Series 66 - Unit 20

CAPM

- determine expected rate of return - determines this on the basis of the asset's systematic risk

Beta is a measure of

Relative systematic risk for stock or portfolio returns.

Strong Form Market Efficiency

Security prices fully reflect all information from both public and private sources

goal of MPT

construct the most efficient portfolio

CAPM premise

- every investment carries systematic (cannot be diversified away) and unsystematic risk

CML uses

- expected return of the portfolio - risk free rate - return on the market - standard deviation of the market - standard deviation of the portfolio

strategic asset allocation

-refers to the proportion of various types of investments that should compose a long-term investment portfolio

The main assumptions of the capital market theory are as follows:

All investors can borrow or lend money at the risk-free rate of return. All investors are rational and evaluate investments in terms of expected return and variability (standard deviation). Therefore, given a set of security prices and a risk-free rate, all investors use the same information to generate an efficient frontier. The time horizon is equal for all investors: when choosing investments, investors have equal time horizons for the chosen investments. There are no transaction costs or personal income taxes; investors are indifferent between capital gains and dividends. There is no inflation. All assets are infinitely divisible: this means that fractional shares can be purchased. There is no mispricing within the capital markets: it is assumed that the markets are efficient and that no mispricings within the markets exist. Another way to state this is that capital markets are in equilibrium.

Investors who accept the efficient market hypothesis usually adopt

a passive investment strategy;

Wrap fee accounts would tend to be most suitable for investors who follow

a tactical approach to investing

Tactical asset allocation continuously

adjusts the asset allocation in an attempt to take advantage of changing market conditions.

modern portfolio theory

an approach that attempts to quantify and control portfolio risk

passive portfolio manager

believes that no particular management style will consistently outperform market averages and therefore constructs a portfolio that mirrors a market index, such as the S&P 500

the market risk premium is the

difference between the expected return for the equities market and the risk-free rate of return.

growth style

focus on stocks of companies whose earnings are growing faster than most other stocks and are expected to continue to do so

The semi-strong form of the EMH states that security prices.

fully reflect all publicly-available information. This would include all historical information

he security market line (SML) is the

graphical depiction of the capital asset pricing model (CAPM).

stock risk premium

he part of the model reflected by the following formula: (market return − the risk-free return) × beta of the stock.

Growth companies have

high P/E ratios and a low dividend payout ratio because they retain most if not all their earnings.

the objective is for the portfolio to

lie on the curve

Sector rotation is the practice of

moving out of those industries that are heading for a decline and into those whose fortunes are likely to rise as the economy follows the business cycle.

Indexing means

that it is only possible to select securities that are within the index, meaning that the universe of investable securities is restricted

MPT diversification allows investors

to reduce the risk in a portfolio while simultaneously increasing expected returns

portfolios above the efficient frontier

unattainable

portfolio diversification reduces

unsystematic risk, such as business risk and enhances returns

Capital market line

-provides an expected return based on level of risk -evaluates diversified portfolios (ERp, RFR, RoM, ST Dev of M&P) -uses STANDARD DEVIATION as measure of risk

Tactical Asset Allocation

-refers to the short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions

stochastic modeling

A method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes. Most popular form is the Monte Carlo Simulation (MCS).

Monte Carlo simulation

It provides insight into the range of outcomes. It is a technique used to model uncertainty in retirement planning. Small changes in the projected rate of return will make large differences in the outcome. The user gets a best-case scenario and a worst-case scenario.

best exemplifies a value stock

Low price-to-book, low price-to-earnings ratio

constant ratio plan

an investment plan that attempts to maintain the type of relationship shown in our example between debt and equity securities in sometimes called a constant ratio plan - the account is rebalanced to bring it back to the desired ratio

ladders

bonds are all purchased at the same time but mature at different times - as the shorter maturities come due, they are reinvested and now become the long-term bonds

semi-strong-form market efficiency

current stock prices not only reflect all historical price data but also reflect data from analyzing financial statements, industry, or current economic outlook - fundamental analysis is of no value in this form, only insider info may produce above-market returns - technical analysis is also of no value

growth managers are looking for

earnings momentum

If the market is efficient, the best strategy is

indexing rather than stock picking.

