PORTFOLIO MANAGEMENT EXAM REVIEW

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George Brown College Canada *

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ACCT3009

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Finance

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Jan 9, 2024

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PORTFOLIO MANAGEMENT EXAM REVIEW Chapter 11: Equity Portfolio Management Strategies Question 1: Discuss how the four asset allocation strategies differ from one another. a) Integrated: This strategy considers both the investor's long-term investment goals and their short- term liquidity needs. It aims to create a diversified portfolio that can achieve long-term growth while also providing enough liquidity to meet short-term needs. b) Strategic: This approach involves establishing a target mix of asset classes that is aligned with the investor's risk tolerance, investment goals, and time horizon. This strategy aims to achieve a balance between risk and return that is appropriate for the investor's goals, and it typically involves a mix of stocks, bonds, and alternative investments. c) Tactical This strategy involves making short-term adjustments to the portfolio's asset allocation based on market conditions and other factors. The goal is to capitalize on short-term opportunities and avoid potential losses. d) Insured This strategy typically involves a mix of fixed-income and insurance products, which can help to protect the investor's principal and provide a guaranteed income stream in retirement. Question 2: Discuss three strategies active managers can use to add value to their portfolios relative to the benchmark index. Stock selection: This involves selecting individual stocks that the manager believes will outperform the benchmark index. Active managers can use fundamental analysis, technical analysis, or a combination of both to identify stocks that are undervalued or have strong growth potential. Sector rotation: This involves shifting the portfolio's weightings across sectors of the economy based on the manager's outlook for the business cycle or other market trends. Risk management: This involves actively monitoring and adjusting the portfolio's risk exposure to mitigate downside risk. Active managers can use diversification, hedging, or

other risk management techniques to protect the portfolio during periods of market volatility or unexpected events. Question 3 :What is the difference between a fundamental approach to active management and a factor-based approach? The primary difference between the fundamental approach and the factor-based approach is in their investment strategy. The fundamental approach focuses on analyzing individual companies' financial and economic data to identify investment opportunities, while the factor-based approach focuses on selecting stocks based on their exposure to specific factors that drive higher returns over time. The fundamental approach is more subjective and relies on the investor's interpretation of financial data, while the factor-based approach is more quantitative and relies on empirical evidence to identify factors that have historically driven higher returns. Both approaches have their strengths and weaknesses and may be suitable for different investors' investment goals and risk tolerances. Question 4: a) Briefly describe a contrarian investment strategy. A contrarian investment strategy is an approach to investing that involves buying securities or assets that are out of favor with the market or have been underperforming for an extended period. The premise behind this strategy is that the market tends to overreact to both positive and negative news, leading to an overvaluation or undervaluation of certain assets b) What is the main premise (or central belief) behind contrarian investing? Explain The central belief of contrarian investing is that it pays to go against the herd mentality and invest in assets that are currently undervalued or out of favor, with the belief that they will eventually return to their intrinsic value, providing an opportunity for significant gains. Question 5: What is ‘tracking error’ and how can a portfolio manager minimize it? Explain your answer. Tracking error is a measure of the deviation of a portfolio's returns from its benchmark index. It represents the degree to which the portfolio's returns differ from the returns of the benchmark index that it is intended to track.

