EXAM 2- INVESTMENTS

There are 3 securities, one for $40, $10, and $50. Investor has $20. How should he allocate his funds?

$8 in A, $2 in B, and $10 in C.

A portfolio expected return is 12%, its standard deviation is 20%, and the risk-free rate is 4%. Which of the following would make the greatest increase in the portfolio's Sharpe ratio? a. An increase of 1% in expected return. b. A decrease of 1% in the risk-free rate. c. A decrees of 1% in its standard deviation.

(look @ end of chapter Q for breakdown of math) Both a and b will have the same impact of increasing the Sharpe ratio.

Which of the following are assumptions of CAPM... There are 9 assumptions, what are they?

- Investors are price takers -Information is costless and available to ll investors -all risky assets can be traded -no taxes -no transaction costs -unlimited borrowing and lending at risk-free rate -Single-period investment horizon -Investors are rational mean-variance optimizers -Investors have homogenous expectations

Capital Asset Pricing Model (CAPM) (3)

- an equilibrium model that underlies modern finance theory (everything is stable) -Depicts the relationship between risk and return -Derived using principles of diversification with simplified assumptions.

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-1,1

APT and CAPM comparisons: ______ applies to well ________ portfolios and not necessarily ________ _________ ______ is more general than ______ in that it gets expected return and ______ relations without the assumption of the market portfolio _____ does not specify how many factors should be included in the model

-APT; diversified; individual stocks -APT; CAPM; beta -APT

Human behavior (4)

-Framing -Mental accounting -regret avoidance -prospect theory

Arbitrage Pricing Theory (APT) assumptions (2):

-If an arbitrage opportunity exist, an investor can create large positions to secure a large profit. -In efficient markets, profitable arbitrage opportunities will quickly disappear.

What are two types of risk?

-Market risk -Unique risk

There 3 versions of EMH, what are they?

-Weak for EMH -Semistrong-form EMH Strong-form EMH

If the market is efficient, why practice portfolio management? (3)

-diversification -tax consideration -matching investors risk preferences

Information processing (4)

-forecasting errors -overconfidence -conservatism -sample size neglect

EMH Predictions

-stock prices should follow a random walk -expected return should be positive in the long run

The smaller the correlation coefficient...

-the greater the risk reduction potential -the better the diversification

if p=1

-the returns are perfectly positively correlated -no risk reduction

What is the separation property regarding portfolio choice? (2)

1. Identify the optimal risky portfolio (T) 2. Choose the weights on the risky portfolio and on the risk free asset.

A portfolio consist of two stocks: A ($3000) with a beta of 1.5 and B ($2000) with a beta of 2. What is the portfolio beta?

1.7

Look at info at end of chapter 7 for 13-19. If the sample CAPM is valid, which of the situations in Problems 13-19 below are possible? Explain. Consider each situation independently.

13. see answers

Weak-form EMH

All information contained in the history of past trading is reflected onto prices

Semistrong-form EMH

All publicly available information

Arbitrage Oppurtunity

Arises if an investor can construct a zero investment portfolio with a sure profit due to security mispricing. (when the law of one price is violated)

EMH: Rationale

As long as the prices do not reflect all available information and arbitrage opportunities exist, competition among investors will make the prices reflect all information (its a dynamic process)

What is the horizontal axis on SML graph?

B

What must be the beta of a portfolio with E(rp)=20% if rf=5% and E(rM)=15%?

B=1.5

By definition for the market portfolio, Bm=

Bm=1

When looking at graph 3 from formula sheet, which one is going to be the efficient frontier?

CAL(T); it dominates any other combination

(Look at CFA 1 for chapter 6): A three asset portfolio has the following characteristics: What is the expected return on this three-asset portfolio?

E(rp)=(.50x15%)+(.40x10%)+(.10x6%)=12.1%

CMA (conservative minus aggressive)

Investment/asset growth factor; the return of a portfolio with low asset growth (ie low investment) minus high asset growth

Why does CAL(T) dominate?

It has the best risk free tradeoff, ie the largest CAL slope

When looking at the diversification graph, what is the vertical axis and what does it do?

It is the return standard deviation, and it measures the total risk

The Fama and French three-factor model uses ___, ___, and ___ as factors. in 3 factor model

MKT, SMB, HML

MKT (Market risk premium)

Market factor

Systematic risk, nondiversifiable risk, and beta risk are example of what type of risk?

Market risk

An investor earns abnormal return using insider information; would it work in weak form? semi strong? strong form?

No, because its only historical information used; no, the information is publicly available; yes.

Can market risk be eliminated?

No, it cannot be eliminated.

Efficient Market Hypothesis (EMH)

Prices of securities fully reflect available information

RMW (Robust minus weak)

Profitability factor; the return of the portfolio of stock with high profitability minus the return of a portfolio with low profitability

In forming a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain.

So long as the correlation coefficient is below 1. the portfolio will benefit from diversification because returns on component securities will not move in perfect lockstep. The portfolio standard deviation will be less than a weighted average of the standard deviations of the component securities.

In forming a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain.

