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Questions and Answers
Which term describes the average return expected from an investment?
Which term describes the average return expected from an investment?
The Sharpe Ratio measures the excess return per unit of risk in an investment.
The Sharpe Ratio measures the excess return per unit of risk in an investment.
True
What is the CAPM equation used to determine?
What is the CAPM equation used to determine?
The expected return of an asset based on its systematic risk.
In bond pricing, ________ refers to the interest rate used for discounting future cash flows.
In bond pricing, ________ refers to the interest rate used for discounting future cash flows.
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Match the terms with their corresponding definitions:
Match the terms with their corresponding definitions:
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What does the Sharpe Ratio measure?
What does the Sharpe Ratio measure?
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A higher Standard Deviation indicates lower risk in an investment.
A higher Standard Deviation indicates lower risk in an investment.
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What is the primary purpose of the Arbitrage Pricing Theory (APT)?
What is the primary purpose of the Arbitrage Pricing Theory (APT)?
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In CAPM, the term ____ represents the excess return of an investment compared to the market return.
In CAPM, the term ____ represents the excess return of an investment compared to the market return.
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Match the following terms with their respective definitions:
Match the following terms with their respective definitions:
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What does the Sharpe Ratio indicate?
What does the Sharpe Ratio indicate?
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Variance is a measure of the average deviation from the mean return.
Variance is a measure of the average deviation from the mean return.
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What does CAPM stand for?
What does CAPM stand for?
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The ________ of a bond measures its sensitivity to changes in interest rates.
The ________ of a bond measures its sensitivity to changes in interest rates.
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Match the following terms with their definitions:
Match the following terms with their definitions:
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Which model incorporates multiple risk factors for asset pricing?
Which model incorporates multiple risk factors for asset pricing?
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A higher correlation between two assets suggests that they are likely to move in opposite directions.
A higher correlation between two assets suggests that they are likely to move in opposite directions.
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What is the primary purpose of the Fama-French 3-Factor Model?
What is the primary purpose of the Fama-French 3-Factor Model?
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In finance, ________ refers to the prices at which bonds are traded in the market.
In finance, ________ refers to the prices at which bonds are traded in the market.
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Which of the following correctly defines unlevered beta?
Which of the following correctly defines unlevered beta?
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Study Notes
Expected Return
- Expected return is the average of the possible returns, weighted by their probabilities.
Variance of Return
- Variance of return measures the dispersion of possible returns around the expected return.
Standard Deviation
- Standard deviation is the square root of the variance and represents the risk of an asset.
Covariance
- Covariance is the measure of how two assets' returns move together.
Correlation
- Correlation is a standardized measure of covariance, ranging from -1 to +1, indicating the strength and direction of the relationship between two assets' returns.
Expected Portfolio Return
- Expected portfolio return is the weighted average of the expected returns of the assets in the portfolio.
Variance of Portfolio Return
- Variance of portfolio return is the weighted average of the variances of the assets in the portfolio, adjusted for the covariances between them.
Utility of Return
- Utility of return measures the satisfaction an investor derives from a given level of return.
Optimal Weights on Risky Asset
- The optimal weights on risky assets are those that maximize the investor's utility given their risk aversion and the risk-return characteristics of the available assets.
Sharpe Ratio
- Sharpe ratio measures the risk-adjusted return of an asset or portfolio, calculated by dividing the excess return over the risk-free rate by the standard deviation of the return.
Covariance between Portfolios A and B
- Covariance between portfolios A and B measures how the returns of the two portfolios move together, taking into account the weights of each asset in each portfolio.
Optimal Weights on Risky Assets
- The optimal weights on risky assets are those that maximize the investor's utility given their risk aversion and the risk-return characteristics of the available assets.
Tangency Portfolio Weights
- Tangency portfolio weights are the weights on risky assets that result in the portfolio with the highest Sharpe ratio. This portfolio represents the most efficient frontier of portfolios achievable with the given assets.
CAPM Equation
- CAPM equation estimates the expected return of an asset based on the risk-free rate and the asset's beta.
CAPM Anomaly (Alpha)
- CAPM anomaly refers to the situation where an asset's actual return deviates from the expected return predicted by the CAPM model.
Unlevered Beta
- Unlevered beta represents the risk of an asset's underlying business operations without considering financial leverage.
Arbitrage Pricing Theory (APT)
- APT is a multi-factor model that explains asset returns based on macroeconomic factors, such as inflation, interest rates, and industrial production.
Fama-French 3-Factor Model
- Fama-French 3-Factor Model expands on CAPM by incorporating two additional factors: size premium and value premium, reflecting the tendency for smaller and value stocks to outperform.
