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93 Cards in this Set
- Front
- Back
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The _______ is a model of all potential investment portfolios plotted on a graph with the expected return as the vertical axis and the standard deviation of the portfolio on the horizontal axis.
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efficient frontier
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All portfolios that fall on the efficient frontier represent _______ choices (highest expected return for a given level of risk or lowest risk for a given level of expected return).
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rational
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All portfolios inside the efficient frontier are _______ choices (an investor can do better by moving to the efficient frontier).
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irrational
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There [ARE/ARE NOT] any portfolios outside the efficient frontier.
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are not
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By introducing a _______ to the concept of the efficient frontier, we change the efficient frontier.
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risk-free asset
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When we introduce a risk-free asset to the concept of the efficient frontier, the new "efficient frontier" becomes the _______.
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Capital Market Line (CML)
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Capital Market Line (CML) Equation
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kp = kRF + [(km - kRF)/σm]σp
or kp = kRF + (σp/σm) [(km - kRF)] |
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As the "_______" in the CML is the only risky component of the portfolio (our portfolio is a combination of the "market" and the risk-free rate), our portfolio has a correlation with the market of _______.
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market, 1.00
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Individual stocks are not likely to have a correlation of 1.00 to the market, so we introduce _______ to apply this to individual stocks and get the _______.
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beta, SML (Security Market Line)
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Security Market Line (SML) equation
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k = kRF + β(km – kRF)
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The CAPM/SML models took a damaging blow in the early 1990's when Eugene _______ & Kenneth _______ (two of the most respected researchers in the field of finance) found that:
- _______ does not do a good job of predicting returns (portfolios formed from high beta stocks do not significantly outperform portfolios formed from low beta stocks) - Firm _______ partially predicts returns (portfolios formed from the smallest firms earn higher returns than portfolios formed from the largest firms) |
Fama, French, beta, size
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Other facts Fama & French found:
- "_______" partially predicts returns (portfolios formed from the lowest MV/BV ratios earn higher returns than portfolios formed from the highest MV/BV ratios). - Later, a third additional factor (_______) was found which partially predicts returns. (Portfolios formed from the top-performing stocks over the last 6 months earn higher returns than portfolios formed from the worst performing stocks over the last 6 months.) |
Value, momentum
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T/F Portfolios formed from high beta stocks significantly outperform portfolios formed from low beta stocks.
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False, Portfolios formed from high beta stocks do not significantly outperform portfolios formed from low beta stocks.
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T/F Portfolios formed from the smallest firms earn higher returns than portfolios formed from the largest firms.
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True
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T/F Portfolios formed from the lowest MV/BV ratios earn lower returns than portfolios formed from the highest MV/BV ratios.
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False, Portfolios formed form the lowest MV/BV ratios earn higher returns than portfolios formed from the highest MV/BV ratios.
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T/F Portfolios formed from the top-performing stocks over the last 6 months earn higher returns than portfolios formed form the worst performing stocks over the last 6 months.
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True
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Why might CAPM/SML Test poorly?
- We are using the wrong measure of the _______ portfolio. - Markets are not _______. - The _______ of CAPM don't hold. - We only have "_______" measures of beta and not "_______" measures. |
market, efficient, assumptions, ex-post, ex-ante
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Assumptions of CAPM:
- All investors can borrow or lend unlimited amounts at the _______ rate. - All investors have the same one-period _______ horizon. - All investors focus on _______ and _______. - All investors have the same (homogeneous) _______. - All assets are perfectly _______. - There are no _______ or _______ costs. - The market is _______ and in _______ (or quickly adjusting to get there). |
risk-free
time exp. return, standard deviation expectations divisible taxes, transactions efficient, equilibrium |
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The _______ theory says that there are an unknown number of (unspecified) risk factors that influence returns.To be practically applied, we need to identify the specific risk factors.
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arbitrage pricing
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The Fama-French 3-Factor Model says that there are three risk factors: _______, _______, & _______.
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market risk, size effect, value effect
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The Fama-French (Carhart) 4-Factor Model adds a fourth risk factor to the 3-factor model, that factor being based on _______.
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momentum
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Both the Fama-French 3-factor & 4-factor models have been criticized for a potential _______ bias.
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data-mining
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For the last 20 years, the field of finance has been struggling with the Asset Pricing Model question - how do we quantify risk and return in a manner to determine the appropriate required return to use for capital budgeting and investment analysis? The previous standard model - CAPM/SML has flaws which make it less than reliable. The competitors also have flaws so they [HAVE/HAVE NOT] replaced the CAPM/SML.
