Chapter 5 HW
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Jan 9, 2024
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Daniella Cavazos, Sebastian
Chavira, Ashton Marroquin,
Joey Parra
Chapter 5 HW
1.
Define a benchmark portfolio and discuss its importance in portfolio evaluation.
A benchmark portfolio is a portfolio that has similar securities, similar risk characteristics, and
similar return expectations as an invested portfolio. Also called a normal portfolio. It is important
in portfolio evaluation because it is used as a comparison performance metric, and it serves as a
yardstick for assessing the relative success of an investor’s portfolio, helping them measure
whether their portfolio is outperforming or underperforming in comparison. Historically, most
investors have settled on popular indexes as benchmarks against which to their portfolio
performance. Yet, for other investors indexes are inappropriate, thus forming an appropriate
benchmark is critical for effective portfolio management. An appropriate benchmark is a
customized portfolio that contains the securities in the universe the manager typically holds and
is weighted as the manager would typically weight the portfolio.
2.
Distinguish between popular indexes that are used properly and improperly as benchmark
portfolios.
Using popular indexes as benchmarks can be a great way to measure how well an investor’s
portfolio is doing. Examples of these indexes are the S&P 500 Index and the Wilshire 5000
Index. It is appropriate to use an index or combination of indexes as the benchmark, if many of
the securities held in the portfolio are contained in the index. For instance, the S&P 500 index
accurately reflects the performance of the large-cap U.S. stock market, making it an appropiate
benchmark for portfolio invested in this asset class. However, when used improperly these
indexes can be misleading evaluations. For example, using the S&P 500 as a benchmark for a
portfolio of small-cap stock would be inappropiate, as it does not align with the portfolio’s
underlying assets. Similarly, using indexes from unrelated asset classes or regions can result in
misleading comparisons that don't accurately assess the portfolio's performance relative to its
intended strategy or market segment.
3.
Describe the asset allocation process.
Asset allocation is a critical investment decision that involves assigning portfolio weights to
various assets, tailored to an investor's risk profile. This allocation can be executed using
software programs or the expertise of a portfolio manager. These weights can be periodically
adjusted to either increase or decrease exposure to specific securities or asset classes, depending
on changing market conditions or the investor's evolving financial goals. In our book, we delve
into four distinct asset allocation strategies: the buy and hold approach, constant weighting
allocation, tactical asset allocation, and dynamic asset allocation strategies. Ultimately, asset
allocation is an ongoing process, necessitating regular reviews and adjustments to ensure that the
portfolio remains in sync with the investor's objectives and the prevailing market dynamics.
Daniella Cavazos, Sebastian
Chavira, Ashton Marroquin,
Joey Parra
4.
Discuss the buy and hold strategy.
A buy and hold strategy is one in which the investor does nothing to rebalance the portfolio
weights. Over time, the current allocation could potentially be much different than the original
weights of the allocation. A major problem with this approach is that the portfolio can have
significantly different return and risk profiles than when originally constructed. It's a relatively
hands-off approach that aims to capture the benefits of compounding over time, and it can be
effective when executed with discipline and patience. However, it's essential to periodically
review and adjust your portfolio to ensure it remains aligned with your financial goals and risk
tolerance.
5.
Discuss the constant weighting strategy.
Investors initially decide on a strategic allocation model and typically allow the target weights
for their portfolios to fluctuate within a narrow tolerance range. Furthermore, when that range is
exceeded the securities in the portfolio are either underweighted or overweighted. As a result,
investors make some trades so that the portfolio will return to its original strategic weights. This
rebalancing model tends to buy securities when the price falls and sell when price rises.
6.
Discuss the dynamic allocation strategy.
The dynamic allocation strategy is an active investment approach that involves continuously
adjusting portfolio weights in response to changing market conditions and asset values. This
strategy relies on macroeconomic variables to determine which asset classes should be
overweighted or underweighted based on their expected performance within the prevailing
economic environment. While mathematical models are often employed to calculate the new
weighting schemes, the ultimate decision to overweight or underweight a specific asset class is
typically made through comprehensive economic analyses. Dynamic allocation can be
implemented using either calendar-based or rules-based models. In a calendar-based approach,
adjustments are made at predetermined intervals, such as annually or quarterly, without
considering real-time market conditions. Conversely, a rules-based model triggers portfolio
rebalancing only when specific criteria, such as price movements or volatility changes, are met.
This strategy allows for adaptability in response to market dynamics and can also consider
external factors like tax policies and asset correlations when making allocation decisions.
