + (2 (w asset 1)(w asset 2)(covariance asset 1, 2)
how to calculate expected return
(probability boom * return in that state) + (probability normal * return in that state) + (probability recession * return in that state)
Fannie May and Freddie Mac
-2 popular GSEs in the US -at one point they were apart of the government but broke off -traded on the stock exchange just like normal companies -traded bonds -backed by the us gov but said they were not -goes to commercial bank and buys my mortgage -pools mortgages and creates a new financial instrument
According to the CAPM, what is the required rate of return for a stock with a beta of .7, when the risk free rate is 7% and the expected market rate of return is 14%?
11.9%
According to the CAPM, what is the expected rate of return for a stock with a beta of 1.2, when the risk free rate is 6% and the market rate of return is 12%
13.2%-- 6% + 1.2(12%-6%)
the covariance of the market's returns with a stocks return is .005 and the standard deviation of the market's returns is .05. What is the stocks beta
2.0- Beta= covariance/ market variance market variance = .05^2= .0025 Beta= .005/.0025= 2
What is the risk measure associated with the capital market line (cml)
CML plots return against total risk which is measured by standard deviation of returns
Which of the following asset classes has historically had the highest returns and standard deviation
Small-cap stocks
Who can invest in each fund
-ETF: anyone -Mutual: anyone -Hedge funds: accredited investor (either wealthy individual or institutional investment aka pension)
What are the three types of funds
-Exchange traded funds (ETF) -Mutual funds -hedge funds
Two types of municipal bonds
-General obligation (GOs) -Revenue : project based (ex. toll road revenue will pay off bond) *difference is taxing authority
Bond categories
-Mortgage related -GSEs (Government sponsored Enterprise)
what is risk
-Variance -square root of variance =STANDARD DEV*
What are variable rate loans
-give low rates- assuming loan will go up in the next coming years -it works when you can refinance and house is going up in value -messes up if house goes down in value
Mortgage backed security (MBS)
-housing loan -no assumed life (1 month to 30 years) -Fannie goes to commerical bank and buys my mortgage (we dont care because we still have to pay bank) -pools mortgages and creates a new financial instrument and sells to other people for a less % than original (will guarantee the difference)
What is the marginal tax rate you are indifferent
1- (muni yield/corp yield)- breakeven for bonds If your marginal TR is higher than breakeven- buy muni, if it is lower, buy corporate
How do you pick whether to buy the taxable bond or the Muni?
Compare: 10 year treasury(1-T) and muni yield-- higher yield the better Or calculate the taxable equivalent of the muni to the corporate ---Muni/(1-T)
how to calculate expected return of a portfolio with 2 assets
E(return of portfolio)= (weight- a1)(expected return- a1) + (weight- a2)( expected return- a2)
What is alpha
Expected return of the stock- required return -want + alpha
Harry Markowitz (1952)
Father of MPT- can we ever have an asset with higher return and lower risk? -efficient frontier (Min variance portfolio and up)
Which of the following is least likely to be considered an appropriate schedule for reviewing and updating an investment policy statement?
Frequently, based on the recent performance of the portfolio
Sharpe-Security market line
Graph: x axis- beta, y axis: required rate of return on an individual stock -ri= return (rf) + Beta [expected return market- return rf] ----CAPM
What do we want correlation to be?
Low to no (correlation) -negative is the best! -because when one asset is + and one is - the risk is the lowest it could be
In a 5 year period, the annual returns on an investment are 5%, -3%, -4%, 2%, and 6%. The standard deviation of annual returns on this investment is closest to
Mean return= (5-3-4+2+6)/5= 1.2 % Squared deviations from the mean: 5-1.2= 3.8^2= 14.44 -3-1.2= -4.2^2= 17.64 -4-1.2= -5.3^2= 27.04 2-1.2= .8^2= .64 6-1.2= 4.8^2= 23.04 sum of squared deviations= 82.8 Sample variance= 82.8/(5-1)= 20.7 sample st dev= 4.55 (sq rt)
What is the municipal yield compared to the 10 year treasury
Muni has lower yield because it is considered after tax, while the 10 year treasury is taxable
2 other risks for mortgage backed securities?
Prepayment risk -contraction risk -extension risk *dont know when you will get paid or when loan will end
How to calculate risk
Probability in boom (return boom- expected return) + Probability in normal (return normal- expected return) + Probability in recession (return recession- expected return)= X - SQUARE ROOT (X)
1928-2016 large cap and small cap return and standard deviations
R bar large cap= 12 % s large cap= 20% R bar small cap= 17% s large cap= 32% Rho (L, S)= .8 (highly correlated- bad because no diversification of risk) R bar t bill= 3.5% S t bill= 3.1 Rho (L, t)= -.03 (better!!!)