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have not
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In practice, you will often see the SML used as it is familiar. Sometimes, the 3-factor or 4-factor models may be used but less often.
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NOTE
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Bracker's recommendation for stock valuation is to use the _______, but recognize that it is not providing "THE" required return. Instead it provides an initial _______ which can be modified slightly up or down if you feel necessary.
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SML, estimate
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Extra beyond risk-free rate to compensate you for risk, usually 3-7%
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market risk premium
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You can argue that QE is pushing the risk-free rate artificially low through Federal Reserve activities & therefore, market risk premium should be a little _______.
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higher
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The market risk premium can depend on:
- degree of perceived _______ factors - economic _______ - riskier than _______ conditions (50-60 years) |
risk, uncertainty, normal
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The official efficient frontier was developed by _______.
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Markowitz
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Economics concept-
* More risk averse = _______ indifference curve * Less risk averse = _______ indifference curve. * Anywhere on indifference curve we're equally happy, risk-return tradeoff. |
steeper, flatter
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From a practical perspective, the efficient frontier is both _______ & _______. Useless because in a practical sense, you'd have to establish standard deviation, correlation, change weights & find every possible portfolio (infinite). Useful because you can use it as an easy way to explain risk/return tradeoff.
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useless, useful
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By combining risk-free rate & portfolio M (market portfolio), I can end up on the _______ line.
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capital market
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By _______ at kRF - the more money we _______ (put in T-bonds) the closer we are to axis.
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lending, lend
LEFT SIDE |
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Moving beyond M (market portfolio), we can keep increase our ROR by _______ at risk-free rate.
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borrowing
RIGHT SIDE |
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Given the poor results of the CAPM in explaining stock returns (Beta seems to have relatively low explanatory power after controlling for firm size and MV/BV ratios), some people are moving to a 3-factor model that incorporates the traditional _______ plus factors for firm _______ and _______ risk factors.
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beta, size, MV/BV
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In the FF 3-Factor Model SMB refers to small-minus-big and is the difference between returns on _______ vs. _______ stocks.
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small cap, large cap
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In the FF 3-Factor Model, HML refers to high-minus-low and is the difference between returns on high & low _______ stocks. Note that in the FF 3-Factor Model, we are looking at the book/market instead of market book ratio so that "value" stocks have _______ book/market ratios and growth stocks tend to have _______ book/market ratios.
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book/market, high, low
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In the FF 3-Factor Model, we would expect small firms to have a Bs of approximately _______ and large firms to have a Bs of approximately _______. We would expect value stocks to have a Bv of close to _______ and growth stocks to have a Bv of approximately _______. For funds, the closer to 1 the Bs the more closely the fund represents a _______ portfolio while the closer to 1 the Bv the more closely the fund represents a _______ fund. However, it should be noted that most funds are not likely to be as strictly value-oriented or small-cap oriented to have a Bv or Bs close to 1. Instead, just think of the further away from zero towards 1, the more value or small-cap characteristics of the fund.
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1,0,1,0, small-cap, value
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Some analysts and researchers have modified the FF 3-factor model one step further and introduced a _______ factor to create a 4-factor model. MOM refers to the average return on the two high prior return portfolios minus the average return on the two low prior return portfolios.
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momentum
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The regression results Bracker did indicate that for this sample of stocks from 2007-now, _______ beta stocks earned higher returns than _______ beta stocks --counter to the predictions of the SML.
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low, high
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The degree of _______ aversion (steepness of indifference curve) will vary from individual to individual based on factors such as personality, age, income, wealth, dependents, etc.
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risk
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The tangent between the efficient frontier & including a risk free asset is the market portfolio (M). Everyone will hold some combination of portfolio M and the risk-free asset. Those that are most risk-averse will place a larger portion of their portfolio in the _______. Those that are less risk averse will place a larger portion of their portfolio in _______. Those that are the least risk averse will borrow money at the risk-free rate and invest all of their wealth plus the borrowed money in Portfolio _______.
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risk-free asset, portfolio M, M
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The market portfolio is the optimal weighting of all _______ assets. Given efficient markets (all securities are fairly value) this represents all investible assets in the world held at their market-value weights.