So long as the correlation coefficient is below 1.0. the portfolio will benefit from diversification because returns on component securities will not move in perfect lockstep. The portfolio standard deviation will be less than a weighted average of the standard deviation of the component securities.

With many risky assets, what is the ideal set-up?

The asset combinations that result in the lowest levels of risk for given returns and the highest returns for given levels of risk are optimal

When looking at graph 3 on formula sheet, which combination will dominate regardless of individual risk preferences?

The combination of portfolio T and a risk free asset

When adding a risky asset to a portfolio of many risky assets, which property of the asset has a greater influence on risk: its standard deviation or its covariance with the other assets?

The covariance with the other assets is more important. Diversification is accomplished via correlation with other assets. Covariance helps determine that number.

the smaller the correlation coefficient...

The greater the risk reduction potential for portfolio

There are 2 investors and 2 portfolios, Security A is $4, B is $6. Investor A has $3 to invest and Investor B has $7. How should they allocate their money to have identical portfolio?

The market portfolio contains all securities in the market, and the proportion of each security in this portfolio is its market value as a percentage of the entire market. Investor 1 will have $1.2 in A, $1.8 in B. Investor 2 will have $2.8 in A and $4.2 in B.

MOM (momentum factor)

The return of a portfolio of winning stocks minus the return of a portfolio of losing stocks

What does the portfolio risk depend on?

The weights allocated to individual securities

If there exist a risk free asset and it is combined with a risky portfolio, is this good or bad?

This is great! It will dominate

Prospect theory

Utility depends on changes instead of levels of current wealth

EMH in reality, which holds.

Weak form and semi-strong. Strong form seldom does

zero investment portfolio

a portfolio with zero net investment, established by shorting one security or a portfolio and use the proceeds to buy another at the same time

Within the context of CAPM, assume: Expected Market return= 15% Risk free rate= 8% Beta of security ABC= 1.25 a) what is the expected return of security ABC? Suppose we have unique information suggesting that the return of security ABC will be 17% b) is security ABC mispriced? c) What is the alpha of security ABC? d) should we buy or sell ABC now?

a) 16.75 b)yes, its underpriced c) .25 d)BUY

Look at graph for #21 on end of chapter Q: The following figure shows plots of monthly rates of return and the stock market for two stocks. a) Which stock is riskier to an investor currently holding a diversified portfolio of common stock? b)Which stock is riskier to an undiversified investor who puts all of his funds in only one of these stocks?

a) Diversified portfolio consist of mostly systematic risk; Beta measure systematic risk; line SCL. Stock B's SCL is steeper therefore its riskier. b) Undiversified consist of firm-specific risk. Stock A has higher firm-specific risk because the deviations of the observation from SCL are larger for stock A than for Stock B. Deviations are measured by the vertical distance of each observations from SCL. Stock A is therefore riskiest to the investor.

Are the following true or false? Explain. a) Stocks with a beta of zero offer an expected rate of return of zero. b) The CAPM implies that investors require higher return to hold highly volatile securities c) you can construct a portfolio with a beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio

a) False . According to CAPM, when beta is zero, the "excess" return should be zero. b) False. CAPM implies that the investor will only require risk premium for systematic risk. Investors are not rewarded for bearing higher risk if the volatility results from the firm-specific risk, and thus, can be diversified. c) False. We can construct a portfolio with the beta of .75 by investing .75 off the investment budget in the market portfolio and the remainder T-bills.

Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a master list of 30 equities drawn from several industries. As the meeting concluded, the client made the following statement; "I trust your stock-pricing ability and believe that you should invest my funds in your five best ideas. Why invest in 30 companies when you obviously have stronger opinions on a few of them?" Trudy Plans to respond to his client within the context of Modern Portfolio Theory. a) Contrast the concepts of systematic risk and firm-specific risk, and give an example of each type of risk. b) Critique the client's suggestion. Discuss how both systematic and firm-specific risk change as the number of securities in a portfolio is increased.

a) Systematic risk refers to the fluctuation in asset prices caused by macroeconomics factors that are common to all risky assets; hence systematic risk is often referred to as market risk. Examples include; business cycle, inflation, monetary policy, and technological changes. Firm-specific risk refers to fluctuations in asset price caused by factors that are independent of the market, such as industry characteristics or firm characteristics. Examples of firm-specific risk factors include litigation, patents, management, and financial leverage. b) Trudy should explain to the client that picking only the five best ideas would most likely result in the client holding a much more risky portfolio. The total risk of a portfolio, or portfolio variance, is the combination of both systematic and firm-specific risk. The systematic component depends on the sensitivity of the individual asset to market movements, as measured by beta. Assuming the portfolio is well-diversified, the number of asset will not affect the systematic risk component of portfolio variance. The portfolio bat depends on the individual security betas and the portfolio weights of those securities. On the other hand, the component of firm-specific risk (sometimes called nonsystematic risk) are not perfectly positively correlated with each other and, as more assets are added to the portfolio, those additional assets tend to reduce portfolio risk. Hence, increasing the number of securities in a portfolio reduced firm-specific risk.