Cov (1, 2) in portfolio risk equation=
Rho (asset 1, 2) (std dev 1)( std dev 2)
the variance of returns is .09 for Stock A and .04 for Stock B. The covariance between the returns of A and B is .006. The correlation of returns between A and B is:
Sq rt .09 = .3, sq rt .04= .2 .006/(.3)(.2)= .1
The risk free rate is 6%, and the expected market return is 15%. A stock with a beta of 1.2 is selling for $25 and will pay a $1 divided at the end of the year. if the stock is priced at $30 at year end, it is:
Underpriced required rate = 6 + 1.2 (15-6)= 16.8% Return on stock= (30-25+1)/25= 24% based on risk the stock plots above the SML and is underpriced
In a defined benefit pension plan:
the plan sponsor promises a predetermined retirement income to participants - promises a specific level of benefits
A portfolio to the right of the market portfolio on the CML is:
a borrowing portfolio-has more risk than the market portfolio. investors seeking to take on more risk will borrow at the risk free rate to purchase more of the market portfolio
What is fannie and freddie's limit for loan buying
about $400,000- anything above is not dealt with by them (could not pool anything larger)
compared to exchange-traded funds (ETFs), open-end mutual funds are typically associated with lower:
brokerage costs
Hedge funds most likely
are not offered for sale to the general public
As the number of stocks in a portfolio increases, the portfolio's systematic risk:
can increase or decrease- when you increase the number of stocks in a portfolio, unsystematic risk will decrease at a decreasing rate. However, the portfolio's systematic risk can be increased by adding higher beta stocks or decreased by adding lower beta stocks
Modern portfolio theory (MPT)
combine assets to create a portfolio
Rho (asset 1 and 2)=
cov (1, 2 )/(st dev 1)(std dev 2) -correlation coefficient
A measure of how the returns of two risky assets move in relation to each other is the:
covariance
What does Securitization or securitizing mean?
creating new financial instruments from loans
compared to investing in a single security, diversification provides investors a way to:
decrease the volatility of returns-diversification provides an investor reduced risk
Which type of municipal bond is riskier
depends on bond credit rating
Portfolio diversification is least likely to protect against losses:
during severe market turmoil
A long time horizon and low liquidity requirements best describe the typical investment needs of an:
endowment- generally intends to fund its causes perpetually
A top down security analysis begins by:
examining economic conditions
Tobin (1958): capital market line (CML)
expands on markowitz -add risk free asset -make tangent line from risk free asset to the min variance set -M= where the cml intersects the efficient frontier -uses risk and return graph
contraction risk
expect certain return for certain amount of years -BUT if interest rates drop unexpectedly- people with mortgages will probably refinance, pay off old and get a new mortgage -if you are holding a security, it is done -life of bond contracts if interest rates go down unexpectedly (don't want $ bc you want the return you had-- if you get $ back you must invest in a lower rate than you had
What are hedge funds
funds that only accredited investors can invest in or institutional investments -risky or safe -can invest in anything (do not have to buy) -lightly regulated mutual fund
Diversifiable (company specific risk) and non diversifiable (market risk)
graph-Total risk of portfolio to the number of stocks in the portfolio -s&p risk (market risk) and below is non diversifiable and any risk above is diversifiable (meaning it can be diversified away by other stocks)
which of the following statements about correlation is least accurate?
if the correlation coefficient is 0, a zero variance portfolio can be constructed-- a zero variance portfolio can only be constructed if the correlation coefficient between assets is -1
Low risk tolerance and high liquidity requirements best describe the typical investment needs of an:
insurance company - need to be able to pay claims as they arise
minimum variance set
less risk per level of return -the outside line of the investment opportunity set (every risky asset combined with other risky assets)
what are mutual funds
long (buy), not engaged in short selling stocks/bonds, etc -dont buy off an exchange, buy fund from company -not liquid because you dont know the constantly changing price (day lag) -do not actively trade
what is beta
measures volatility (risk) -rise ( in slope of the regression line) -measures how much an asset portfolio moves compared to a 1% increase or decrease in the market
What is an ETF
mimics market and price movement of any type of asset market (ex. large cap, small cap, gold, etc) -stock that has bond diversification -mutual fund that trade on exchange with low fees
What happens if you buy a muni from a different state
must pay state income tax- so buy from the state you live in to get tax free benefit
What was the housing market like in 2003?
people could get loans fro houses they couldn't afford (people lied on their loans)
Non agency MBS
private label MBS- investment banks can buy higher $ mortgages - only purchased by credited investors- not normal people
How does fannie and freddie attempt to accomplish their goal
purchase mortgages from banks
which of the following statements about the SML and the CML is least accurate
securities that plot on the SML have no value to investors-- wrong because they are expected to earn their equilibrium rate of return and therefore do have value to an investor
Total risk equals
systematic + unsystematic risk
What are municipal bonds
tax free bonds
In a defined contribution pension plan:
the employee accepts the investment risk-NO promises of a specific income
What is fannie and freddie's mission
to create more liquid mortgage market and also to maximize SH value (doesnt work)
How did fannie and freddie get in trouble regarding these loans?
usually wouldn't take bad loans, but people were lying so they got in trouble -did not care because they would get bailed out by the government (although they said they weren't)
Which of the following statements about risk-averse investors in most accurate? A risk averse investor:
will take take additional investment risk if sufficiently compensated for this risk
extension risk
you buy bond expecting certain rate and length -if interest rates go up, no one will refinance and your time holding the bond will be longer (this is at a bad time because bond prices are going down)
What does it mean when you have a perfect -1 correlation between assets?
you get the ultimate benefit of diversification- able to have a completely risk free portfolio
What does it mean when you have a perfect +1 correlation between assets?
you have no diversification benefits (only way to increase return is to increase risk