indexing

investment portfolios constructed to mirror the components of a particular stock index, will normally perfomr in line with the index

barbells

investor purchases bonds maturing in one or two years and en equal amount maturing in 10 or more years with no bonds in between

bullets

investor purchases bonds today that mature in 12 years - 2 years from not, purchase some more bonds, but those should have a 10 yr maturity -in another 2 years another purchase is made bonds that have 8 yrs to go - bonds purchased at different times but all mature together

Dollar cost averaging is the investment formula where an investor

invests the same amount at regular intervals

In strategic asset allocation, once the allocation is determined,

it remains relatively constant until some change to the investor's objectives occurs. Periodically, the portfolio is re-balanced to reflect any changes in market conditions.

A strategy used by bond investors to mitigate interest rate risk that involves buying bonds with short-term, intermediate-term, and long-term maturities is called

laddering

In a financial market that is efficient, the prices of securities will

not differ from their justified economic values for any length of time.

alpha and beta are

not used in the CML equation while standard deviation is

MPT focuses on

relationships among all investments in a portfolio - specific risk can be deiversified away bu building portfolios of assets whose returns are not correlated

weak form implies

that market information cannot be used to identify future price movements.

strategic asset allocation which, due to its focus on

the long-term goals of the client, tends to be a passive style. Buy and hold is another example of a passive (not active) style.

market risk premium

the part of the model reflected by the following formula: (market return − risk-free return).

random walk theory

throwing darts at the stock listings is as good a method as any for selecting stocks for investment

weak form - what wont and will work

wont - technical analysis will - fundamental analysis and insider info

Semi-strong form - what wont and will work

wont - technical and fundamental analysis will - insider info

the more active the portfolio, the greater role

commissions will play in determining overall portfolio performance

value

concentrate on undervalued or out-of-favor securities whose price is low relative to the company's earnings or book value and whose earnings prospects are believed to be unattractive by investors and securities analystss

there is no such term as

semi-weak EMK

optimal portfolio

that returns the hgihest rate of return consistent with the amount of risk an investor is willing to take - makes the best trade-off between risk ad reward for a given investors investment profile

constant dollar plan

-the goal is to maintain a constant dollar amount in stocks, moving money in and out of a money market fund when necessary

Weak Form Market Efficiency

current stock prices have already incorporated all historical market data and that historical price trends are, therefore, of no value in predicting future price changes

active management

relies on the manager's stock picking and market timing ability to outperform market indices

the security market line (SML) depicts the tradeoff between

risk and expected return for all assets, whether individual securities, inefficient portfolios, or efficient portfolios.

expected return formula

risk-free rate plus the (difference between the market return and the RF) times the beta

security market line (sml) formula

risk-free rate plus the (difference between the market return and the RF) times the beta

efficient market hypothesis

security prices adjust repidly to new information with security prices fully reflecting all available information

CML, like markowitz's efficient frontier, uses

standard deviation as the measure of risk

Two of the major factors involved in the capital asset pricing model (CAPM) are interest rates stock risk premium tax rates market risk premium

stock risk premium market risk premium

The efficient market hypothesis is in direct contradiction to

technical analysis because the efficient market hypothesis is founded on the notion that all historical price and volume data, which is used by technical analysts, is already accounted for in the current stock price

Each of the following terms is commonly found in modern portfolio theory EXCEPT A) the efficient set B) the internal rate of return C) the capital asset pricing model D) the feasible set

the internal rate of return Internal rate of return (IRR) is not a component of modern portfolio theory as are the other 3 terms.

Strong form - what wont and will work

wont - technical, fundamental, and insider info will - random walk

partial protection

writing a covered call and receiving the premium, an investor, in effect, reduces the stock cost by the premium amount