7.
Evaluate the appropriate implementation of a tactical asset allocation strategy.
The appropriate implementation of a tactical asset allocation strategy entails making short-term
adjustments to a portfolio's asset mix to take advantage of prevailing market conditions. This
approach aims to enhance returns by temporarily favoring asset classes expected to perform well
while minimizing exposure to those expected to underperform.
However, effective tactical asset
allocation requires skill in timing the market accurately, as mistimed adjustments can lead to
less-than-ideal outcomes.
Daniella Cavazos, Sebastian
Chavira, Ashton Marroquin,
Joey Parra
8.
Assess the following investment scenario from a rebalancing perspective: an investor owns
an equally-weighted portfolio of treasury bonds, investment grade bonds, large cap equity
securities. Over the subsequent six-month period, the treasury bonds fall by 2%, investment
grade bonds fall by 6% and equity securities rise by 12%.
From a rebalancing perspective, this divergence in performance has disrupted the portfolio's
original equilibrium. The equity portion has outperformed, resulting in an overweight position,
while the underperformance of bonds has reduced their allocation. To maintain the desired risk-
return profile, the investor should consider selling some of the overperforming equities and
reallocating the proceeds into the underperforming bonds to restore the original equally-weighted
allocation. This rebalancing action helps manage risk and aligns the portfolio with the investor's
long-term financial objectives.
9.
Explain the asset selection decision.
Asset selection is the stage of the investment process in which the investor decides which
financial securities are to be included in the portfolio. Investors commonly use 4 valuation
techniques. Discounted cash flows model, which estimates the intrinsic value of an asset by
calculating the present value of all FCF the assets is expected to generate.
2
nd
technique is
Relative Valuation, which compares the fundamentals of similar companies with aim of
identifying which are undervalued. 3
rd
is technical analysis, which is the use of historical pricing
and volume data to make asset selection decisions 4
th
is indexing, which results in performance
that closley matches general stock market returns.
10. Summarize the discounted cash flow technique.
Discounted cash flow models estimate intrinsic value of an asset by calculating the present value
of all future cash flows the asset is expected to graduate. To find the intrinsic value, you must
divide Operating cash flow by required return of equity minus sustainable growth, once you do
this, you divide TMV by the amount of shares you own, to result in $ per share. If the IV is
greater than market price of security, then security is undervalued, and managers will buy. Vice
versa, managers will probably lose shares.
11. Summarize relative valuation.
Relative Valuation compares the fundamentals of similar companies, with the aim of identifying
which are undervalued. First you identify a group of similar assets. with the same payoff and
same price. It uses t
he law of one price
.
Once similar assets have been identified, their prices
multiples are calculated and compared. A drawback is that investments are rarely identical. Each
asset is likely to have similar characteristics. Investors must use their skills and judgement.
12. Discuss specific relative valuation multiples.
There are 5 relative valuation multiples. Price to Earnings, which divides stock against estimated
earnings. Firms with PE ratios are considered to be more expensive. Price to Book, which is
stock price divided by book value of equity. A low ratio is a signal of potential undervaluation,
book values are more stable than earners, and advisors must be careful of accounting differences
among firms. Price to Sales is stock price divided by total revenues. Revenue figures are difficult
to manipulate. Price to Cash Flow is stock price divided by operating cash flow. Analysis is
industry specific and high ratios indicate the firm's shares are expensive. Last is Enterprise to
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Daniella Cavazos, Sebastian
Chavira, Ashton Marroquin,
Joey Parra
Earnings, which is enterprise value divided by earnings before interest taxes, and depreciation. It
ignores capital expenditure.
13. Summarize technical analysis.
Technical Analysis is the use of historical pricing and volume data to make asset selection
decisions A difference between technical analysis and the prior two is that TA believes that
market sentiment and past price and volume data can be used to give more accurate predictions
of future asset prices. It relies on the market not being so efficient
14. Summarize indexing.
Is necessarily results in performances that closely match general stock market returns. Passive
investing is appropriate for those investors who have average risk tolerance. He never. Like all
investments, passive investors must be sensitive to expensive ratios charged by the passive
vehicle managers.
15. Distinguish between fundamental analysis and technical analysis.
Technical analysis is the use of historical pricing and volume data to make asset selection
decisions. They utilize market sentiment, past price and volume data can be used to give more
accurate predictions of future asset prices. Both the discounted cash flow and relative valuation
methods are part of fundamental analysis, in which the investment adviser uses basic economics
and financial principles to value a financial asset.