A portfolio manager can minimize tracking error by constructing a portfolio that closely mirrors the benchmark index, regularly rebalancing the portfolio, managing the portfolio's risk, and using active management strategies to try to outperform the benchmark index. Chapter 5: Efficient Capital Markets Question 1: Behavioural finance considers how various psychological traits affect how individuals act as investors. Explain how the following biases will affect investor behaviour. a) Confirmation bias Confirmation bias is a psychological bias that occurs when individuals seek out and interpret information in a way that confirms their pre-existing beliefs or hypotheses. In the context of investing, confirmation bias can lead investors to seek out information that supports their investment decisions while ignoring or dismissing information that contradicts their beliefs. b) Escalation bias Escalation bias, also known as the sunk cost fallacy, is a psychological bias that occurs when individuals continue to invest in a losing investment or project, despite evidence suggesting that it is unlikely to succeed. In the context of investing, escalation bias can lead investors to continue to hold onto a stock or other asset even as its value declines, in the hope that it will eventually recover. Escalation bias can be a costly mistake in investing, as it can prevent investors from cutting their losses and reallocating their investments to more promising opportunities. Question 2: Differentiate between behavioral finance and fusion investing. Behavioral finance and fusion investing are two distinct approaches to investing that differ in their focus and underlying principles. Behavioral finance is primarily concerned with understanding and managing the psychological factors that can influence investment decisions, while fusion investing seeks to combine traditional financial analysis with other factors to gain a more complete understanding of investment opportunities. Question 3: Studies of filter rules have used a range of filters from 0.5 percent to 50 percent. What are these types of trading rules and what were the results if investors used large filters?

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Studies have examined the performance of filter rules using a range of filter sizes, from 0.5 percent to 50 percent. The results have been mixed, with some studies finding that filter rules can outperform buy-and-hold strategies over certain time periods, while others have found little or no evidence of significant outperformance. When larger filters are used, the strategy tends to generate fewer trades and may be less sensitive to short-term market movements. However, this also means that the strategy may be slower to respond to changes in market conditions and may miss out on gains or losses during periods of volatility. Additionally, the use of large filters can increase the risk of false signals or whipsaws, where the strategy generates a buy or sell signal that is quickly reversed, leading to losses. Question 4: What is an efficient capital market? An efficient capital market is a financial market in which asset prices reflect all available information in a timely and accurate manner. In an efficient capital market, all market participants have equal access to information about asset prices, financial performance, and economic conditions, and all participants have the ability to act on that information quickly and cost-effectively. Efficient capital markets are characterized by high levels of liquidity, transparency, and competition among market participants. Question 5: Describe the three major forms of the efficient market hypothesis and what each means to investment methods. Do studies support of refute each of these forms of the EMH? a) Weak form EMH This form of the EMH states that all past market prices and trading volume data are already reflected in asset prices, and therefore technical analysis, which involves using past market data to predict future prices, is ineffective. According to the weak form EMH, investors cannot consistently generate abnormal returns by analyzing past market data alone. b) Semi-strong form EMH This form of the EMH states that all publicly available information is already reflected in asset prices, including financial statements, news articles, and other publicly available data. According to the semi-strong form EMH, investors cannot consistently generate abnormal returns by analyzing publicly available information alone. Studies have generally supported the semi-strong form EMH, finding that publicly available information is quickly and accurately incorporated into asset prices. However, some studies have found evidence of information asymmetry, where some investors

have access to information that is not yet reflected in asset prices and can generate abnormal returns by acting on that information. c) Strong form EMH This form of the EMH states that all information, including insider information, is already reflected in asset prices, and therefore it is impossible to consistently generate abnormal returns by any means, including insider trading. According to the strong form EMH, even insiders with access to privileged information cannot consistently generate abnormal returns, as the information is already reflected in asset prices. Studies have generally refuted the strong form EMH, finding evidence of insider trading and other practices that generate abnormal returns based on non-public information. However, it is worth noting that insider trading is illegal in many countries, and the existence of insider trading does not necessarily refute the broader idea of market efficiency. Chapter 6: An Introduction to Portfolio Management Question 1: After reviewing economic forecasts and sales estimates for the oil and gas industry, you estimate that the rate of return for ABC Energy common stock to range between − 10% and + 15% with the following possibilities. Compute the expected return for ABC. Probability Possible Returns 0.15 −0.10 -0.015 0.20 −0.05 -0.01 0.40 0.10 0.04 0.25 0.15 0.0375 0.0525 = 5.25% Question 2: You own a portfolio of stocks. Would you prefer that the portfolio lie on the efficient frontier or below it? Explain. An investor would generally prefer that their portfolio lie on the efficient frontier or above it. The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk, or the lowest level of risk for a given expected return. Question 3: Your portfolio consists of one stock, ABC Inc. You decide to diversify by purchasing shares in XYZ Inc. If XYZ has a correlation coefficient of + 1 with ABC is your portfolio diversified? Explain.