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risky
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Assumptions of the SML:
- We can borrow/lend unlimited amounts at the risk-free rate. If this is not true, the CML will stop at point F instead of continuing on. Then , the EF would be the CML up to point F and the old efficient frontier the rest of the way (assuming we can lend at the risk-free rate, but not borrow at it). |
NOTE
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Assumptions of the SML:
- Consider the idea that all investors have the same (homogeneous) expectations. That means that we all have the same expected return, standard deviation forecasts for all investment opportunities and the same correlations for every possible pair of investment opportunities. This is required in order for us all to have the same _______ & _______. If we have different (heterogeneous) expectations, we have different efficient frontiers. With everyone having a different efficient frontier, we will all have different "market" portfolios ad different capital market lines. One key takeaway though is that the assumptions do not seem to fit reality. Instead, they are created to make the model. This may be a reason why the SML results do not seem to match our real-world observations. |
efficient frontier, market portfolio
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If the CAPM and SML are valid, we should expect (1) high beta stocks to earn higher returns than low beta stocks. Explain why this statement is true.
- Conceptually, the SML uses beta as its risk measurement. Since high beta stocks are _______ than low beta stocks, they should generate higher returns. Mathematically, if we look at the SML [k= kRF+B(kM-kRF)], the expected return on the market risk premium should always be positive since no one would invest in stocks if they were expected to earn a lower return than they could earn without risk. Since the market risk premium is always positive, multiplying by a higher beta should generate a higher return. |
riskier
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If the CAPM and SML are valid, we should expect (2) beta to be the only factor that explains consistent differences in returns across stocks. Explain why this statement is true.
- Beta should be the only factor that explains consistent differences in returns across stocks, because it is the only one of the three variables in the SML that will be different for different securities. Other factors (such as firm size) are not part of the SML and therefore should have no consistent impact on return differences (after controlling for beta, small firms and large firms should generate _______ rates of return). |
similar
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Despite the well-known problems with the CAPM/SML, it is still a standard model used by financial professionals. Part of the reason for that is that some still believe the CAPM to be a reasonable model (the errors could be due to expected returns being different than realized returns, mis-specified market portfolio, or lack of an efficient frontier). Another part of it is that, while it does a poor job of predicting returns, the market return IS a strongly significant explanatory variable for returns.
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NOTE
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The CAPM is a one-factor model with that factor clearly specified - _______ risk. APT is a _______ model with no specification as to what the factors are or even how many there are. However, since the number of factors is not specified, APT does not eliminate the possibility that there is one factor (like the CAPM).Nor does it specify what the factors are, so it is possible that there is only one factor and that factor is market risk. Therefore, you could view the CAPM model as a special case of APT. We could also view the FF 3-factor model as a special case of APT. Note that while both CAP and FF 3-factor could fit the APT framework, the APT is broader (could support a 132-factor model). So, while they are consistent with APT, they do not imply that APT is a good model.
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market, multifactor
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The primary flaw with APT is it is unspecified to the point that it is consistent with many potential models, but provides no _______.
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direction
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To calculate beta for a stock, take the (Annualized SD of stock x correlation between stock & S&P 500)/Annualized SD of S&P 500.
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Note
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There are several reasons why actual returns may be different than expected returns. Over a short period (such as one year), we could see unexpected factors influence stock returns. Betas for individual securities are not stable (we estimate them based on past returns, but we really need the beta over FUTURE periods which we don't know). Therefore, this is a poor test of the SML.
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NOTE
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The Fama and French 3-factor model expands on the CAPM/SML to include the _______ effect and the _______ effect in addition to traditional beta.
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size, value
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While the momentum effect is a well-documented anomaly, the 4-factor model [is/is not] as widely used/accepted as the 3-factor model.
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is not
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If the Bs (coefficient on he SMB- small minus big) variable is 0.1, what does that tell us about the portfolio?
The Bs coefficient is the size beta. A beta close to 1 indicates _____ cap stocks while a beta close to zero indicates ____ cap stocks. Typically the beta will be less than one even for a small cap mutual fund because the small cap stocks in the FF model are the smallest of small. For most small cap mutual funds, the stocks are between small-mid cap. |
small, large
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If the Bv (coefficient on the HML- high minus low) variable is 0.6, what does that tell us about the portfolio?
The Bv coefficient is the value beta. A beta close to 1 indicates _____ stocks while a beta close to zero indicates _____ stocks. Typically the beta will be less than one even for value funds because they will have some stocks with slightly higher MV/BV ratios in the fund. |
value, growth
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Where the indifference curve is _____ to the efficient frontier is where the investor should choose their optimal portfolio.
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tangent
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The introduction of a risk-free asset that we can both invest in (lend at) and borrow from is critical to the creation of the CML and CAPM. The introduction of this risk-free asset allows investors to move from the old efficient frontier (which was curved) to the new efficient frontier or _____ (which is _____). Also, we must be able to _____ at the RF rate in order to extend the CML above Portfolio M.
