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22 The steps of the investment process: -Identify the clients financial goals, their financial situation unique risk factors -Formulate a comprehensive investment policy, including: -Return objectives -Risk tolerance: how much risk you can take -Investment horizon: planned liquidation date -Liquidity needs: Liquidity: ease and speed with which an asset can be sold without having to discount the value -tax constraints -legal and regulatory constraints: prudent investor rule=>the fiduciary responsibility of a professional investor and suitability responsibility of have to do acceptable for clients. **The prudent investor rule requires professional investors who manage money for others to constrain their investments to those that would have been approved by a
prudent investor

-any unique preferences or situation -Construct a suitable portfolio, taking into account current market conditions, and capital market expectations -Set up a schedule for regular monitoring and rebalancing of the portfolio in light of changes in market conditions, the clients goals, or their situation. **An investor has a long time horizon and desires to earn the market rate of return. However, the investor will need to withdraw funds each year from their investment
portfolio. The biggest constraint a planner would face with this client is a liquidity constraint **The stage an individual is in his/her life cycle will affect his/her return requirements and risk tolerance

-Investment policy statement

-Investor objectives Individual investor: human capital, the major asset for ppl. -Professional Investors Personal trusts: an interest in an asset held by a trustee for the benefit of another person Mutual fund: are firms that manage pools of individual investor money o May not hold more than 5% of the shares of any publicly traded company
**To Hedge means to mitigate a financial risk

-Pension funds Pension benefit: the employer bears all the funds investment performance risk Defined contribution: the employee bears all of the funds investment o 401K-matching o IRA- tax deferred, withdraw is taxable o Roth 401K(Roth IRA)- after tax -Active & Passive strategies Passive management: can be applied to both the securities selection and the asset allocation decision (hold not sell) o Passive core strag.: a portfolio manager indexes part of a portfolio and actively manages the rest of the portfolio o Passive market timing strategy: an investment manager keeps approximately 50% of her funds invested in the market portfolio and 50% of her funds invested in the riskless asset at all times. Active management: assumes an ability to outguess other investors and to identify either securities or asset classes that will shine in the near future (buy and sell) o Active market timing strategy: changing percentage depend on market

Ch.5 **The rate of return on Treasury bills is known at the beginning of the holding period while the rate of return on risky assets is not know until the end of the holding period. -Holding- Period Return (HPR): rate of return over a given investment period HPR= [PEND Pbeg + Div] / Pbeg => dividend yield+capital gain yiel -Arithmetic average: average, ignores compounding
** If you desire to forecast performance for next year, the best forecast will be given by the arithmetic average return

-Geometric average: compound o rg=(1+r1)(1+r2)(1+r3)1/3-1 -Dollar-weighted average return: internal rate of return on investment **if you want to measure the performance of your investment in a fund, including the timing of your purchases and redemptions you should calculate the dollar weighted

*Arithmetic average always>geometric average -APR = Per-period rate Periods per year o 1 + EAR = (1 + Rate per period) o 1 + EAR = (1 + Rate per period)n = (1 + APR/n)n o APR = [(1 + EAR)1/n 1]n o Continuous compounding: 1 + EAR = eAPR -Time Series of Return

-Scenario analysis: Possible economic scenarios; specify likelihood and HPR -Probability distribution: Possible outcomes with probabilities -Expected return: Mean value of distribution of HPR -Variance: Expected value of squared deviation from mean -Standard deviation: Square root of variance (perceived risk)

-Normal distributor:

Sri= (ri-ri)/i ri =E(ri)+Sri * i

-Risk Aversion: optimal mix of the risk-free asset and optimal risky asset =>A=E(rp) - rf /p2

-Scenario Expected Return= (r)= %sr(s) -Variance= 2 = %p[r(s)- (r)]2 -Standard Deviation= =var(r) = %s [ r(s) (s)] -Optimal capital allocation to the risky asset (Leverage)=y= [(rp)-rf]/A*2p -Standard Deviation for complete portfolio=c= [%*var(p)] =yp There is no for risk free asset (t -bill) **The return on an asset over a period between portfolio revisions is called holding period return -CAL (Capital Allocation Line): The choice between risky & risk-free asset Sharp Ratio= slope of the CALhigher the sharp the better