Look at Security Characteristic Line (SCL) example in Chapter 7, the alpha is a) positive b)Negative c)Zero

a) positive

See chapter 7 question 4; Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%. a) What should be the expected rate of return for each company, according to the capital asset pricing model (CAPM)? b)Characterize each company as underpriced, overpriced, or properly priced.

a)$1 store= 13 $5 store= 10 b) overpriced, underpriced

What is the expected rate of return for a stock that has a beta of 1 if the expected return on the market is 15%? a) 15% b) More than 15% c) cannot be determined without the risk-free rate.

a. Its expected return is exactly the same as the market return when beta is 1

Kaskin, Inc. stock has a beta of 1.2 and Quinn, Inc., has beta of .6. Which of the following statement is most accurate? a) The equilibrium expected rate of return is higher for Kaskin than for Quinn. b) The stock of Kaskin is higher vitality than Quinn. c) The stock of Quinn has more systematic risk than that of Kaskin

a. The flaw in statement b is that beta only represents systematic risk. If the firm-specific risk is low enough, the stock of Kaskin, Inc. could still have less total risk than that of Quinn. Statement c is incorrect. Lower beta means the stock carries less systematic risk.

Under the EMH, no ______ return could be earned

abnormal; if not arbitrage opportunities could exist

Strong-form EMH

all relevant information, including insider information

HML (high minus low)

book to market factor; the return of a portfolio stock with with high book-to-market ratios minus low book-to-market ratio

passive management

buying a well diversified portfolio without attempting to find misplaced securities

Diversification

by including different securities in a portfolio, the unique risk (but not the market risk) of securities tend to cancel out as the number and the types of securities increase

In the SCL example in chapter 7 graph; the beta is ____ one. a)Larger than b)equal to c)smaller than

c)smaller than

Which one is the most diversified? a) 11 stocks b) 5 stocks, 6 bonds c) 1 T-bill, 3 domestic stock, 2 international stock, 3 domestic bonds, 2 international bonds

c.

The existence of arbitrage opportunities will

drive the prices to fully reflect all available information.

The optimal combinations are described as______?

efficient frontier

Are efficient frontiers top-tier portfolios or bottom-tier?

efficient frontier portfolios are dominant

What is market risk due to?

factors common to the whole economy

What is unique risk due to

factors specific to one or or a few companies

Active management

focus on security analysis and timing

Security Market Line (SML)

graphical representation of the expected return-beta relationship of the CAPM

Underpriced/Undervalued (relationship between price and return) A security offers too ____ an ______ _______ for its level of risk.

high, expected return

Framing

how the risk is described can affect investors decisions

Stocks offer an expected rate of return 10% with a standard deviation of 20%, and gold offers an expected return of 5% with a standard deviation of 25%. a) in light of of the apparent inferiority of gold stocks with respect to both mean return and vitality, would anyone hold gold? If so, demonstrate graphically why one would do so. b) How would you answer (a) if the correlation coefficient between gold and stocks were 1? Draw a graph illustrating why one would or would not hold gold. c) Could the expected returns, standard deviations, and correlation in part (b) represent an equilibrium for security market?

idk, come back for this

sample size neglect

investors are too quick to infer a pattern or trend from small sample

Regret avoidance

investors blame themselves more when an unconventional or risky bet turns out badly (herding)

Mental accounting

investors may segregate accounts in their mind and take risks with their gains that they would not take with their principle (house money affect)

Risk premium on an individual security is a function of

its return covariance with the market return.

The optimal combinations of assets leads to a...

linear efficient frontier

Assume both portfolios A and B are well diversified, that E(rA) = 14% and E(rB) = 14.8%. If the economy has only one factor, and βA = 1 while βB = 1.1, what must be the risk-free rate?

look at Qs

Overpriced/Overvalued (relationship between price and return) A return offers too ____ an ________ ________ for its level of risk.

low, expected return

if p= +1

no risk reduction

If the market is efficient we should choose active or passive management?

passive

Mutual fund and professional manager performance, what are implications?

perisitent positive performance, persistant negative performance

Security Characteristic Line (SCL)

plot of a security's predicted excess return from the excess return of the market

EMH: Prediction Shri-term price changes are ____ and ______

random; unoredictable

Empirical anomalies

return patterns that aren't supposed to happen if the EMH holds, yet we observe them in reality.

Alpha

the abnormal rate of return on a security in excess of what would be predicted by CAPM

Risk premium on the market depends on....

the average risk aversion of all market participants.

The smaller the correlation...

the better the diersification

When lookinng at the two security portfolio with different return correlations graph, the smaller the correlation means...

the better the diversification; achieve a portfolio that is risk free

SMB (Small minus Big)

the return of a portfolio of small stocks in excess of the return on a portfolio of large stocks.

if p=-1

the returns are perfectly negatively correlated

forecasting errors

too much weight is placed on recent events

firm-specific risk, idiosyncratic risk, nonsystematic risk, or diversifiable risk are examples of what type of risk?

unique risk

Fundamental analysis

using economic and accounting information to predict stock prices (other publicly available info)

Technical analysis

using prices and volume information to predict future prices (historical)

Can unique risk be eliminated?

yes

Refer to the 3rd representation of CAPM; E9ri)=BiE(Rm); under CAPM alpha s/b what number?

zero