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8/13/2019 CC-Portfolio Management

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Crash Course forPortfolio Management

CFA Level-I Exam

This files has expired at 30-Jun-13


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www.edupristine.com Neev Knowledge ManagementPristine

Portfolio Management and Wealth Planning



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Portfolio Management

Investment PolicyStatement

Introduction to Portfolio Management Introduction to Asset Pricing Models

Importance:

imposes investmentdiscipline & providesguidance for investmentadvisorsInvestment objectives:

Return objectivesCapacity to take riskWillingness to take riskConstraints:

Liquidity needsInvestment time horizonTax concernsLegal & regulatory factorsUnique needsPreferences

The difference betweenability and willingness to take

on risks.

Strategic Asset AllocationRisk BudgetingTactical Asset AllocationSecurity AnalysisDriftPerformance Review



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Risk and returns




E(Rp) = wAE(RA) + wBE(RB)

Var (A) =

Var(Rp)=w2A2(RA)+ w2B2(RB)+2wA*wB*(RA)*(RB)*(RA,RB)

P = B)Cov(A,w)-2w(1w)-(1w 2B22

A

2

N

N

t

2

1

__

2

R-R

Q. 2return of stock P=100.0 2return of stock Q=225.0 Cov(P, Q) =53.2Current Holding $1 Mn in P.New Holding: $1 million in Q and $3 million in stock P. What percentage of portfoliorisk (P) is reduced?Ans.P=w= 0.75P2= 100*(0.75)2+ 225*(0.25)2+2*0.25*0.75*53.2P= 9.5 old = 100 = 10Reduction = 5%

B)Cov(A,w)-2w(1w)-(1w 2B

22

A

2



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Assumptions of Capital Market theory

All investors use mean variance framework and selectonly those securities which lie on the eff icient frontierUnlimited lending & borrowing possible at the risk freerateAll investors are rational & have identical expectationsThere is one period horizonAll assets are infinitely divisibleThere are no taxes or transaction costsThere is no inflation

Interest rates will remain constant throughout theholding periodCapital markets are in equilibrium

Optimal portfolio for each investor is the point whereher indifference curve is tangent to the efficient frontier.

Systematic Risk: Non diversifiable

Investors get compensation for taking systematicrisk

Non-Systematic Risk: Company specific risk Investors are not compensated for taking non-

systematic risk

M2

Uses total risk Produces the same portfolio ranking as that of Sharpe ratio

JensensAlpha

Uses systematic risk (b) Measures the percentage return over that of a portfolio with

the same beta.

p

pf R-RRatioSharpe

p

fp R-RRatioTreynor

b

)()(2 fmp

mfp RRRRM

)]([ fmfpp RRRR b






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Capital Market Line

E(Ri)

Systematic Risk (i)

RFR

mkt=1

E(Rmkt)

Security Market Line

Market portfolio with =1

SML: E(Ri) = Rf+ *(Rmkt- Rf)

E(Rp)

Risk (p)

I2 I1

I2 I1Efficient

frontier

Efficientfrontier

RFRX

Y

CML: E (Rp) = RFR + wM[E(RM) RFR]

m

imi

m

mimi

m

mii

RRCov

b

,

2

,

2

),(






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Question 1

Which of the following statements about CML and SML are least likely true?

A. The CML graphs the risk premiums of efficient portfolios and the SML graphs mainlythe Individual asset risk premium that are a part of a diversified portfolio

B.The risk premium on an efficiently diversified portfolio as a function of the portfoliostandard deviation is represented by the CML.

C.The SML is valid only for individual assets




Answer 1

C.

The SML can be plotted not only for individual assets but also efficient portfolioscomprising of only the market and risk free assets.




Question 2

Which of the following is most likely correct about a minimum variance portfolio?

A. A minimum variance portfolio has a standard deviation which is lower than thestandard deviation of each of the individual component assets.

B. With an increase in the correlation coefficient between two asset classes, thestandard deviation of the portfolio reduces.

C. The minimum variance of a perfectly correlated portfolio between the stocks andbonds is lower than the standard deviation of the bond.




Answer 2

A. Minimum Variance Portfolio is defined as the portfolio that has lowest standard

deviation of all portfolios with a given expected return




Question 3

A well diversified portfolio is least likely to be which of the following:

A. A portfolio comprising of stocks with a high percentage of unsystematic risk and lessof systematic risk

B. A portfolio comprising of stocks with a low correlation coefficient

C. A portfolio comprising of stocks with high beta values




Answer 3

C.

