FIN 327 Lachance Exam 2
Asset allocation process
1. Identifying asset classes 2. For each asset class, compute the expected return, standard deviation and correlations 3. Derive the efficient frontier 4. Select the optimal portfolio
Probability distribution
A __________ __________ is used to represent the possible future returns and their likelihood.
Trading range
A period of time when prices move within a relatively tight support/resistance range. This indicates that the forces of demand and supply are balanced.
Alpha
A positive parameter ___________ means that the stock had superior performance after controlling forth exposure to the market.
Expected return; standard deviation
A probability distribution allows us to compute a security's ______________ and _____________.
Higher
A stock with a __________ beta should give you a higher expected return.
Global economy
A top-down approach of a firm's prospects must start with the __________ ____________.
T-bills
Although it is hard to find assets that are perfectly risk-free in real terms, it is commonly assumed that ____________ are close enough to be considered risk-free.
Fundamental analyst
An individual who uses a firm's financial information and models to determine what the stock's price should be. They buy underpriced stocks and sell overpriced ones.
Small firms effect High book-to-market ratio Post earnings announcement drift
Anomalies of semi-strong market efficiency.
Behavioral finance
Assumes that human psychology affects investment decisions and that investors don't always act rationally which sometimes results in price bubbles.
Compounded (time-weighted)
Because ____________ returns give the same weight to every period, they may not be a good representation of performance when there are changes over time in the size of the assets managed.
Psychology
Biases when forming beliefs. Preferences differ from standard expected utility theory.
0 or negatively
Bonds are usually ___ or ___________ correlated.
Equilibrium
CAPM is an ___________ price setting model. The theory with these models is that if expected returns deviate from their prediction, then buying/selling pressure should affect prices until ___________ is restored.
Capital allocation
Combining a risk-free asset with a risky asset is a __________ __________ problem.
Asset allocation
Combining several risky assets is a __________ __________ problem.
Implementation cost
Commissions, bid-ask spread, short-sale costs and constraints.
Monthly Quarterly Year to date
Common formats for less than a year include monthly:
Event studies
Commonly used in finance to examine how information is incorporated in price.
Not always. When a dividend is paid, the market automatically reduces the price of the stock by a corresponding amount.
Do stocks with higher dividends make you more money?
Behavioral finance
Does not assume that prices are always correctly reflecting available information.
Risk premium
E[rm] - rf
Diversified
Firm-specific risks can be ___________ away by increasing the number of stocks in the portfolio.
Information processing
Forecasting errors, memory bias Overconfidence Conservatism Sample-size neglect and representativeness
Behavioral biases
Framing Mental accounting Regret avoidance
Macroeconomic factors
GDP, Inflation, Employment, Exchange rates, Interest rates, Budget deficit, Sentiment
Information processing
Getting the probable distribution wrong.
Compounded (time-weighted) returns
Give the amount of money accumulated at the end of a period if $1 was invested initially and the dividends reinvested.
Lower
Higher dividend yields come at the expense of ___________ capital gains.
Lower
Historically, asset classes with lower risk (standard deviation) had __________ returns.
Standard deviation
How is risk measured when using the normal distribution?
Sharpe ratio
If the problem is to chose an optimal risky portfolio to combine with a risk-free asset in the capital allocation problem, then the best choice is the portfolio with the highest ___________ __________.
Risk; return
If the problem is to chose the optimal portfolio among the portfolios on the efficient frontier, then it would be necessary to define the investor's preferences for ___________ and __________ to get a solution.
Negatively
In recent years, stocks and bonds are often __________ correlated.
Geometric
In the special case where returns are annual, a ___________ average is the same thing as an annualized return.
Coupon payments
Income for bonds
Cash dividends
Income for stocks
Consumer price index
Inflation is measured as a percentage increase in the _______________.
Negatively; positively
International stocks used to be ___________ correlated but are now more ___________ correlated.
Efficient frontier
Investors should prefer portfolios on the ___________ ____________ which represents the set of portfolios that offers the highest expected return for each level of standard deviation.
Higher; lower
Investors should prefer risky portfolios with higher Sharpe Ratios. For the same level of risk you get a __________ expected return. For the same level of expected return you get _________ risk.
Behavioral bias
Making decisions that are not perfectly rational given the information that is available.
Historical measures of risk and return
Measures for reporting past performance assessment. These measures are objective.
Standard deviation
Measures the extent to which possible returns are close or far from the expected return.
Expected measures of risk and return
Measures to make decisions about future investments. These measures are subjective.
Limits to arbitrage
Mispricing can persist even with rational agents.
0
Money market instruments should have almost ___ correlation with all asset classes.
