INVESTMENT

Explain:

5 basic assumptions on Markowitz model (20 pts)

The five basic assumptions on Markowitz model

a. Investors consider each investment alternative as being represented by a probability
distribution of expected returns over some holding period.
b. Investors maximize one-period expected utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
c. Investors estimate the risk of the portfolio on the basis of the variability of expected
returns.
d. Investors base decisions solely on expected return and risk, so their utility curves are a
function of expected return and the expected variance (or standard deviation) of returns
only.
e. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given
level of expected return, investors prefer less risk to more risk.

Enumerate five assumptions of capital markets theory (20 pts)

1. All investors have homogeneous expectations; that is, they estimate identical probability
distributions for future rates of return.

It means that all investors have the same expectations and make the same choices
in a given situation.

2. There is no inflation or any change in interest rates, or inflation is fully anticipated. This is
a reasonable initial assumption, and it can be modified.

Anticipated inflation is the percentage increase in the level of prices over a given
period that is expected by participants in an economy.

3. Capital markets are in equilibrium. This means that we begin with all investments
properly priced in line with their risk levels. It is a theoretical concept that represents all
the portfolios that optimally combine the risk-free rate of return and the market portfolio of
risky assets.

4. All investments are infinitely divisible. So it is possible to buy or sell fractional shares of
any asset or portfolio. This assumption allows us to discuss investment alternatives as
continuous curves.
• This is the assumption that investors can hold fractions of assets. It is deemed
convenient from a modeling perspective considering that it allows for continuous
rather than discrete jump functions.
5. Investors can borrow or lend any amount of money at the risk-free rate of return (RFR).
• The risk-free rate of return is the theoretical rate of return of an investment with
zero risk.

MATCHING TYPES

1. Risk - uncertainty of future outcomes

2. Variance or standard deviation of expanded returns - It is a statistical measure of the
dispersion of returns around the expected value whereby a larger variance or standard
deviation indicates greater dispersion.
3. Range of Returns - a larger range of expected returns, from the lowest to the highest
4. Semi-variance - A measure that only considers deviations below the mean
5. Expected rate of return - weighted average of the expected rates of return for the individual
investments in the portfolio.
6. Positive co-variance - the rates of return for two investments tend to move in the same
direction relative to their individual means during the same time period
7. Negative co variance - the rates of return for two investments tend to move in different
directions relative to their means during specified time intervals over time.
8. Magnitude of co- variances - depends on the variances of the individual return series, as
well as on the relationship between the series
9. Co variance and correlation - measure of the degree to which two variables move together
relative to their individual mean values over time.
10. Impact of new security in a portfolio - The first is the asset’s own variance of returns, and
the second is the covariance between the returns of this new asset and the returns of every
other asset that is already in the portfolio.
11. 3 asset portfolio - shows the dynamics of the portfolio process when assets are added. It
also shows the rapid growth in the computations required, which is why we will stop at
three!
12. Capital market theory- expanded the concepts introduced by Markowitz portfolio theory by
introducing the notion that investors could borrow or lend at the risk-free rate in addition to
forming efficient portfolios of risky assets.
13. Capital asset pricing model - represented a major step forward in how investors should
think about the investment process
14. The concept of risk free asset - The major factor that allowed Markowitz portfolio theory to
develop into capital market theory
15. Completely diversified portfolio - all risk unique to individual assets in the portfolio is
diversified away.
16. Systematic risk- defined as the variability in all risky assets caused by macroeconomic
variables
17. Unique risk- of any single asset is offset by the unique variability of all of the other holdings
in the portfolio
REVIEW:

CHAPTER 11

Top-down (three-step) approach- both the economy/ market and the industry effect have a significant
impact on the total returns for individual stocks.

Two general approaches to the valuation process

• the topdown, three-step approach

• the bottom-up, stock valuation, stockpicking approach.

Discounted Cash Flow Techniques

• Present Value of Dividends (DDM)

• Present Value of Operating Free Cash Flow
• Present Value of Free Cash Flow to Equity

Relative Valuation Technique - where the value of a stock is estimated based upon its current price
relative to variables considered to be significant to valuation, such as earnings, cash flow, book value, or
sales.

Dividend Discount Model - This model assumes that the value of a share of common stock is the
present value of all future dividends

Weighted average cost of capital - required rate of return for a corporation

Free cash flow to equity - which is a measure of cash flows similar to the operating free cash flow

The Price/Cash Flow Ratio - The growth in popularity of the relative price/cash flow valuation ratio can
be traced to concern over the propensity of some firms to manipulate earnings per share, whereas cash
flow values are generally less prone to manipulation.

The Price/Book Value Ratio - has been widely used for many years by analysts in the banking industry as
a measure of relative value

The Price/Sales Ratio - has a volatile history.

CHAPTER 8

Arbitrage Pricing Theory - the leading alternative to the CAPM

Multifactor models- can be viewed as attempts to convert the APT into a working tool for security
analysis.

The APT and Stock Market Anomalies - small-firm effect and the January effect

CAPM framework - at the identity of the single risk factor (i.e., the excess return to the market portfolio)
is well specified.
Volatility (VOL) - Captures both long-term and short-term dimensions of relative return variability

Momentum (MOM) - Differentiates between stocks with positive and negative excess returns in the
recent past

Size (SIZ)- Based on a firm’s relative market capitalization

Growth (GRO)- Uses historical growth and profitability measures to predict future earnings growth

Earnings Yield (EYL) - Combines current and historical earnings-to-price ratios with analyst forecasts
under the assumption that stocks with similar earnings yields produce similar returns

Value (VAL) - Based on relative book-to-market ratios

Estimating Expected Returns for Individual Stock - One direct way to employ a multifactor risk model is
to use it to estimate the expected return for an individual stock position.

1. Under efficient capital markets, security prices adjust rapidly to the arrival of new information.
TRUE
2. The current prices of securities reflect all information about the security and its issuer. TRUE
3. In an efficient market, the expected returns implicit in the current price of the security should
reflect its risk. TRUE
4. The investigator and a stock trading should use only publicly available data on implementing the
trading rule. TRUE
5. Return protection studies examine abnormal rates of return for a period immediately after an
announcement of a significant economic event. FALSE
6. Event studies attempt to prevent the time series of future rates using information. FALSE
7. Return protection studies attempt to prevent the time series of future returns for individual
stocks only. FALSE
8. Quarterly earnings report studies and updates all publicly available information. TRUE
9. Quarterly earnings report indicates there were abnormal stock returns during the 10-to-20-
week period. FALSE
10. Estimating the relevant variables in the fundamental analysis is much of an art and science.
TRUE
11. There is no magic formula for superior estimation. TRUE
12. One can be superior if he or she has the ability to interpret the impact or estimate the effect of
some public information better than others due to his/her better understanding. TRUE
13. A portfolio management in superior analysis with superior analysts have unique insights unique
insights and analytical ability. TRUE
14. A portfolio can be managed actively or passively. TRUE