Investments Exam #3

β is the ___________________ of stock returns and market returns

slope of in the regression

(A two stock portfolio and risk) What matters is how the stocks in the portfolio:

move together That movement is measured in terms of correlation between Stock A and Stock B

There is _______ for the market as numerator and denominator are 0

no IR

A manager with a positive alpha is _________________________; a negative alpha is ____________________________.

outperforming; underperforming.

Tracking Error is the standard deviation of:

relative portfolio returns

The greater the beta, the _____________ the stock

riskier

standard deviation consists of systematic and unsystematic risks but returns only stem from _____________ risk

systematic

Differs from ___________ or market risk, which influences most assets in varying degrees

systemic risk (Unsystematic risk)

All portfolios represent efficient portfolios with equal compensation for:

taking risk

(The Efficient Frontier) It does offer an investment universe of portfolio. You would never buy a portfolio:

that is dominated by another

Alpha (𝛼) represents:

the actual return of the portfolio less the return predicted by CAPM.

In a portfolio, these risks offset each other - some good news, some bad - and therefore, a portfolio diversifies away __________ risk.

unsystemic

Expected Return of a portfolio is the:

weighted average of the return of each stock the portfolio standard deviation is NOT THE WEIGHTED AVERAGE

You _________ choose a portfolio not on the efficient frontier.

would never

Not all stocks and portfolios lie on the efficient frontier. But through combinations:

you move to the efficient frontier

We measure the systematic risk with:

β or beta

𝐸(𝑟) =

𝑅[𝑓] + (𝑅[𝑚] − 𝑅[𝑓]) * β

Jen's Alpha Example Example: A portfolio returned 15%. The market return was 10% and the risk-free rate was 3%. The portfolio beta was 1.5

Jensen's Alpha = . 15−(0.3+(.10−.03)∗1.5) =0.015 = 1.5% Note that the excess return of 5% is different than the alpha of 1.5%

_____________________________________________ are more common in relative return portfolios, although Sharpe Ratio is often seen.

Jensen's alpha (or just alpha) and IR

systematic part of return + unsystematic part of return =

(return on stock) - expected return This is for a single stock (includes unsystematic part of return

Treynor Ratio

-A measure of risk-adjusted performance that relates a portfolio's excess returns to the portfolio's beta. -(R[p] - R[f]) / B[p]

Jensen Alpha

=R[p] - (R[f] + (R[m] - R[f]) * B) -Alpha (𝛼) represents the actual return of the portfolio less the return predicted by CAPM.

____________________ on the Capital Market Line have the same (and optimal) Sharpe Ratio

All portfolios

The theories of _______________________________________ leads us to understand optimal portfolios in terms of risk and return

CAPM and the security market line -We can use this relationship to also evaluate portfolios and to measure the return in terms of the risk it took to generate the return

_______ contains only the optimal portfolios (with highest possible Sharpe Ratio).

CML

The model is used to compare expected return and predicted return

Capital Asset Pricing Model For example, assume your analysis, using a DCF, suggested a stock had a 18% expected return. If the CAPM model suggested that a 10% expected return was fair, then the stock is attractive.

____________________ is a major component of calculating portfolio risk

Correlation

series of portfolios that represents the maximum return for a given risk level.

Efficient Frontier

You will have a series of mixes, each with an optimal risk-return relationship. The line that represents these portfolios is call the:

Efficient Frontier`

Information Ratio =

Excess Return / Tracking error -another way to measure how much risk was taken to generate the excess returns -The measure can be used on an absolute basis - it should be >0 - but more commonly on a relative basis to other portfolios.

Actual Return =

Expected Return + Unexpected Return

Similarly, stock D is offering too little return for its level of risk.

Expected return: 5% Return/Beta: 1.6%

Holders of each asset are only paid for market risk or beta. Therefore, stock B is offering too much return for its level of risk.

Expected return: 9 % Return/Beta: 8%

Risk _________ the weighted average. Correlation __________

IS NOT matters

Sharpe Ratio

Reward-to-volatility ratio; ratio of portfolio excess return to standard deviation.

________ contains all properly priced portfolios and assets

SML

_______ plots return against beta while the ______ plots it against standard deviation

SML CML

What represents a series of efficient portfolios formed by combination of risk free and risky assets

Security Market Line

It assumes a portfolio with unsystematic risk diversified away Which ratio?

Sharpe

It can be negative or positive.

Sharpe

Return measure is absolute (vs. risk free rate) and not relative vs. the market

Sharpe -Therefore, it is useful to compare portfolios, including the market, and not useful in isolation

Comparing Measures _________________________________ have no meaning in isolation

Sharpe and Treynor

Stock Price change from beta & market risk Market Change: 2.0% Beta 2.5

Stock Price change: 5%`

Unexpected Return =

Systematic Portion + Unsystematic Portion For example: You may expect a stock to go up 10% but it rises more. But then the market rallies strongly. And a competitor's factory is wiped out by a tornado. You get extra systematic return (market) and unsystematic return (tornado). The unexpected return could be negative too, if, for example, the market went down and the tornado hit the company's factory instead.

System-wide risk, which influences a large number of assets in varying degrees. type of risk

Systematic Risk

Same as market risks, such as political changes and economic data. type of risk

Systematic risk

This risk cannot be diversified away

Systematic risk

Diversification is free and therefore investors will not get paid (will not get a return) for taking on risk that could be diversified away. T/F

T

Monumental finding by Henry Markowitz, developing Modern Portfolio Theory.

