Investment Analysis Fundamental Concepts Quiz

Mutual Funds and Multifactor Model

• Sensitivities in the multifactor model are represented as betas, indicating relative sensitivity to various risk factors.
• Multifactors in mutual funds include elements like style and size, influencing performance.

Capital Market Line (CML)

• The capital market line represents the risk-return trade-off and is associated with systematic risk, which is non-diversifiable risk attributable to market movements.
• CML connects expected returns of efficient portfolios with the risk-free rate, illustrating how risk increases with potential return.

Capital Allocation Line (CAL)

• The capital allocation line connects the risk-free asset to efficient portfolios, reflecting different combinations of risk and return based on investor preferences.

Risk-Averse Investors

• Risk-averse investors prefer lower risk investments, valuing capital preservation and seeking reliable returns over speculative opportunities.

Portfolio Construction Example

• A portfolio consisting of 25% in Asset A (15% standard deviation) and 75% in Asset B (10% standard deviation) indicates a diversified approach to risk.
• A correlation coefficient of 0.75 signifies a strong positive relationship between the returns of Asset A and Asset B, impacting overall portfolio risk and return.

Capital Asset Pricing Model (CAPM)

• The expected rate of return for a stock with a beta of 0.8, risk-free rate of 5%, and market rate of return of 10% is calculated as:
  • Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 5% + 0.8 * (10% - 5%) = 9%.

Carhart Model and WML Factor

• In the Carhart model, the WML (Winners Minus Losers) factor is computed as the return difference between high-performing and low-performing stocks, indicating a momentum strategy.

Liquid Investments

• An investment that can be easily converted into cash is classified as liquid, providing quick access to capital without significant loss in value.

Portfolio Diversification

• True statements about portfolio diversification emphasize the reduction of unsystematic risk by holding a variety of investments, thus enhancing returns relative to risk.

Multifactor Models

• Least accurate statements about multifactor models may include oversimplifications, such as suggesting that all relevant factors are always included, which is rarely the case in practice.