If XYZ Inc. has a correlation coefficient of +1 with ABC Inc., the portfolio would not be considered diversified. The addition of XYZ Inc. to the portfolio would not reduce the portfolio's overall risk, as the two stocks move in perfect lockstep with each other. Investors would need to consider other assets with lower correlations or negative correlations to achieve diversification benefits. Question 4: Given the following market values for stocks in your portfolio and their expected rates of return, what is the expected rate of return for your common stock portfolio? Stock Market Value ($) Weight (Wi ) Exp. Return (Ri) Wi × Ri Richmond 20,000 0.2778 0.06 0.0167 Adelaide 16,000 0.2222 −0.05 -0.0111 King 24,000 0.3333 0.04 0.0133 Front 12,000 0.1667 0.08 0.0133 72000 0.0322 3.22% Question 5: a) What does an investor’s utility curve indicate? An investor's utility curve indicates the investor's preferences for risk and return. It shows the relationship between the level of risk an investor is willing to accept and the corresponding expected return that the investor requires to compensate for taking on that risk. The shape of an investor's utility curve reflects their risk aversion or risk tolerance. A steeply sloping utility curve indicates a high level of risk aversion, meaning that the investor requires a higher expected return to compensate for taking on additional risk. In contrast, a less steeply sloping utility curve indicates a lower level of risk aversion, meaning that the investor is willing to accept more risk for a given level of expected return. An investor's utility curve can be used to help determine the optimal portfolio allocation that balances risk and return based on the investor's preferences. b) What is an investor’s optimal portfolio as it applies to the efficient frontier? An investor's optimal portfolio is the portfolio that lies on the efficient frontier and offers the highest expected return for a given level of risk, or the lowest level of risk for a given expected return. The efficient frontier is the set of all portfolios that offer the highest

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expected return for a given level of risk or the lowest level of risk for a given expected return. The optimal portfolio allocation for an investor depends on their individual risk preferences and return expectations, as well as their investment constraints, such as liquidity needs, tax considerations, and regulatory requirements. Chapter 7: An Introduction to Asset Pricing Models Question 1: Differentiate between alpha and beta. Beta measures the degree to which a portfolio's returns move in line with the market, while alpha measures the excess return of the portfolio beyond what would be expected based on its market exposure. Beta is a measure of systematic risk, while alpha is a measure of skill in active portfolio management . Question 2: You expect a risk-free rate (RFR) of 4.5% and the market return (RM) of 8%. Use the capital asset pricing model (CAPM) to calculate the expected (required) rate of return for a stock with a beta (β) of 0.75. 4.5% + 0.75(8%-4.5%) = 7.13% Question 3: You overhear a conversation where an investor states that he has 40 different stocks in his portfolio and has decided to increase it to over 100 stocks to eliminate all risk. Is he correct? Explain your answer. No, the investor is not correct in assuming that adding more stocks to his portfolio will eliminate all risk. While diversification can reduce some types of risk, such as company- specific risk, it cannot eliminate all risk. In fact, over-diversification can lead to a lack of focus and potentially lower returns. It can also increase transaction costs and make it more difficult to monitor the performance of individual stocks in the portfolio. Instead of focusing solely on the number of stocks in the portfolio, the investor should consider the overall diversification of the portfolio, including factors such as industry exposure, geographic exposure, and correlation among the stocks. A well-diversified portfolio should have exposure to a variety of factors that can affect returns, while also maintaining a level of focus and discipline in the investment strategy. Question 4: Consider the following data for two risk factors (1 and 2) for security J: λ0 = 0.06 bJ1 = 1.60 λ1 = 0.03 bJ2 = 2.30