Compounded (time-weighted) returns Dollar-weighted returns Annualized returns Average returns
Multi-period returns
Holding period return
Often referred to as a total return because it is a combination of capital gains and dividend yields.
Noise risk
Possibility that mispricing continues and even worsens.
Active; passive
Proponents of the efficient market hypothesis believe that ___________ management is largely wasted effort and unlikely to justify the expenses incurred. Therefore, they advocate a ____________ investment strategy that makes no attempt to outsmart the market.
Efficient markets
Rational. Assumes that all price informational is already incorporated in prices. Prices change only when new information arrives. Prices follow a random walk.
Nominal
Regular returns are called __________ returns.
Real
Returns which are net of inflation are called ___________ returns.
SEC
Rule 10b-5 sets limits on trading by corporate officers, directors, and substantial owners, requiring them to report trades to the ____________.
Fundamental
Semi-strong form market efficiency rules out profiting from ____________ analysis.
Increased
Since 2014, the dollar index has ___________.
Semi-strong form market efficiency
States that all publicly available information regarding the prospects of a firm (balance sheet, earnings forecast) already must be reflected in the stock's price.
Weak form market efficiency
States that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices, trading volume or short interest.
Greater fool theory
States that the price of an object is determine not by its intrinsic value, but rather by the often irrational beliefs and expectations on market participants.
Efficient market hypothesis
States that the right price for a stock is the one you observe in markets. The price reflects all available information.
Strong form market efficiency
Stock prices reflect all information relevant to a firm, even private information available only to company insiders.
Contrarian
Strategy that picks stocks that performed poorly in the last period.
Momentum
Strategy that picks stocks that performed well in the last period.
Insider trading
Strong form market efficiency rules out profiting from ___________ ___________.
Technical analyst (chartist)
Studies the prices, volume and short interest of stocks and identifies patterns that tell them when to buy or sell stocks.
Continuation patterns Reversal patterns
Technical analysts typically look for signs of either _______________ or _______________.
Normal distribution
The ___________ ___________ is commonly used in finance to describe the possible outcomes of an investment in terms of risk and return.
Expected return
The ____________ ____________ equation measures a weighted-average of the possible returns.
Correlation coefficient
The _____________ ____________ denoted by 𝜌 measures the extent with which two time-series of historical returns "move together".
GDP
The _____________ is the measure of the economy's total production of goods and services.
Bubbles
The actions of irrational investors can lead to price ____________.
-1; 1
The correlation coefficient ranges between ___ and ___.
Ex date
The date stockholders must have purchased a stock before in order to be entitled to a dividend.
Chasing alpha
The expression "_________ __________" is often used to refer to analysts who seek to identify securities with superior performance.
Fundamental risk
The idea that you might be correct about the reason that motivates your stock purchase or sale but since so many different things affect stock price, something else might go wrong.
10 year bond
The interest rate most accessible in the financial media is the yield on the ________________.
Holding period return
The most basic measure of return for one period.
Lognormal
The normal distribution is used only for short periods of time like days. For longer periods like years, the _______________ distribution is used.
Support
The price level at which demand is thought to be strong enough to prevent the price from declining further.
Resistance
The price level at which selling is thought to be strong enough to prevent the price from rising further.
Reward to variability (Sharpe) ratio
The slope of the capital allocation line.
Capital asset pricing model
Theory that defines what the risk premium should be for a security
Top-down; bottom-up
To identify stocks that they want to purchase, fundamental analysts can use the following approaches: __________________ and __________________.
Dollar-weighted
To reflect changes in the amount of money invested ___________ returns can be used.
Limits to arbitrage Psychology
Two types of problems identified by behavioral finance.
Information processing Behavioral biases
Two types of psychological biases
Arithmetic average Geometric average
Types of average returns:
Positively
Typically, stocks, and risky assets in general, are __________ correlated with each other.
Beta
Used to measure a stock's sensitivity to market movements. Comes from a regression of a stock's returns on the market's returns (in excess of the risk-free rate).
Annualized returns
Used when returns cover a period of more than one year.
Technical
Weak form market efficiency rules out profiting from _____________ analysis.
Market; firm-specific
When analyzing the returns of individual securities, it is assumed that they are affected in part by ___________ risk and ___________ risk.
Compounded (time-weighted)
When professional investment managers report performance, the convention is to present ______________ returns.
Behavioral
Whereas conventional theories presume that investors are rational, ____________ finance starts with the assumption that they are not.
Core PCE
________ ________ is another inflation measure that excludes food and energy.
Dollar-weighted
___________ returns are basically the same thing as the IRR measure.
Fundamental
____________ investors use pricing models to uncover stocks that are underpriced or overpriced.
Market
_____________ risk cannot be eliminated because it affects all stocks.