-CML (capital market line): The capital allocation line using the market index portfolio as the risky asset -Real rate of return= (1+Nominal return/1+inflation rate) -1 **Optimal risky portfolio can be identified by finding the tangency point of the capital market line and the efficient frontier also the line with the steepest slope that connects the risk free rate to the efficient frontier

Ch.6 -Market risk=systematic risk=non-diversifiable risk: risk factors common to the whole economy -Unique risk=firm-specific risk=non-systematic risk=diversifiable risk: risk that can be eliminated by diversification -Covariance and Correlation: Portfolio risk depends on covariance between returns of assets o Expected return on two-security portfolio= (rp) =W1r1+W2r2 o Covariance= Cov(rS,rB)= SBSB o Correlation (SB)= Cov(rS,rB)/ SB

-Asset Allocation with Two Risky Assets: o Weighted average of return on components, with investment proportions as weights

rP=BrB + SrS
o Weighted average of expected returns on components, with portfolio proportions as weights

o Variance: -Optimal Risky Portfolio: Best combination of risky and safe asset form portfolio
o Two risky asset :
wB =
2 S

2 [ E (rB ) - rf ]s S - [ E (rs ) - rf ]s Bs S r BS 2 [ E (rB ) - rf ]s + [ E (rs ) - rf ]s B - [ E (rB ) - rf + E (rs ) - rf ]s Bs S r BS

wS = 1 - wB

Standard deviation: SS +BB

**Standard deviation is a measure of the riskiness of an asset held in isolation **Decreasing the number of stocks in a portfolio would like increasing the unsystematic risk of the portolio -Minimum variance portfolio (min var): WB=S2-BSSB/ S2+B2-2BSSB WS=1-WB, (when SB=0, WB=S2 / B2+S2=> no relationship between S and B, 0 correlation) -Single-Index Stock Market: Index model: Relates stock returns to returns on broad market index/firm-specific factors Excess return: RoR in excess of risk-free rate Beta: Sensitivity of securitys returns to market factor Firm-specific or residual risk: Component of return variance independent of market factor Alpha: Stocks expected return beyond that induced by market index -Excess Return (Ri): iRm: component of return due to movements in overall market i= Cov(ri,rm)/ m2 o i: Stocks expected excess return if market factor is neutral o ei :component attributable to unexpected events relevant only to this security (non-systematic) -Mean-variance utility function: u-E(r)(1/2 A)2 o

Ri=rirf=iRm +i +ei

Ch.7 2 -Market portfolio: E(rM)rf= M -Capital Asset Pricing Model (CAPM): securitys required rate of return relates to systematic risk measured by beta E(rP)= rf + P[E(rm)-rf] systematic risk measure by Portfolio beta= P=Wii **Investor get higher E(rP) only if they bear systematic risk o Assumption: 1. All investors will choose to hold the market portfolio, which includes all risky assets in the world 2. Investors complete portfolio will vary depending on their risk aversion 3. The return per unit of risk will be identical for all individual assets 4. The market portfolio will be on the efficient frontier and it will be the optimal risky portfolio o Use of CAPM: theoretical relationship between market risk and expected return on investment well- functioning financial markets 1) used to derive the cost of equity capital for major investment 2) used as a benchmark for risk adopted performance 3) derive fair rate of return in court proceeding **CAMP: investors not compensated for bearing nonsystematic risk, only for bearing systematic risk -mutual fund theorem: states that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio (separating property) -SML (security market line) CAPM: mean-beta relationship (individual assets or portfolios)lies above SML (underrated by CAPM) E(rs)= rf + s[E(rm)-rf] **In CAPM world, all on SML for equilibrium **If all investors become more risk averse the SML will have the same intercept with a steeper slope, and stock price will fall **According to the CAPM, a security with a positive alpha is considered underpriced, with fairly priced securities has zero alphas -CML (capital market line): all investors hold an identical risky portfolio, also representation of the expected return& beta relationship of the CAPMefficient complete portfolio (RP) = Rf+ [Rm-Rf/m]P -Multifactor model: allow for several systematic factors descriptions of security return Two-index portfolio in realized return Two-factor SML -Farma-French Three Factor Model: basis of firm size, book to market ratiothey might not be included in CAPM beta G=x, regression: i= E(rg)-{rf+Bi[E(rM)-rf]} -Arbitrage Pricing Theory: for asset x rx,t=x+x,1*f1,t+x,2*f2,t.+ex,t o Well-diversified portfolio: a portfolio with practically negligible reduced risk 1) nonsystematic risk is negligible 2) arbitrage portfolio 2) positive return, zero net investment, risk free portfolio o APT:

o Return on well-diversified portfolio: o Arbitrage portfolio: a zero-net investment, risk free portfolio with a positive alpha **if a portfolio has positive alpha, use benchmark portfolio to convert to zero-beta portfolio (shorton asset =>-) then positive and 0- portfolio=> 0-net investment position by risk free asset adjustment. After highly diversified, residual risk (eP) small=> only P =>Arbitrage **An important characteristic of market equilibrium is the absence of arbitrage opportunities -Construction an arbitrage portfolio with systemic factor

*Buying, selling more alpha to 0 -APT only applies to well-diversified portfolio -Both APT, CAPM agree on expected return-beta relationship -APT more general not require reframe on market portfolio only takes actions of few arbitragers to enforce the fair market price -Good stock picker: decided by alpha=> CAPM actual return-CAPM (the bigger the better) **Problem with APT: fail to identify key term economic variables in the risk-return relationship

Ch8. -Random walk: stock price changes are random and no prediction. The market are functioning efficiently -EMH(Efficient mart hypothesis): stocks already reflect all available information competition as source of efficiency o Weak form EMH: stock price already reflect all information contained in history of trading ( ) The average rate of return is significantly greater than zero The correlation between the market return one week and the return the following week is zero Could have consistently made superior returns by forecasting future earning performance with your new Crystal Ball forecast methodology o Semi-strong form EMH: stock price already reflect all public information o Strong form EMH: stock prices already reflect all relevant information, including inside info **Market efficiency:1) there are no arbitrage opportunities 2) securities prices react quickly to new information3) active trading strategies will not consistently outperform passive strategies -Technical analysis: search for recurrent and predictable patterns in stock price o Resistance level: unlikely to rise above o Support level: unlikely to fall below -Fundamental analysis: using earning dividend prospects, future interest rate, firm risk and risk evaluation of the firm to determine propertied pricefind determinates of stock price (stock price= discounted rate of expected future cash flow **firms with high earnings yields P/E>ytm on the firms bonds outperformed the S&P average -Active: assume market inefficiency -Passive: assume semi-strong efficiency buying well diversified portfolio without attempt to find misprice securities (index fund): proportion to market index) -Weak-Form Tests: Patterns in Stock Return Returns over Short horizons: o Momentum effect: Tendency to continue to abnormal performance in following periods o Technical analysis: positive serial correlationpositive follow positive, negative follow negative Return over long horizons: negative serial correlationpositive followed by negative o Reversal effect: contrarians will benefit invest in recent loses, avoid recent winners extreme conversation of market tend to reverse itself ( low P/E good time to buy, high P/E-expensive) ** What would you conclude if you found that there was a positive serial correlation in daily returns on NASDAQ stocks? Momentum investors will profit ** IF you found that there was negative serial correlation contrarians will profit **if you found that January returns consistently exceed December returns? **PE effect

-Semi-Strong Test: not expect strong (inside info does make money) Anomalies: Pattern of returns contradicting EMHrisk premiums or inefficiencies & Anomalies or data mining -Market Assumption: Inefficient markets -Asymmetrical info access -Idiosyncratic expectations -Persistent trends and mean reversion -Trading data reflects sentiment and strength of trends

EMH -Equal information access -Homogeneous processing -Random walk -Trading data irrelevant