## CFA Level 1 – Portfolio Management

What does a total return objective consider

Returns from both capital gains and the reinvestment of current income, but is not net of inflation

What does the real total return objective consider

Returns from both capital gains and the reinvestment of current income net of inflation

What does the implementation process of portfolio management focus on

Putting the plan that has been devised to work. The portfolio is constructed and assets are allocated based on the investment strategy and market forecasts.

Correlation coefficient formula

(Cov of A and B) / [(STD of A) x (STD of B)

What is the most important decision to be made in the investment process?

asset allocation

What is the formula for beta given covariance and variance to the market?

(Covstock,market)/(Varmarket) — the trick here is to convert standard deviation to variance by squaring it. Also, the denominator only includes the variance of the market; the variance of the stock itself should be excluded if it’s provided

What does an investment policy statement do?

An investment policy statement identifies a benchmark portfolio that will be used to judge the performance of the portfolio manager.

What is the importance of risk and return in an investment policy objective?

Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible.

What is “semivariance?”

Downside dispersion is measured using semivariance (the dispersion of returns occurring below a specified target return such as zero).

What is the definition for “beta?”

Beta (systematic risk) is the slope coefficient of the regression line (historical returns of the stock against the historical returns of the market) and is used to construct the SML.

What is the measure of risk used in Markowitz portfolio theory?

Markowitz Portfolio Theory relies on your understanding of basic statistics. You need to understand and be able to calculate the mean, the standard deviation and the correlation coefficient. The measure of risk used is the standard deviation of the returns for an individual investment =s = [S(R actual – ER)^2(Probability)]^1/2

In the context of the SML, when is a security over/under priced?

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

How is the holding period return calculated?

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate – risk free rate).

What are some common investment contstraints?

Liquidity needs, time horizon, tax concerns, legal and regulatory factors and unique needs and preferences

How is the expected return for a portfolio calculated?

ERportfolio = Σ(ERstock)(W% of funds invested in each of the stocks) ER = w1ER1 + w2ER2, where ER = Expected Return and w = % invested in each stock.

What happens when the underlying assumption of zero transaction costs is relaxed (CAPM)?

With positive transactions costs, there will be rates of return on both sides of the SML for which the cost of trading will be greater than the expected gains from trading. This means there is a band of expected returns for each level of systematic risk that is consistent with efficient pricing, once transactions costs are considered.

Why is an investment policy statement important?

The investment policy statement provides a clear articulation of the risk a client will accept, and addresses risk in the context of the client’s return requirement or expectations. Write a policy statement that specifies the investor’s goals and constraints. Then itemize the risks the investor is willing to take to meet these goals.

What are the four general steps in the portfolio management process?

1. Write a policy statement that specifies the investor’s goals and constraints. Then itemize the risks the investor is willing to take to meet these goals. 2. Develop an investment strategy designed to satisfy the investor’s policy statement based on an analysis of the current financial and economic conditions. 3. Implement the plan by constructing the portfolio, allocating the investor’s assets across countries, asset classes, and securities based on the current and future forecast of economic conditions. 4. Monitor and update the investor’s needs and market conditions. Rebalance the investor’s portfolio as needed.

What is a “preservation of capital” return objective?

Capital preservation is the objective of earning a return on an investment that is at least equal to the inflation rate. The concern is the maintenance of purchasing power, which means that the real rate of return must equal the inflation rate.

What produces a kinked capital market line?

One of the key assumptions of the CAPM is the ability of investors to lend and borrow at the risk-free rate. This assumption is necessary to produce a straight line CML. Investors can lend all they want by buying investments at the risk-free rate, but investors must pay a premium over the risk-free rate to borrow. Unequal borrowing and lending rates put a kink in the CML.

What does Markowitz portfolio theory rely on?

Markowitz Portfolio Theory relies on your understanding of basic statistics. You need to understand and be able to calculate the mean, the standard deviation and the correlation coefficient. The measure of risk used is the standard deviation of the returns for an individual investment. Downside dispersion is measured using semivariance (the dispersion of returns occurring below a specified target return such as zero). Beta (systematic risk) is the slope coefficient of the regression line (historical returns of the stock against the historical returns of the market) and is used to construct the SML.