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CML, linear, borrow
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According to the CML, in order to increase our portfolio return we need to increase our exposure to the _____ portfolio which also increases our risk (SD).
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market
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The two types of risk in the CAPM are _____ (sometimes called non-systematic or diversifiable) risk and _____ (sometimes called systematic or non-diversifiable) risk.
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firm-specific, market
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Beta risk is designed to measure _____ risk. Beta measures how sensitive a stock is to the overall _____. Stocks with beta greater than one have higher than average risk while stocks with betas less than one have less than average risk.
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systematic, market
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Only _____ risk is compensated for in the financial markets according to the CAPM. This is because any rational investor will hold a diversified portfolio and eliminate virtually all all of their _____-specific risk. Note that this also implies market efficiency.
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market, firm
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If a stock has a beta >1, its volatility must be _____ than that of the overall market. Since correlation can not be greater than one, the only way beta can be greater than one is if the SD (volatility) of the stock is greater than the SD of the market. However, the converse is not true. A stock with a high volatility can also have a low beta if it has a low correlation with the overall market. Therefore, high beta implies high volatility, but low beta does not necessarily imply low volatility. It should also be noted that most stocks will have SDs (volatility) significantly higher than the overall market. This is because a single stock has not diversified away any firm-specific risk while the overall market has diversified away virtually all of the firm-specific risk.
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higher
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Betas of individual stocks are NOT stable over time. They have a tendency to drift toward _____. While individual betas are not stable, portfolio betas tend to be more stable. For instance, a high portfolio of stocks with a high beta this year will also likely have a high beta next year. This is why FF used portfolios instead of single stocks in their classic tests of the CAPM in the 1990's.
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one
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Performance evaluation is critical as we must evaluate performance not based purely on return, but risk-adjusted return. It also is important to compare to a relevant _____.
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benchmark
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Primary Performance Evaluation Measures:
Sharpe Measure Equation |
SM = (kP - kRF) / op
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Primary Performance Evaluation Measures:
Treynor Measure Equation |
TM = (kP - kRF) / Bp
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Primary Performance Evaluation Measures:
_____ - intercept from regression of SML (or alternative models such as FF 3-Factor Model) |
Jenson's Alpha
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During periods where realized returns come in below the risk-free rate the Sharpe Measure and Treynore Measure will be _____.
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unreliable
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Both Jenson's Alpha and the Treynor Measure assume the CAPM is _____.
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valid
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Sharpe's Measure may be more appropriate for _____ diversified portfolios (unless you are using it as a component of a broader, diversified portfolio).
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poorly
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All three performance measures (Sharpe Measure, Treynor Measure, Jenson's Alpha) are very highly _____.
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correlated
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Choosing an appropriate benchmark (performance measures) is critical. The benchmark should match the investment _____ and _____ of the portfolio. When using the Sharpe Measure or Treynore Measure, calculate values for your _____ AND the _____ and compare. When using Jensen's alpha, calculate Jenson's alpha for your portfolio and for the benchmark and compare.
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objectives, characteristics
portfolio, benchmark |
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One way to see how well an investment manager does at diversifying their portfolio is _____ to market.
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correlation
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All else equal, the closer the correlation is to _____, the better job the portfolio manager is doing at diversification.
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1
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how you invest your portfolio across asset classes
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asset allocation
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Asset Allocation - some use it _____ (stocks, bonds, real estate, etc.) and other define it more _____ (small-cap, value, international-developed markets, international-emerging markets, etc.).
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broadly, narrowly
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Stock selection vs. asset allocation
- Studies find that asset allocation is more important than stock selection in overall portfolio _____ over time. |
risk-return
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Why are portfolio evaluation measures beyond return necessary?
Two reason - _____ and _____. First is objective. We know that different asset classes have different performance at different periods of time. For instance, in a period of sever economic contraction, T-bonds should outperform while high-yield (junk) corporate bonds and equity are likely to do worse. Anyone running an equity fund will likely have negative returns if looking at the 2007-2009 time frame. That doesn't mean that the portfolio manager did poorly. If the portfolio manager is required to be almost fully invested in equities, there is very little she could have done to earn positive returns during this time period. What matters is how she did relative to her _____ (objective). If she had a small cap fund, did she outperform the Russell 2000? If so, she did a good job even if she has negative returns. Alternatively, if she only earned 15% per year in a 3-year period when the |
objectives, risk, benchmark
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Why are portfolio evaluation measures beyond return necessary?
