Reading 53: Portfolio Risk and Return: Part II

greatest

The implications of this conclusion are very important to asset pricing (expected returns). The riskiest stock, with risk measured as standard deviation of returns, does not necessarily have the ______________________ expected return.

capital allocation line (CAL)

The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets is referred to as the ___________________________________.

security characteristic line

The regression line used when estimating beta is referred to as the asset's ___________________________________.

zero correlation

The risk-free asset has __________________________ of returns with any portfolio of risky assets.

beta

The sensitivity of an asset's return to the return on the market index in the context of the market model is referred to as its _____________. -is a standardized measure of covariance.

capital asset pricing model (CAPM)

This is the most common means of describing the SML, and this relation between beta (systematic risk) and expected return is known as the ______________________________________________.

factor sensitivity

This model states that the expected excess return (above the risk-free rate) for Asset i is the sum of each ___________________________ or factor loading (the βs) for Asset i multiplied by the expected value of that factor for the period. The first factor is often the expected excess return on the market, E(Rm − Rf ).

compensated

To sum up, unsystematic risk is not __________________________ in equilibrium because it can be eliminated for free through diversification.

Treynor measure

Two measures of portfolio performance based on systematic (beta) risk rather than total risk are the _______________________ and Jensen's alpha.

capital market line (CML)

Under the assumption of homogeneous expectations, this optimal CAL for all investors is termed the ___________________________________. Along this line, expected portfolio return, E(RP ), is a linear function of portfolio risk, σP.

ex ante

We have shown the Sharpe ratio as an _________________________ (before the fact) measure, using the expected values of portfolio returns and standard deviation. However, it can also be used as an ex post (after the fact) measure of portfolio performance, using mean returns and sample standard deviation over a period.

unsystematic risk

When an investor diversifies across assets that are not perfectly correlated, the portfolio's risk is less than the weighted average of the risks of the individual securities in the portfolio. The risk that is eliminated by diversification is called __________________________________ (also called unique, diversifiable, or firm-specific risk).

Sharpe ratio

When evaluating the performance of a portfolio with risk that differs from that of a benchmark portfolio, we need to adjust the active portfolio return's risk. Of the alternative ways to consider both risk and return in evaluating portfolio performance, the most commonly used is the _______________________.

equilibrium

When the market is in _______________________, expected returns equal required returns. Since this means that all assets are correctly priced, all assets plot on the SML.

unsystematic

Whether risk adjustment should be based on standard deviation of returns or portfolio beta depends on whether a manager's portfolio bears _____________________________ risk.

Jensen's alpha

____________________________ for Portfolio P is calculated as αP = Rp − [Rf + βP (RM − Rf )] and is the percentage portfolio return above that of a portfolio (or security) with the same beta as the portfolio that lies on the SML

Attribution analysis

_____________________________, an analysis of the sources of returns differences between active portfolio returns and those of a passive benchmark portfolio, is part of performance evaluation.

Performance evaluation

_________________________________ of an active manager's portfolio choices refers to the analysis of the risk and return of the portfolio.

Statistical factors

__________________________________ often have no basis in finance theory and are suspect in that they may represent only relations for a specific time period which have been identified by data mining (repeated tests on a single dataset).

Abnormal return

___________________________________ = Actual return - expected risk-adjusted return

Return generating models

___________________________________ are used to estimate the expected returns on risky securities based on specific factors. For each security, we must estimate the sensitivity of its returns to each specific factor. Factors that explain security returns can be classified as -macroeconomic -fundamental, and -statistical factors

Multifactor models

___________________________________ most commonly use macroeconomic factors such as GDP growth, inflation, or consumer confidence, along with fundamental factors such as earnings, earnings growth, firm size, and research expenditures

market model

A simplified form of a single-index model is the ______________________________, which is used to estimate a security's (or portfolio's) beta and to estimate a security's abnormal return (return above its expected return) based on the actual market return.

homogeneous

A simplifying assumption underlying modern portfolio theory (and the capital asset pricing model, which is introduced later in this topic review) is that investors have ________________________ expectations (i.e., they all have the same estimates of risk, return, and correlations with other risky assets for all risky assets). -Under this assumption, all investors face the same efficient frontier of risky portfolios and will all have the same optimal risky portfolio and CAL.

beta risk

Because the SML shows the equilibrium (required) return for any security or portfolio based on its beta (systematic risk), analysts often compare their forecast of a security's return to its required return based on its __________________.

systematic risk

Because the market portfolio contains all risky assets, it must be a well-diversified portfolio. All the risk that can be diversified away has been. The σP σM risk that remains cannot be diversified away and is called the ________________________________ (also called nondiversifiable risk or market risk).

market portfolio

By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the __________________________ is efficient.)

risk-free rate

Capital market theory assumes that investors can borrow or lend at the ___________________________.

