Investment Management / Part 1

TRUE OR FALSE? Unsystematic risk is unique to each asset.

ANSWER: TRUE

_ _ _ _ is the technical indicator used as a principle measure of unsystematic risk.

Alpha is the technical indicator used as a principle measure of unsystematic risk.

Asset allocation can further be classified as _ _ _ _ asset allocation or _ _ _ _ asset allocation.

Asset allocation can further be classified as strategic asset allocation (SAA) or tactical asset allocation (TAA).

COMPLETE THE SENTENCE _ _ _ is the technical indicator used as a principal measure of systematic risk. Under this measurement, the total market is the optimal risky portfolio for comparison purposes and has a beta value of _ _ _ _.

Beta is the technical indicator used as a principal measure of systematic risk. Under this measurement, the total market is the optimal risky portfolio for comparison purposes and has a beta value of 1.00.

CAPITAL ASSET PRICING MODEL To estimate risk, the Capital Asset Pricing Model divides the total risk of any asset into two components:

CAPITAL ASSET PRICING MODEL [1] Systematic risk (market risk) [2] Unsystematic risk (non-market or specific risk)

Consider the following historical data when advising a client on asset allocation strategies: [1] Short-term assets for emergency or consumption should combine liquidity with low volatility. [2] Allocation of assets other than short-term assets should not be based on short-term performance but on the long-term risk/return profile of the assets. [3] While real estate can be volatile over the short term, it can provide a hedge against inflation. The decision to buy assets such as real estate should be made on the basis of lifestyle considerations coupled with the appropriate financial issues. [4] Because the future is not predictable, you should encourage your clients to allocate assets to a diversity of holdings that will achieve an acceptable return while reducing risk.

Consider the following historical data when advising a client on asset allocation strategies: [1] Short-term assets for emergency or consumption should combine liquidity with low volatility. [2] Allocation of assets other than short-term assets should not be based on short-term performance but on the long-term risk/return profile of the assets. [3] While real estate can be volatile over the short term, it can provide a hedge against inflation. The decision to buy assets such as real estate should be made on the basis of lifestyle considerations coupled with the appropriate financial issues. [4] Because the future is not predictable, you should encourage your clients to allocate assets to a diversity of holdings that will achieve an acceptable return while reducing risk.

In the Capital Asset Pricing Model, the market itself is set as a _ _ _ _ _ representing the optimum risky portfolio, and risk is defined as a _ _ _ _ _ _.

In the Capital Asset Pricing Model, the market itself is set as a benchmark representing the optimum risky portfolio, and risk is defined as a possible change in the market value of an asset.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE Information is _ _ _ _ _ _.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE Information is freely available and insider information is already priced into the market.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors are able to invest and borrow to an _ _ _ _ _ at the prevailing _ _ _ _ rate.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors are able to invest and borrow to an unlimited degree at the prevailing risk-free rate.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors are _ _ _ _ to risk, preferring the less risky of two investments with the same level of return, and preferring the investment with greater return of two investments with _ _ _ _ _ .

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors are averse to risk, preferring the less risky of two investments with the same level of return, and preferring the investment with greater return of two investments with the same level of risk exposure.

_ _ _ _ _ refers to establishing the long-term benchmark asset mix of the various asset classes.

Strategic asset allocation refers to establishing the long-term benchmark asset mix of the various asset classes.

Studies have shown that _ _ _ _ _ decisions account for 80 to 90% of the variations in returns on an investment portfolio.

Studies have shown that asset allocation decisions account for 80 to 90% of the variations in returns on an investment portfolio.

Cyclical fluctuations in securities markets is an example of _ _ _ _ risk

Systematic

This is the risk that is explained by market fluctuations and general economic conditions.

Systematic risk

_ _ _ _ _ risk causes random variances in returns and is beyond the control of investors and corporate management.

Systematic risk causes random variances in returns and is beyond the control of investors and corporate management.

Tactical asset allocation is an active management strategy employed to add value by _ _ _ _ _.

Tactical asset allocation is an active management strategy employed to add value by temporarily departing from the long-term policy asset mix

The Capital Asset Pricing Model (CAPM) is a model that is used to estimate risk and determine the optimum price of an asset based on its risk component, according to the following relationships between predictability and risk: [1] When the expected return on an investment is fairly predictable, there is _ _ _ _ risk. [2] When the expected return on an investment is highly uncertain, there is _ _ _ _ risk.