Information Ratio
- Information Ratio measures the risk-adjusted performance of a portfolio relative to a benchmark, based on the portfolio's excess return over the benchmark and its tracking error.
Bond Price
- Bond price depends on the present value of its future cash flows, calculated by discounting each cash flow at the relevant spot rate for its maturity.
Duration
- Duration measures the sensitivity of a bond's price to changes in interest rates, representing the weighted average time until the bond's cash flows are received.
Portfolio Duration
- Portfolio duration is the weighted average of the durations of individual bonds in the portfolio, reflecting the overall interest rate sensitivity of the portfolio.
Expectation Hypothesis
- Expectation hypothesis suggests that the term structure of interest rates reflects market expectations for future short-term interest rates. The theory predicts that current long-term rates are the geometric average of expected future short-term rates.
Expected Return
- The anticipated return on an investment.
- Calculated as the weighted average of possible returns, given their probabilities.
- Formula:
Variance of Return
- Measures the dispersion of possible returns around the expected return.
- High variance indicates high risk.
- Formula:
Standard Deviation
- The square root of the variance of return.
- Represents the average deviation of returns from the expected return.
Covariance
- Measures the relationship between two variables (returns in this case).
- Positive covariance indicates that returns move together.
- Negative covariance suggests they move in opposite directions.
- Formula:
Correlation
- A normalized version of covariance (measured between -1 and +1).
- Indicates the strength and direction of the relationship between two variables.
- A correlation of 1 indicates a perfect positive relationship, while -1 indicates a perfect negative relationship.
- Formula:
Expected Portfolio Return
- The weighted average of the expected returns of each asset in the portfolio.
- Formula:
Variance of Portfolio Return
- Measures the dispersion of possible portfolio returns around the expected portfolio return.
- Formula:
Utility of Return
- A function that captures an investor's preferences regarding risk and return.
- Higher utility implies higher investor satisfaction.
- Formula:
Optimal Weights on Risky Assets
- The weights that maximize the expected utility of the portfolio.
- Found by solving an optimization problem that balances expected return and risk.
- Depend on the investor's risk aversion and available assets.
Sharpe Ratio
- Measures risk-adjusted return of an investment.
- Higher Sharpe ratio indicates better risk-adjusted performance.
- Formula:
Covariance between Portfolios A and B
- Measures the relationship between the returns of two portfolios.
- Formula:
Optimal Weights on Risky Assets
- The weights that maximize the expected utility of the portfolio, taking into account the investor's risk aversion and the correlation between assets.
- Found by solving an optimization problem.
Tangency Portfolio Weights
- The weights that maximize the Sharpe ratio for a portfolio consisting of risky assets.
- Represents the most efficient portfolio of risky assets.
CAPM Equation
- Describes the relationship between the expected return of an asset and its systematic risk (beta).
- Formula:
CAPM Anomaly (Alpha)
- The difference between an asset's actual return and its expected return based on the CAPM.
- Positive alpha suggests the asset is outperforming its expected return, indicating skillful investment.
- Negative alpha suggests underperformance.
Unlevered Beta
- Measures the systematic risk of an asset without considering any debt financing.
- Similar to the beta but adjusts for the leverage effect of debt.
Arbitrage Pricing Theory (APT)
- A multi-factor model that explains the expected return of an asset based on multiple macroeconomic factors.
- Factors include inflation, interest rates, and economic growth.
- Explains return beyond the CAPM's single factor (beta).
Fama-French 3-Factor Model
- A popular multi-factor model that extends CAPM and APT.
- Includes size (SMB, small minus big) and value (HML, high minus low) factors, in addition to beta.
Information Ratio
- Measures the risk-adjusted performance of an investment strategy (active portfolio) relative to a benchmark portfolio.
- Higher IR implies better performance.
- Formula:
Bond Price
- The present value of all future cash flows (interest payments and principal repayment) discounted at the appropriate spot rates.
- Formula:
Duration
- A measure of a bond's price sensitivity to changes in interest rates.
- Higher duration indicates greater price volatility.
- Formula:
Portfolio Duration
- The weighted-average duration of the bonds in a portfolio.
- Represents the overall sensitivity of the portfolio to interest rate changes.
Expectation Hypothesis
- A theory that explains the relationship between yields on bonds with different maturities based on market expectations of future interest rates.
- Assumes that investors can create a portfolio of shorter-term bonds to achieve the same return and risk as a long-term bond while minimizing reinvestment risk.
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Description
This quiz covers key concepts in investment returns, including expected return, variance, standard deviation, covariance, and correlation. Test your knowledge of how these metrics are used to evaluate portfolio performance and understand risk in investment strategies.
