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CHANGE UNIT
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Capital Market Theory - TABLET OF CONTENTS
- Modern Portfolio Theory
- Designed to build a diversified portfolio with low volatility, the most efficient portfolio.
- An efficient portfolio is one that offers the most return for a given level of risk or the least risk for a given amount of return.
- Or Greatest Risk with the lowest risk
- Assets are not chosen individually, It focuses on the relationship between all of the investments in the portfolio
- MPT looks for securities whose returns are not correlated
- Assumes investors behave rationally
- Feasible set is collection of all feasible portfolios which the efficient set is selected after this
- Portfolio optimization
- Efficient Frontier
- Collection of efficient portfolios
- Most return for given amount of risk OR least risk for a given amount of return
- When plotted on a risk-return chart, forms a parabola or curve
- The optimal portfolio is one that is on the efficient frontier or on the curve. It has the highest return with the lowest risk; highest Sharpe ratio
- Portfolios found below the efficient frontier are inefficient. Above = unattainable
- Capital Asset Pricing Model - TABLET OF CONTENTS
- Expected return
- Identifies 2 risk that each investment has; systematic and unsystematic.
- If a portfolio is broadly diversified, the only risk to worry about is systematic risk
- Expected return is greater than the required return = positive alpha
- Capital Market Line
- Capital Market Line is used to evaluate diversified portfolios
- Provides an expected return for a portfolio based on the following
- The expected return of the market
- The risk-free rate of return
- The standard deviation of the portfolio relative to the standard deviation of the market
- Standard Deviation measures risk in both capital market line and the efficient frontier
- Security Market Line
- Graphical representation of the CAPM.
- The line accounts for the impact of the systematic risk only
- FORMULA
- (Expected return of the market minus risk free return) * the stock's beta + risk free return
- Example
- The expected return of the market is 8%. The risk free return is 3%. Your client is considering a security of beta 1.4. What is the expected return
- (8% - 3%) * 1.4 = 7%
- Expected return = 7% + 3% = 10%
- Efficient Markets Hypothesis (EMH) = TABLET OF CONTENTS
- Random Walk Theory
- It is impossible to beat the market, taking a random walk is as good as any other method for choosing which securities to buy, sell and when.
- Meaning, they believe even active portfolio management cannot beat the market or make excess returns
- Technical Analysis will never work
- All information is priced into the market, an investor can't time the market.
- Equilibrium Market
- There is no mispricing, there is a balance between supply and demand
- FORMS
- Weak Form
- States that the market prices reflect past information only; leaving room for excess returns to be earned by
- Inside information
- Fundamental analysis
- Technical Analysis doesn’t work
- Semi-Strong
- Fundamental and Technical analysis is of no value
- Believes only with Insider information can someone achieve above market returns
- All public information is already reflected in prices
- Strong form
- States the market prices reflect both public and private information
- Trading done by insiders is already reflected in the current stock prices, so that you cannot profit by trading on inside information
STRATEGIES - TABLET OF CONTENTS
- Diversifying a portfolio by asset class helps to reduce systematic risk
- 3 Main Asset Classes
- Real Estate, precious metals, commodities, and collectibles are also asset classes
- Asset allocation may be passive or active