A portfolio that consists of stocks all with high betas would be more reactive to changesin the market but nothing can be said about the firm specific risk from the value of beta.Therefore such a portfolio may or may not be well diversified. From the given options Cis most likely not to be well diversified.




Question 4

Which of the following about portfolio theory is least likely correct?

A. A high standardised covariance of a stock means the stock has a high contribution tothe portfolio variance.

B. The sharpe ratio of the portfolio increases when an investor is able to borrow at ahigher rate and invest at the risk free rate.

C. The sharpe ratio grows with the length of the holding period at the rate of square rootof time.




Answer 4

B.

The sharpe ratio reduces when the investor is able to borrow at a higher rate than therisk free rate but invests at the risk free rate. There is a kink in the CAL when such ascenario arises.




Question 5

A 26 year old investor wants to discuss his investment plan with his portfolio

management advisor. The investor wants to satisfy his long term investment needs.Which of the following parameters should not be of concern for the client?

A. Capital preservation

B. Tax concerns

C. Legal and regulatory factors




Answer 5

A.

Capital preservation is a concern when the funds are needed in the near future. Sincethe investor wants to plan for long term, capital preservation is not a concern.




Question 6

Mr X purchases 100 shares of a company that has an expected return of 24%. If the

expected market return is 14% and the risk free rate is 8%. Find the beta of the stock.A. 2.67

B. 0.7

C. 1.25




Answer 6

A.

Using the CAPM equation: E(R)= Rf+ *(Rm-Rf),24 = 8 + * ( 14 - 8)

we get =2.67



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Answer 7

A.

Percentage investment in risky asset is 620000/420000 = 1.48. Using the expectedreturns formula E(rc)= Rf+ y*(Rp- Rf), E(Rc)= 7+ 1.48 * (12-7) = 14.38%.




Question 8

The following information regarding two stocks is available

Expected returns Standard deviationStock A 12% 5%

Stock B 22% 13.8%

The risk free rate is 5%

Which of the following about the stocks is true?

A. Stock A is better than Stock B since it rewards the investors better for the riskinvolved

B. Stock B has a higher return than Stock A. Hence it is a better investment than A

C. Stock A and B reward the investor equally after adjusting for risk




Answer 8

A.

Stock A has a higher sharpe ratio than B .Hence it is a better investment option.



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Question 9

An insurance company offers a 1 year insurance policy on a residential property valued

at $100000. The probability of a loss to the insurer is 0.4% and that of no loss is99.6%. The risk free interest rate is 5%. What is the minimum profit that the insurancecompany would make should it invest in T bills?

A. $13

B. $20

C. $34



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Answer 9

B.

The insurance company should charge minimum premium of 0.04*100000=400 whichwhen invested at the risk free rate gives $420. Therefore profit to the company is $20.



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Question 10

An analyst prepares the following report about 2 stock returns for different scenarios:

Good market Normal market Bad market

Probability 34% 29% 37%

Stock returns

Stock A 12% 17% 5%Stock B 22% 25% -20%

If the portfolio comprises of these two stocks weighted in the ratio of 3:2, find theexpected return on this portfolio.

A. 9.45%

B. 10.02%

C. 21.56%



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Answer 10

A.

Individual stock expected return is R= 0.34*R1+0.29*R2+0.37*R3. Portfolio expectedreturn is E(Rp)= 3/5*Ra + 2/5*Rb

R1 = 3/5*12 + 2/5*22 = 16%

R2 = 3/5*17 + 2/5*25 = 20.2%

R3 = 3/5*5 + 2/5* (-20) = -5%

Total return = 0.34* 16%+0.29* 20.2%+0.37* -5%

= 9.44%



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Question 11

The portfolio standard deviation is calculated using the formula p= w1*1 - w2*2.

Which of the following about the portfolio is least correct?A. The portfolio is perfectly hedged

B. The expected returns on this portfolio is always higher than the expected returns on aportfolio that has a standard deviation that equals w1*1 + w2*2

C. This portfolio will have a standard deviation of 0 despite the standard deviation of 2being very high.



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Answer 11

B.

The expected return is not dependent on the standard deviation but the weights of w1and w2. Therefore for a given set of weights the expected return would be the same forboth the portfolios.



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Question 12

Which of the following investment objective is least likely to be a concern for a 65 year

old?A. Investment in fixed income securities

B. Current income

C. Tax deferred investment



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Answer 12

C.

The need for tax deferred investments decrease for older retirees.


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