λ2 = 0.05 a) Use the arbitrage pricing theory (APT) to calculate the expected returns for the stock E(Ri) = Rf + β1λ1 + β2λ2 + ... + βn*λn = 0.06 + 0.03x1.6 + 0.05x2.3 = 0.223 = 22.3% b) If the security pays a dividend of $0.60 and the market price of the stock is $14.00, what is the expected price one year from now? Expected total return = Total return – dividend yield = 22.3 % - 0.6/14 = 18% $14 x (1 + 18%) = 16.52 Question 5: Microeconomic-based risk factor models often incorporate small minus big (SMB) and high minus low (HML) risk factor proxies. Describe each of these. SMB: SMB measures the risk associated with investing in small-cap stocks versus large-cap stocks. It is calculated as the difference in the average returns of a portfolio of small-cap stocks and a portfolio of large-cap stocks. Small-cap stocks are typically considered riskier than large-cap stocks due to their higher volatility, greater sensitivity to economic conditions, and lower liquidity. Therefore, a positive SMB indicates that small-cap stocks have outperformed large-cap stocks, while a negative SMB indicates that large-cap stocks have outperformed small-cap stocks. HML: HML measures the risk associated with investing in value stocks versus growth stocks. It is calculated as the difference in the average returns of a portfolio of high book-to-market value stocks (value stocks) and a portfolio of low book-to-market value stocks (growth stocks). Value stocks are typically considered riskier than growth stocks due to their higher sensitivity to economic and market conditions, and their lower expected growth rates. Therefore, a positive HML indicates that value stocks have outperformed growth stocks, while a negative HML indicates that growth stocks have outperformed value stocks. Chapter 12: Bond Fundamentals and Valuation Question 1: An investor in the 29 percent tax bracket is trying to decide which of two bonds to purchase. One is a corporate carrying a 6.25 percent coupon and selling at par. The other is a municipal bond with a 4.50 percent coupon and it also sells at par. Assuming that all other relevant factors are equal, which bond

should the investor select? ETY = 4.5%/(1-29%) = 6.34% Question 4: Calculate the following for a 20-year, 6.5 percent coupon bond paid semiannually with $1,000 par value if the required yield on the bond is 5.2 percent . a) Current price N = 20 x 2 = 40 I = 5.2/2 = 2.6 PMT = (6.5%x1000)/2 = 32.5 FV = 1000 CPT PV = -1160.45 b) Current yield 6.5%/ 1160.45 = 5.6% c) Yield to call (YTC) if the bond is callable at 101.75 in 10 years N = 20 PMT = 32.5 FV = 101.75 PV = -1160.75 CPT I/Y = 6.85% d) If interest rates remain unchanged, is the company likely to call the bond based on your calculation in part (b) above? Why or why not? e) Calculate the realized yield (or horizon yield) if you expect to sell the bond at 102.50 in six years. Chapter 13: Bond Analysis and Portfolio Management Strategies

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Question 1: Calculate the Macaulay duration of a $1,000 corporate bond with a four- year term to maturity, an 8.0 percent coupon (annual payments) and a market yield (i.e. required rate of return) of 11.0 percent. Question 4: You have a portfolio with a market value of $875 million and a Macaulay duration of 6.5 years (assuming a market interest rate of 4.0%). If interest rates increase to 4.5 percent, what would be the estimated value of your portfolio using modified duration assuming semiannual interest payments? Question 1 The S&P 500 had an average annual rate of return of 13 percent over the last five years. During the same period, North portfolio earned 9 percent annually with a beta of 0.75 and South portfolio earned 11 percent annually with a beta of 1.25. Which portfolio would you prefer, using on the Treynor portfolio measure, to invest in based on past performance if the risk-free rate is 5.0 percent?

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