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Holding period return

the total return received from holding an asset or portfolio of assets; not for different time frame and different investments.

arithmetic mean return

average of a series of periodic returns

geometric mean return

compound annual rate

money weighted rate of return

Internal Rate of return on a portfolio based on all of its cash inflows and outflows

gross return

total return before deducting fees for management and admin

net return

Difference between return and initial investment.

after tax nominal return

return prior to paying tax

real return

nominal return adjusted for inflation

leveraged return

a return to an investor that is a multiple of the return on the underlying asset

Risk and Return of major asset classes

Small-cap stocks --> Large-cap stocks --> Long-term corporate bonds --> Long-term treasury bonds --> Treasury bills --> Inflation (from the riskiest to the least risky) based on standard deviation and expected returns

risk-averse investor

dislikes risks (prefers Less risk to more risk); choose the one with Less risk (lower standard deviation)

risk-seeking investor

prefers more risk, given equal return will choose the riskier investment

Geometric Mean

[(1+R1) X (1+RT)]^(1/t)-1

-Short term, one year

Arithmetic mean is better for _ term returns

N(n-1)

N variance terms = how many covariance terms

Correlation coefficient between A and B =

the Covariance of a and B/ (SD of a* SD of B)

How to calculate variance of a portfolio

-Sum each assets variance * (the respective weight^2), as well as 2 times each assets pair combinations' covariance and the weight of both assets

Risk Averse

You don't like risk

higher

The lower the covariance at a given risk the _______ the return

20

A portfolio of _______ unrelated common stocks achieves most of the benefits of diversification

Sharpe Ratio

Slope of the capital market line

index funds match the market

Evidence that investor behavior is consistent with portfolio theory

Market

A virtual place (sometimes physical) where there are trades.

Yes because it may be good if market goes down

Would we ever take a risky stock that has a lower return than the risk free rate?

beta and leverage

Basset = cov(UCF, Market)/ SD^2 market

When beta's greater than 1 do well

good years; in bad years They do worse than the market

Expected return on asset J (equation)

Risk free rate + sensitivity of asset to factor(expected return of factor - risk free rate) ..... the term to the side of the plus sign gets repeated for every factor

Fama French Results

Two characteristics describe most of the variation in security returns

Book to market ratio

Book value per share of common stock / stock price

Value Potential

Portfolio Classification is made up of what Two influences?

More exclusivity

What is a Critical Portfolio Type?

Complex Specifications

What is a Bottleneck Portfolio Type?

Many Sources of supply

What is a Routine Portfolio Analysis?

What is Leverage Portfolio type?

Many qualified sources of supply

Blue chip:

highest quality co.'s with proven earnings and dividend records. NYSE listed issues mainly

Growth

companies in a period of above avg growth. Low div. payout ratios, sell at higher P-E multiples than mature companies because of exceptional growth.

Emerging growth

brand-new ventures of high risk but also high potential reward.

Income

mature companies with high div. payout ratios (such as utilities)

Cyclical

companies whose fortunes track the business cycle closely (home building is highly cyclical)

counter-cyclical

operate in reverse of business cycle

Defensive

company who remains unaffected during business cycle downturns. (drug and public utilities companies)

Speculative

companies that fly high during business cycle upturns.

Special situation

A company going through a takeover, restructuring, bankruptcy, or manage change.

Balance between equities and debt

The major decision to be made for a client

Interest bearing investments

lower credit risk and no volatility of return. Downside: susceptible to market risk and purchasing power risk.

Equity investments

higher credit risk and much greater volatility of returns. Grow at a faster rate than inflation, building purchasing power risk.

LT horizons

Inflation has proven to be the greatest risk, making equity investments the better choice for LT horizon

ST horizons

Equity can be much more volatile, making interest bearing securities the better vehicle.

Strategic asset allocation

Selecting proportion to be invested in different types of securities. Proportion of assets in each asset clase is termed portfolio balance or normal asset allocation. The target weights depend on investment objective, time horizon, risk tolerance

tactical asset allocation

minimums and maximums are set for each asset class's portfolio proportion. Allows port. Manager to take advantage of market conditions. (time the market w/in allowed percentages)

Active asset management

based on belief that analysis can ID undervalued sec. and produce superior return. Strategy seeks to find inefficiencies in market pricing.

Passive asset management

Based on belief that the market is efficient in pricing securities; and that an index fund can be used for each class, giving desired diversification with min. annual expenses.

asset allocation.

Primary determinant of investment performance over time

Value line index

1,700 stocks of companies listed on the NYSE, AMEX, AND NASDAQ that are followed by Value Line investment survey

Wilshire 7,000 index

It's now about 7,000 stocks

russell 2,000 index

2,000 small-cap issues

Investment policy statement

used to give customer a summary of what can be expected from the strategy chosen

Portfolio rebalancing

Balances may shift dur to relative performance of each asset class. To rebalance a portfolio just reallocate money from the overperforming assets to those that are underperforming.