The Capital Asset Pricing Model (CAPM) is a model that is used to estimate risk and determine the optimum price of an asset based on its risk component, according to the following relationships between predictability and risk: [1] When the expected return on an investment is fairly predictable, there is less risk. [2] When the expected return on an investment is highly uncertain, there is greater risk.

The Capital Asset Pricing Model (CAPM) is a model that is used to estimate _ _ _ _ and determine _ _ _ _ _ _ .

The Capital Asset Pricing Model (CAPM) is a model that is used to estimate risk and determine the optimum price of an asset based on its risk component.

How is the Security Market Line calculated?

The expected rate of return on a portfolio is calculated using the Market Line Formula, which shows a linear relationship between risk and return. The formula is calculated as follows: E(Rp) = Rf + ßp(Rm - Rf)

The overall objective of strategic asset allocation is _ _ _ _ _ _.

The overall objective of SAA is normally based on balancing the need to control risk, including inflation, interest rate and market risk, against the desire for enhanced returns.

Corporate difficulties, such as servicing debt interest and repayment of principal is an example of _ _ _ _ _ risk.

Unsystematic risk

WHAT IS THE SECURITY MARKET LINE? The return on a portfolio is essentially a function of the portfolio's beta, times the current market return. Because investors have no control over the fluctuations of the market itself, beta is the only controllable determinant of a portfolio's equity component return. This return on a portfolio is expressed in the Security Market Line, which shows a linear relationship between risk and return. A higher return can be expected from a portfolio only by incurring higher risk and, conversely, to minimize risk an investor must be satisfied with a lower return.

WHAT IS THE SECURITY MARKET LINE? The return on a portfolio is essentially a function of the portfolio's beta, times the current market return. Because investors have no control over the fluctuations of the market itself, beta is the only controllable determinant of a portfolio's equity component return. This return on a portfolio is expressed in the Security Market Line, which shows a linear relationship between risk and return. A higher return can be expected from a portfolio only by incurring higher risk and, conversely, to minimize risk an investor must be satisfied with a lower return.

How can you use the Security Market Line to determine the risk-adjusted performance level of a portfolio?

You can determine the risk-adjusted performance level of a portfolio using the Security Market Line by comparing the expected rate of return to the actual rate of return and adjusting for the difference.

How can you reduce systematic risk to a portfolio?

You can reduce systematic risk by assessing beta indicators of common stocks to create a portfolio mix that meets risk objectives.

Factors influencing investment policy include the client's: [List 7]

[1] Return objectives [2] Risk tolerance [3] Time horizon [4] Liquidity needs [5] Legal constraints [6] Tax considerations [7] Other special circumstances

Unsystematic risk is also known as _ _ _ _

non-market or specific risk.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors will hold investments for _ _ _ _ _ _ _.

KEY ASSUMPTIONS OF MPT COMPLETE THE SENTENCE It is assumed that investors will hold investments for the same period.

KEY ASSUMPTIONS OF MPT / COMPLETE THE SENTENCE It is assumed that investors have the same expectations of fluctuations in _ _ _ _ _

KEY ASSUMPTIONS OF MPT / COMPLETE THE SENTENCE It is assumed that investors have the same expectations of fluctuations in future levels of returns from various assets.

Complete The Sentence Modern portfolio theory looks at _ _ _ _ _ rather than _ _ _ _ _.

Modern portfolio theory looks at the market as whole rather than analyzing investments on an individual basis.

Under modern portfolio theory how is investment performance measured?

The return on a portfolio is more fully evaluated by comparing the actual return with the expected return based on the risk characteristics, or beta coefficient, of that particular portfolio.

This is the portion of total risk not explained by market fluctuations.

Unsystematic risk

[NOTES / CAPITAL ASSET PRICING MODEL] [1] When the expected return on an investment is fairly predictable, there is less risk. [2] When the expected return on an investment is highly uncertain, there is greater risk.

[NOTES / CAPITAL ASSET PRICING MODEL] [1] When the expected return on an investment is fairly predictable, there is less risk. [2] When the expected return on an investment is highly uncertain, there is greater risk.

Variations in investment returns can be traced to the following four sources:

Variations in investment returns can be traced to the following four sources: [1] Asset allocation [2] Market timing decisions [3] Securities selection [4] Chance

What are the 5 key assumptions of modern portfolio theory?

What are the 5 key assumptions of modern portfolio theory? [1] Aversion to risk [2] Time horizon [3] Expected returns [4] Borrowing rate [5] Perfect Market

How can you reduce unsystematic risk to a portfolio?