How is beta calculated?

beta of stock A = covariance between stock and the market / variance of the market

If borrowing/lending rates are different, is it still possible to have a straight CML?

Yes. The introduction of a zero-beta (no systematic risk) portfolio with a return that is higher than the risk-free rate can result in a straight CML even with the assumption that borrowing and lending rates are different. Margin accounts represent borrowing, so unless the margin lending rate is the same as the risk-free rate, this does not solve the problem (a kinked CML) that results from unequal borrowing and lending rates in the model.

What type of risk is positively related to expected excess returns according to CAPM?

Systematic. The CAPM concludes that expected returns are a positive (linear) function of systematic risk.The risk that cannot be diversified away is systematic risk (nondiversifiable risk or market risk). Since the market portfolio contains all risky assets, it must represent the ultimate in diversification. All the risk that can be diversified away must be gone. Unsystematic risk (diversifiable risk or unique risk) is the risk that can be diversified away by adding more securities to a portfolio.

How is the CML related with the SML?

The SML and CML both intersect the vertical axis at the risk-free rate. The SML describes the risk/return tradeoff for individual securities or portfolios, whereas the CML describes the risk/return tradeoff of various combinations of the market portfolio and a riskless asset.

How much of the variation in a single portfolio’s returns can be explained by its target asset allocation?

Studies have demonstrated that approximately 90% of the variation in a single portfolio’s returns can be explained by its target asset allocations. It is very difficult to generate abnormal portfolio returns by market timing and security selection within asset classes.

How does the return on an index provide for dividend reinvestment?

A portfolio with equal numbers of shares of each stock in the price-weighted index will match the performance of the index assuming there are no stock splits, stock dividends, or changes in the make-up of the index. The return on the index does not include cash dividend payments. Since the reinvested dividends will add to the number of shares of those stocks that pay dividends, the portfolio return that reinvests dividends will exceed that of the index.

Why does the mispricing of small company stocks persist at times?

Mispricings of small company stocks can persist because the small size of the positions that can be established limits the ability to execute sufficiently profitable arbitrage trades. The total profit to be gained by exploiting a mispricing may be small enough that it does not represent a significant profit opportunity to large funds.

How can the lack of theoretical explanation allow mispricings to persist?

If the reasons underlying a persistent pricing anomaly are not well understood, it is difficult to exploit. Arbitrageurs will use their funds to exploit other mispricings which they believe they understand better and are, therefore, better able to exploit and profit from.

According to capital market theory, what represents the risky portfolio that should be held by all investors who desire to hold risky assets?

Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is suboptimal, and points above the CML are not feasible. The optimal portfolio for an investor is determined as the point where the investor’s highest utility curve is tangent to the efficient frontier.

How should investor’s feel about loads and transaction fees?

Premiums, loads, and redemption fees are compensation for sales and marketing efforts, but they are not performance incentives for the portfolio managers. Different classes of shares can be structured with different schedules of front-end, back-end, and distribution fees. The optimal choice depends on the investor’s expected holding period and is not necessarily the one with the lowest total annual fees.

What are the assumptions of capital market theory?

* Markowitz investors: All investors use the Markowitz mean-variance framework to select securities. This means they want to select portfolios that lie along the efficient frontier, based on their utility functions.

What shape will the indifference curve have for risk-averse versus less risk averse investors?

Risk averse = steep. Less risk averse = flatter

The market portfolio in the Capital Market Theory contains which types of investments?

The market portfolio contains all risky assets in existence. It does not contain any risk-free assets.

What does the efficient frontier outline?

The efficient frontier outlines the set of portfolios that gives investors the highest return for a given level of risk or the lowest risk for a given level of return. It is also the point at which there are no more benefits to diversification.

On a graph of risk, measured by standard deviation and expected return, what does the efficient frontier represent?

The efficient set is the set of portfolios that dominate all other portfolios as to risk and return. That is, they have highest expected return at each level of risk.

Factors that affect individual’s ability to take risk

1) Time horizon

2) Expected income

2) Expected income

Factors that affect individual’s willingness to take risk

1) Personality type

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