Passive portfolio rebalancing

Funds are continually reallocated from overperforming asset classes to underperforming asset classes to maintain optimal "target" mix

Active portfolio rebalancing

Funds are reallocated from underfperforming or "market" performing asset classes to those that the manager believes will outperform the market over the coming time period. This is essentially tactical portfolio rebalancing

Indexing

This gives built-in diversification by simply buying index fund shares that match the asset classes selected.

Growth investing

Selection of equity investments based solely on earnings growth or stock price growth over time.

Value investing

selection of equity investments based on finding securities that are fundamentally undervalued in the makerplace. These tend to be solid companies that are currently out of favor. Look at price/earnings ratio and price/book value ratio.

For personal clients (individual/joint accounts)

current financial status, family composition, tax situation, employment information

Tax situation

If client is in low tax bracket, then taxable investments may be appropriate.

Investment strategy:

To meet goals, a certain amount of money must be available at a future date.

Diversification among mutiple asset classes

Reduces market risk of portfolio and standard deviation of portfolio returns

Market risk

Reduce market risk through constructing a portfolio that uses multiple asset classes. Defensive stocks also reduce market risk.

Factors considered when creating the financial profile of a customer

investment experience, financial knowledge, financial goals (NOT investment timing, it is relevant once the investment vehicles have been selected).

Capital risk

The risk of losing money. By increasing number of stocks in portfolio, risk is reduced through diversification.

Liquidity risk

Risk that a security can only be sold by incurring large transaction costs. Easiest to sell are large cap issues traded on NYSE. Small cap stocks are inactively traded and have a high level of liquidity risk.

If interest rates rise, which suffer the most?

Longest maturity, lowest coupon. 0 coupon bond is most susceptible to interest rate risk.

During periods of inflation, best instruments are?

Tangible assets (tend to keep pace with inflation). Any security that gives a fixed return is a bad bet (fixed annuities or COD)

Margin Trading

Finance an account with money borrowed from the broker.

Margin

The proportion of your own money.

Margin Arrangements

Differ for stocks and futures

Maintenance Margin

Minimum equity margin level

Margin Call

Requirement for more equity funds

Margin =

Equity / Stock Value

minimum variance portfolio

smallest variance among all portfolios with identical expected return

minimum variance frontier

graph of the expected return/ variance combination for all minimum variance portfolios

global minimum variance portfolio

portfolio with smallest variance among all possible portfolios

efficient frontier

developed by Prof Harry Markowitz 1952

correlations btw assets

factors that affect diversification

when correlation btw assets = -1

when does a portfolio with std dev. 0 exist?

equally weighted portfolio risk

variance = (1/n)average variance all assets + ((n-1)/n) average covariance

it changes from a curve to a line

what happens to the shape of efficient frontier when we add a risk free asset?

capital allocation line (CAL)

risk return line that lies tangent to the efficient frontier

what will happen if risk free borrowing is not available?

investors desiring a higher return need to select portfolios along the original efficient frontier and not on CAL

CAL equation

intercept: RFR

Capital market line (CML)

the line with an intercept point equal to the risk-free rate that is tangent to the efficient frontier of risky assets; represents the efficient frontier when a risk-free asset is available for investment

CAPM assumptions

investors only need to know expected returns, variances and covariances

implications of CAPM

same risky tangency portfolio: market portfolio

less than 1

value of beta of defensive stock

greater than 1

value of beta of cyclical stock

the SML, but not CML

if markets are in equilibrium, risk and return combinations for individual securities will lie along....

problems when using all assets

too many parameters 2n + n(n-1)/2

Market model

a regression equation that specifies a linear relationship between the return on a security (or portfolio) and the return on a broad market index

beta instability problem

the beta derived from market model is good estimate of historical relationships not necessarily good predictor of future

adjust beta

assume AR(1) with alpha = 1 or more often assume it tends to 1 over time

statistical inputs are unkown

problems for min variance frontier instability

constrain portfolio weights

how to address instability?

not regression slopes

standardized sensitivities (fundamental factor models)

fundamental

which model uses more factors: fundamental or macro?

assumes:

asset pricing theory (APT)

diff btw APT and multifactor models

APT is cross sectional equilibrium pricing models explains variation during a single time period <> multifactor times series regression explain variation over time

active return

Rp - Rb

std. dev of active return

active risk, tracking error or tracking risk

active risk squared

active factor risk + active specific risk

information ratio

(Rp - Rb) / s(Rp-Rb)

pure factor portfolio

portfolio that has sensitivity equal to one to only one risk factor and zero to the remaining factors

tracking portfolio

has a designed set of factor exposures

Treynor-Black model

portfolio optimization framework that combines market inefficiency & modern portfolio theory

Yes

Can test scores be reliable but not valid?

ex ante information ratio

alpha A / unsystematic std. dv. A

return objectives

2 inv. objectives

IPS elements

description of client's situation