You can reduce unsystematic risk to a portfolio through diversification. Diversification among 20 or more various securities almost eliminates unsystematic risk, and almost all the risk remaining is systematic, or market, risk.

COMPLETE THE SENTENCE You would increase the portfolios beta coefficient (risk level) if the stock market is expected to _ _ _ _ and decrease its beta coefficient if the stock market is expected to _ _ _ _. This strategy requires successful market timing to succeed.

You would increase the portfolios beta coefficient (risk level) if the stock market is expected to rise and decrease its beta coefficient if the stock market is expected to decline. This strategy requires successful market timing to succeed.

[NOTES / MPT / KEY ASSUMPTIONS] The differences in current market prices of assets generally reflect expected fluctuations in future rates of return.

[NOTES / MPT / KEY ASSUMPTIONS] The differences in current market prices of assets generally reflect expected fluctuations in future rates of return.

[NOTES / SYSTEMATIC RISK] The risk inherent to the entire market or an entire market segment. Systematic risk, also known as "undiversifiable risk," "volatility" or "market risk," affects the overall market, not just a particular stock or industry.

[NOTES / SYSTEMATIC RISK] The risk inherent to the entire market or an entire market segment. Systematic risk, also known as "undiversifiable risk," "volatility" or "market risk," affects the overall market, not just a particular stock or industry.

How can you test the value of an IPS? You can test the value of an IPS by asking five questions: [1] Is the IPS designed to meet the real needs and objectives of the client? [2] Is the IPS written so clearly that a competent stranger could manage the portfolio in keeping with its intentions? [3] Would the client have been able to remain committed to the IPS during the actual conditions of the markets over the past 50 or 60 years? [4] Would the investment Advisor have been able to remain committed to the IPS during the actual conditions of the markets over the past 50 or 60 years? [5] Would the IPS have achieved the client's objectives under the market conditions of the past? For an IPS to be valuable, you must be able to answer yes to each of these questions.

How can you test the value of an IPS? You can test the value of an IPS by asking five questions: [1] Is the IPS designed to meet the real needs and objectives of the client? [2] Is the IPS written so clearly that a competent stranger could manage the portfolio in keeping with its intentions? [3] Would the client have been able to remain committed to the IPS during the actual conditions of the markets over the past 50 or 60 years? [4] Would the investment Advisor have been able to remain committed to the IPS during the actual conditions of the markets over the past 50 or 60 years? [5] Would the IPS have achieved the client's objectives under the market conditions of the past? For an IPS to be valuable, you must be able to answer yes to each of these questions.

Other investors set goals based on outperforming a market index, such as: • Earning a risk-adjusted rate of return above the S&P/TSX Composite Index • Outperforming the S&P/TSX 60 Index by 2% per annum Still other investors might articulate a benchmarking strategy, such as: • Earning a return equal to a weighted average portfolio consisting of 20% treasury bills, 30% bonds and 50% stocks as measured by the ScotiaCapital 91-day T-bill Index, the PC Bond Universe Bond Index and the S&P/TSX Composite Index

Other investors set goals based on outperforming a market index, such as: • Earning a risk-adjusted rate of return above the S&P/TSX Composite Index • Outperforming the S&P/TSX 60 Index by 2% per annum Still other investors might articulate a benchmarking strategy, such as: • Earning a return equal to a weighted average portfolio consisting of 20% treasury bills, 30% bonds and 50% stocks as measured by the ScotiaCapital 91-day T-bill Index, the PC Bond Universe Bond Index and the S&P/TSX Composite Index

The_ _ _ _ _ _ describes the strategies and steps the investment Advisor will take to accomplish the client's objectives. This makes the _ _ _ _ __ a tool for managing the client's expectations and avoiding panicky or overoptimistic reactions to changes in the markets. By keeping clients focused on their objectives, the _ _ _ _ _ _ helps them meet those objectives.

The investment policy statement describes the strategies and steps the investment Advisor will take to accomplish the client's objectives. This makes the investment policy statement a tool for managing the client's expectations and avoiding panicky or overoptimistic reactions to changes in the markets. By keeping clients focused on their objectives, the IPS helps them meet those objectives.

Briefly explain the rebuttals to the criticisms of modern portfolio theory?