Another issue (closely related) is risk. Higher risk should mean _____ returns. If two portfolio managers (let's assume they have the same objective) each earn an average return of 9% per year over a 5 year period, that doesn't mean they have performed the same. Instead, whoever took _____ risk did better (since they had the same return). Portfolio evaluation is designed to control for objectives (through benchmarking) and risk (through risk-adjusted performance measures). |
higher, less
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For the Magellan fund, _____ is probably the best measure as Magellan is a well-diversified portfolio. This makes _____ an acceptable risk measurement. I like alpha better than the Treynor measure because it also provides a quick test of statistical _____ . Also, it easily extends to the 3-factor and 4-factor models if one feels those are more appropriate. Finally, since the average return on the portfolio is less than the RF rate it is difficult to compare Sharpe and Treynor to other funds/benchmark other than to say it underperformed if the other funds/benchmark were positive for their Sharpe and Treynor measures.
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Jensen's alpha, beta, significance
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For the Select Biotech Fund, _____ is probably still the best. An argument could be made for the _____ measure because it is not a well-diversifed portfolio and therefore _____ risk may be more relevant. However, assuming an investor wants to add this fund to a more diversified portfolio of funds in order to moderately overweight exposure to biotech rather than as his primary holding, _____ is still an appropriate measure.
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Jensen's alpha, Sharpe, total, beta
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For the emerging markets, I would go with _____ due to the easy interpretation, quick test of statistical significance and ease with which the FF 3-factor model can be applied. However, in this case the _____ and _____ Measures are also reliable as the excess return is positive.
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Jensen's alpha, Sharpe, Treynor
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For the Low-Priced Stock Fund and Disciplined Equity Funds, a stronger argument could be made for the _____________________. The reason is that these funds are designed to have a particular style (LP will have more small-cap exposure and DE should have more value-exposure - although the regression results do not necessarily support this for DE). As small-cap and /or value portfolios should have higher returns according to the 3-factor and 4-factor models, not incorporating this may make these fund managers appear to be outperforming the market instead of just matching their style perspectives.
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3-factor or 4-factor Jensen's alpha
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One problem for both the Select Biotech & Emerging Market funds is that we probably have a poor benchmark with the _____. A biotech sector index would be better for the SB fund while an emerging market index would be better for the EM fund.
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S&P 500
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Another problem with performance evaluation techniques is the _____ frame. While it is helpful to look at long-run results instead of just results over 2-3 ears in terms of reducing the chance factor, it is likely that over this 15-year period portfolio managers and other key personnel critical to running the fund have changed. Strategies may have also changed. Due to that, performance form the early stages may be less relevant to an investor today.
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time
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Potential problems with our performance evaluation techniques: You could also argue that the _____ has changed which may make past results less important in predicting future results. Changes in investment regulation, economic conditions, etc. may make past performance less meaningful. For example, an investment strategy that did extremely well in 2001-2006 may not be well suited to the current environment.
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climate
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It is hard to separate _____ from _____ in investing.
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luck, skill
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Why use excess returns instead of raw returns in our performance measures?
Investors hire portfolio managers to undertake risk and earn a payoff for that risk. The portfolio manager should be able to earn at least the risk-free rate of return without risk, so it is not enough to earn positive returns. The portfolio manager must earn more than the risk-free rate in order to generating performance. |
note
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What happens to our performance evaluation measures during periods where actual return is negative?
Any time we have returns that are negative (or less than the RF rate) over the evaluation period the results from the Sharpe Measure and Treynor Measure become _____. The reason for this is that when the numerator is negative, increasing levels of risk actually improve our risk-adjusted return measures instead of hurting those measures. Thus, when evaluating two portfolios with the same degree of return (assuming that return is less than the RF rate), we will see whichever portfolio manager took more risk have a _____ (less negative) Sharpe & Treynor measure. Clearly, we don't want to classify taking more risk and earning the same return as better risk-adjusted returns, so the results are no longer meaningful. |
meaningless, better
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the process of choosing an appropriate index to compare a portfolio manager's performance to
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benchmarking
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If my portfolio has no specific objective other than maximizing risk adjusted return, then benchmarking may be extremely difficult (and possibly not even relevant). With no specific objective, my benchmark would be a value-weighted portfolio of every possible investment.
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NOTE
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THe F&F 3-factor models benchmark for _____ and _____ through the _____ and _____ risk factors (much the way the traditional Jensen's alpha benchmarks for the overall equity market). The F&F 4-factor model benchmarks for _____. However, there are still other factors (country, sector, dividends, etc) that may be part of your overall portfolio objective that are not accounted for in the F&F 3-factor or 4-factor models, so care should still be taken in benchmarking.
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size, value, SMB, HML
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