separation theorem

Combining the CML (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from what to invest in and is called the ________________________________. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification.

no

Do you actually have to buy all the securities in the market to diversify away unsystematic risk? _____. Academic studies have shown that as you increase the number of stocks in a portfolio, the portfolio's risk falls toward the level of market risk. One study showed that it only took about 12 to 18 stocks in a portfolio to achieve 90% of the maximum diversification possible. Another study indicated it took 30 securities

CAL

For an individual investor, the best __________ is the one that offers the most-preferred set of possible portfolios in terms of their risk and return.

single-index model

Here, the expected excess return (return above the risk-free rate) is the product of the factor weight or factor sensitivity, Beta i, and the risk factor, which in this model is the excess return on the market portfolio or market index, so that this is also sometimes called a __________________________.

diversified

If a fund uses multiple managers so that the overall fund portfolio is well ____________________ (has no unsystematic risk), then performance measures based on systematic (beta) risk, such as the Treynor measure and Jensen's alpha, are appropriate.

total risk

If a single manager is used, then the ________________________ (including any nonsystematic risk) is the relevant measure and risk adjustment using total risk, as with the Sharpe and M2 measures, is appropriate.

equal

In equilibrium, a security's expected return and its required return (by investors) are __________________. Therefore, we can use the CAPM to estimate a security's required return.

active portfolio management

In practice, many investors and portfolio managers believe their estimates of security values are correct and market prices are incorrect. Such investors will not use the weights of the market portfolio but will invest more than the market weights in securities that they believe are undervalued and less than the market weights in securities which they believe are overvalued. This is referred to as __________________________________________ to differentiate it from a passive investment strategy that utilizes a market index for the optimal risky asset portfolio.

passive investment strategy

Investors who believe market prices are informationally efficient often follow a ________________________________________ (i.e., invest in an index of risky assets that serves as a proxy for the market portfolio and allocate a portion of their investable assets to a risk-free asset, such as short-term government securities).

risk-adjusted performance (RAP)

M2 is considered a measure of ___________________________________. The intuition is that M2 is the additional return that could have been earned by leveraging the active portfolio (borrowing at Rf) so that its risk is equal to that of the market portfolio.

systematic risk

One important conclusion of capital market theory is that equilibrium security returns depend on a stock's or a portfolio's _________________________, not its total risk as measured by standard deviation. -diversification is free -investors will not be compensated for bearing risk that can be eliminated at no cost

right

Portfolios that lie to the ________________ of the market portfolio on the capital market line are created by borrowing funds to own more than 100% of the market portfolio (M).

borrowing funds

Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market line) are created by ___________________________ to own more than 100% of the market portfolio (M).

capital market line

Portfolios that represent combinations of the risk-free asset and the market portfolio are plotted on the _________________________________________.

mispriced

Remember, all stocks should plot on the SML; any stock not plotting on the SML is _____________________.

systematic risk

Systematic risk is measured by the contribution of a security to the risk of a well-diversified portfolio, and the expected equilibrium return (required return) on an individual security will depend only on its ______________________________.

systematic

The CAPM holds that, in equilibrium, the expected return on risky asset E(Ri ) is the risk-free rate (Rf ) plus a beta-adjusted market risk premium, βi [E(Rmkt ) − Rf ]. Beta measures ________________________ (market or covariance) risk.

efficient

The CML uses total risk = σp on the x-axis. Hence, only ____________________ portfolios will plot on the CML. On the other hand, the SML uses beta (systematic risk) on the x-axis. So in a CAPM world, all properly priced securities and portfolios of securities will plot on the SML

total risk

The Sharpe ratio is based on ________________ (standard deviation of returns), rather than systematic risk (beta). For this reason, the Sharpe ratio can be used to evaluate the performance of concentrated portfolios (those affected by unsystematic risk) as well as well-diversified portfolios (those with only systematic, or beta, risk)

Sharpe ratio

The ____________________ of a portfolio is its excess returns per unit of total portfolio risk. Higher ratios indicate better risk-adjusted portfolio performance.

assumptions

The _______________________ of the CAPM are: 1. Risk aversion 2. Utility maximizing investors 3. Frictionless markets 4. One-period horizon 5. Homogeneous expectations 6. Divisible assets 7. Competitive markets

Treynor measure

The ________________________ is interpreted as excess returns per unit of systematic risk, and represented by the slope of a line

M-squared (M2)

The ____________________________ measure produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms.

slope measure

The difference between the Sharpe ratio and M2 measure is that the Sharpe is a ______________________ and M2 is measured in percentage terms.

market risk premium

The difference between the expected return on the market and the risk-free rate is termed the _____________________________________.

measure of slope

are analogous to the Sharpe ratio and M2 in that the Treynor measure is a __________________________ and Jensen's alpha is a measure of percentage returns in excess of those from a portfolio that has the same risk (beta) but lies on the SML.