[1] Although The S&P/TSX Composite Index (or the S&P 500 Index) does not represent the entire Canadian (U.S.) stock market and is therefore limited, the S&P 500 Index represents 80 to 90% of the market value of all stocks listed on the New York Stock Exchange. [2] There have been divergences in beta values of as much as half of a point or more because of differences in the length of the base time period chosen to calculate the beta value, as well as the frequency of measurement within the chosen period. This problem has been addressed by most beta measurement services by using a three- to five-year period, with measurements every two to four weeks. [3] It is assumed that the beta value shifts reflect changing business conditions in the overall macroeconomic picture, where those changes offer more corporate earnings potential and growth opportunities for some corporations and less for others. The fact that beta value instability is not limited to individual stocks, but, instead, is characteristic of industry groups as well, tends to confirm that conclusion. However, shifts in beta values of specific stocks occur gradually, allowing adjustments in portfolios to be made. [4] While level of beta rating availability is not suffi cient to cover the entire Canadian market, there are beta value ratings on almost all interlisted stocks that trade on the TSX/TSX Venture Exchange and the NYSE or AMEX. These provide guidance to the volatility of applicable individual interlisted stocks, and ignoring these ratings is tantamount to omitting a significant piece of investment decision information.

How can you adjust the risk component of a portfolio?

[1] Concentrate portfolio holdings in securities with expected positive alphas, thus having a total portfolio with a positive alpha rating. [2] Shift the volatility of the portfolio (its beta coefficient) in anticipation of general market movement.

What are four criticisms of modern portfolio theory?

[1] The S&P/TSX Composite Index (or the S&P 500 Index) does not represent the entire Canadian (or U.S.) stock market and, therefore, is not a perfect tool to measure the performance of all securities. [2] Various measurement techniques result in different beta values for the same stock. [3] The betas of individual securities are not stable over time. In some cases, the beta value of an individual stock could change as much as 50% over a five-year period. [4] For Canadian investors, the concept of beta is of limited value because beta ratings tend to be available only for large cap stocks.

What are the limitations of a risk-adjusted performance evaluation?

[1] The source of the beta used in a formula may be disputable. [2] The beta may have changed over the measurement period. [3] A particular index may not be suitable for measuring a particular portfolio's performance. [4] The portfolio manager may not be free to invest in (or trade) all securities in the market. [5] The performance measurement period may be too short.

[NOTES / ALPHA] If the alpha is positive, there is an expected return separate from that attributable to systematic risk. If the alpha is negative, there is an expected loss separate from that attributable to systematic risk.

[NOTES / ALPHA] If the alpha is positive, there is an expected return separate from that attributable to systematic risk. If the alpha is negative, there is an expected loss separate from that attributable to systematic risk.

[NOTES / MODERN PORTFOLIO THEORY] The concepts of the theory provide the basis for decision making in planning a diversified portfolio with the maximum expected return given an investor's level of risk tolerance.

[NOTES / MODERN PORTFOLIO THEORY] The concepts of the theory provide the basis for decision making in planning a diversified portfolio with the maximum expected return given an investor's level of risk tolerance.

[NOTES / MPT / ALPHA & BETA] Remember that beta is not only the measure of risk, but also the measure of expected gain in a rising market. Provided alpha is eliminated early in the diversification process, and beta constitutes the portfolio's only major component of risk, it can be used to calculate expected return from the portfolio's equity component.

[NOTES / MPT / ALPHA & BETA] Remember that beta is not only the measure of risk, but also the measure of expected gain in a rising market. Provided alpha is eliminated early in the diversification process, and beta constitutes the portfolio's only major component of risk, it can be used to calculate expected return from the portfolio's equity component.

[NOTES / MPT / KEY ASSUMPTIONS / PERFECT MARKET] It is assumed that securities are divisible and that unlimited amounts of funds can be invested free of transaction costs and taxes in any number of assets without affecting the equilibrium of the price or the rate of return associated with each and every investment. Information is freely available and insider information is already priced into the market.

[NOTES / MPT / KEY ASSUMPTIONS / PERFECT MARKET] It is assumed that securities are divisible and that unlimited amounts of funds can be invested free of transaction costs and taxes in any number of assets without affecting the equilibrium of the price or the rate of return associated with each and every investment. Information is freely available and insider information is already priced into the market.

[NOTES / UNSYSTEMATIC RISK] A small but definite level of unsystematic risk is present in even the most diversified portfolio. It constitutes a vital part of the security's total risk, but is not necessarily a significant factor.

[NOTES / UNSYSTEMATIC RISK] A small but definite level of unsystematic risk is present in even the most diversified portfolio. It constitutes a vital part of the security's total risk, but is not necessarily a significant factor.