The Efficient Frontier

_______________________________ does not tell us which portfolio on the efficient frontier to own

The Markowitz (MPT)

______________ represents portfolios that dominate the portfolios of the efficient frontier, except for the market portfolio. (More on this later

The SML

Similar to Sharpe, it is a relative measure and can be positive or negative Which ratio?

Treynor Ratio

Unlike Sharpe Ratio, __________________ looks on at systematic risk (beta)

Treynor Ratio

There is _____ risk-free portfolio

a Security Market Line

Sharpe Ratio measures:

a portfolio's excess return relative to the standard deviation of the portfolio

When comparing portfolios, a __________ Sharpe Ratio is desirable

higher

Stockholders only are compensated for ____________ risk

market (systematic)

Excess Return is the difference between portfolio return and ____________________________

market returns (information ratio)

Think of CAPM as a one-factor model, where that factor is ______________. Multi-factor models, such as APT, expand on CAPM.

market risk

(The Efficient Frontier) It describes a series of portfolio combinations, where each point: or conversely:

maximizes return for a given level of risk minimizes risk for a given level of return.

Both ratios look at absolute return and the amount of risk taken to generate that return, although each uses a different:

measure of risk

Key Assumption: Investors want to maximize return for a given level of risk or:

minimize risk for a given level of return.

The blue dot on the far left represents the portfolio with the lowest standard deviation. This is the:

minimum variance portfolio.

You need _____ return as you increase risk

more

Any portfolio below the minimum variance portfolio is considered inefficient. You would:

never own it.

Unlike the efficient frontier, this line is straight. The slope of the line is the:

optimal Sharpe ratio. It is called the Capital Market Line

It is important to use the ________ index to calculate alpha (look at R-squared, for example) and to compare portfolios with ________ investment objectives.

right similar

β measures a stock's level of systematic risk and:

sensitivity to market moves.

Note that the sharpe ratio uses:

standard deviation (not beta)

Key: The expected return depends only on an asset's _____________ risk

systematic

Sharpe, Treynor Ratios, & Jensen Alpha used to:

test that assumption -If these measures suggest excess return, the questions is: Is it skill or luck

Eventually, the incremental level of risk reduction is ______ and you have:

tiny optimized the risk-return tradeoff.

If β = 2, then the stock will change at ___________ as the market.

twice the rate

Sharpe Ratio Example: Example 1: A portfolio returns 15% and the risk free rate is 3%. The standard deviation of the portfolio is 20%.

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = (.15−.03)/.20 = 0.6

Sharpe Ratio Example: Example 2: A portfolio returns -15% and the risk free rate is 3%. The standard deviation of the portfolio is 20%.

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = (−.15−.03)/.20 = -0.90

Like return, ______ in a portfolio is the weighted average of each stock's ______

beta` beta

You do not get paid for taking _______________ risks

unsystematic

The model states that the expected return for a stock is based on the risk free rate, the equity risk premium and the beta of the stock

Capital Asset Pricing Model

But one portfolio has the highest Sharpe Ratio which is:

"Sharpe Optimal" or more commonly: The Market Portfolio

The Correlation Coefficient, ρ, ranges from ___________ and measures how stocks move together.

-1 to 1

Important Slides: 8 & 9

8 & 9

ERP=

R[m] - R[f]

Indeed, it is all that remains in a diversified portfolio type of risk

Systematic risk

They are the risks that are company or asset specific, such as company fraud, earnings surpise, product recall, and so on type of risk

Unsystematic Risk

known as unique or asset-specific risks type of risk

Unsystematic Risk

Portfolio AB Risk Calculation The calculation takes in the weights of each stock, the standard deviation of each stock and the _____________________________________

correlation between each stock

β is the ________________ between the market and a stock

correlation coefficient

While stocks will have ___________ of market risk (beta), market forces act so that all portfolios will have the same risk-return tradeoff because of market forces

different levels

Note that ρ measures _______________ and not __________

direction scale

(The Efficient Frontier) The theory ______ you which portfolio to buy (but we will learn later there is an optimal market portfolio)

does not tell

Note that as correlations ________________, every combination of Stocks A and B offers a better risk-return trade off than the same combination when the two stocks are perfectly correlated

drop below 1

CAPM suggests markets are ______________ and that you ___________ get excess return (for a given level of risk).

efficient cannot

CAPM is intuitive but difficult to validate _____________

empirically.

The _____________ premium is how much extra return you need for each unit of additional risk.

equity risk

You can short (or borrow) at the risk free rate, meaning the SML ___________

extends

Information Ratio: Example Two portfolios have an alpha of 3% per year for five years and both have betas of 1. Portfolio A has annual excess returns of 2%,4%,3%,4%,2%. Portfolio B has annual excess returns of 0%,-2%,6%,9%,2%. Which has higher IR?

finish

As you diversify, therefore, you have the potential to increase return for a:

given level of risk or reduce risk to a given level of return.

If β = 0.5, then the stock will change at _________ as the market.

half the rate

Comparing Measures For all measures, __________ is better

higher

As you add stocks to the portfolio, they will decrease risk, as long as:

the correlation is less than 1.

If you have eliminated unsystematic risks, you are on:

the efficient frontier

CAPM measures risk but is presented in terms of expected return. The risk component, however, is that:

the expected return can also be used as the appropriate discount rate.

If β = 1, then the stock will change at _________ as the market

the same rate

You will always own portfolios that rest on:

the security market line

alpha measures:

the skill of a manager