16. Explain the Fama decomposition.
The Fama decomposition breaks total return into four components: risk-free rate of return, the
expected return demanded from the client, the extra return from market timing, and the extra
return from security selection.
17. Discuss the important distinction between total risk and systematic risk in the Fama
decomposition.
In the Fama decomposition the return on investment is calculated by using systematic risk. Net
selectivity is defined as the difference between the actual return on the portfolio and the return
that should have been earned on total risk.
18. Demonstrate how portfolio managers are evaluated on market timing skills in the Fama
decomposition.
The difference between total selectivity and net selectivity is the return that accounts for the lack
of diversification. This asset allocation is how the portfolio managers can account for market
timing skills in Fama decomposition.
19. Discuss the contributions of BHB as researchers in attribution analysis.
The contributions of Brinson, Hood, and Beebower (BHB) as researchers in attribution analysis
have been significant and influential in the field of finance and investment management. Their
work, published in the 1986 study titled "Determinants of Portfolio Performance," introduced a
groundbreaking framework for evaluating the sources of portfolio returns.
Daniella Cavazos, Sebastian
Chavira, Ashton Marroquin,
Joey Parra
20. Distinguish between assets allocation skills and asset selection skills in the BHB model.
In the BHB (Brinson, Hood, and Beebower) model, asset allocation skills and asset selection
skills are two distinct components used to evaluate the performance of an investment portfolio.
These skills refer to different aspects of portfolio management and contribute to the portfolio's
returns in distinct ways.
21. Contrast attribution analysis of equity securities as described in the BHB model with the
analysis of fixed-income securities.
The BHB model and fixed-income attribution analysis are two different approaches used to
assess the performance of investment portfolios, one focusing on equity securities and the other
on fixed-income securities.
22. Explain the policy effect of fixed-income attribution analysis.
The policy effect, also known as the policy allocation effect, is a component of fixed-income
attribution analysis used to evaluate how a portfolio's performance is influenced by its strategic
allocation to various asset classes or sectors. This analysis assesses how well a portfolio
manager's long-term allocation decisions have contributed to the portfolio's returns relative to a
benchmark.
23. Explain the interest rate anticipation effect of fixed-income attribution analysis.
The interest rate anticipation effect is a component of fixed-income attribution analysis used to
evaluate how a portfolio's performance is influenced by its ability to anticipate and position for
changes in interest rates. This analysis assesses how well a portfolio manager's decisions related
to interest rate movements have contributed to the portfolio's returns.
24. Explain the analysis effect of fixed-income attribution analysis.
Fixed-income attribution analysis breaks down the total return of a fixed-income portfolio into
various components to evaluate how different factors contribute to the performance.
25. Explain the trading effect of fixed-income attribution analysis.
Fixed-income attribution analysis is a technique used by portfolio managers and investors to
assess the performance of a fixed-income investment portfolio. It helps them understand the
sources of return and risk in their portfolios by breaking down the overall return into various
components. The trading effect is one of these components, and it plays a crucial role in
determining the portfolio's performance.
Related Questions
Beta is useful in practice because it assists in:
Select one:
a.
designing portfolios suited to investors’ risk preferences.
b.
eliminating all the risk.
c.
measuring portfolio manager’s performance.
d.
Both A and C.
arrow_forward
Jason Jackson is attempting to evaluate two possible portfolios consisting of the same five assets but held in different proportions. He is particularly interested in using beta to compare the risk of the portfolios and, in this regard, has gathered the following data:
LOADING...
.
a. Calculate the betas for portfolios A and B.
b. Compare the risk of each portfolio to the market as well as to each other. Which portfolio is more risky?
Question content area bottom
Part 1
Data table
(Click on the icon here
in order to copy its contents of the data table below into a spreadsheet.)
Portfolio Weights
Asset
Asset Beta
Portfolio A
Portfolio B
1
1.35
17%
29%
2
0.69
26%
8%
3
1.24
10%
22%
4
1.06
11%
20%
5
0.87
36%
21%
Total
100%
100%
a. The beta of portfolio A is
enter your response here.
(Round to three…
arrow_forward
Ay 2.
Considering the above risk-adjusted portfolio metrics (Sharpe ratio, Treynor ratio, Sortino ratio, information ratio, alpha), which is the overall best measure for evaluating the performance of an active manager, and why?
arrow_forward
Assess how the Modern Portfolio Theory (MPT) may be used by investors to classify, estimate, and control expected risk to maximize portfolio expected return for a given investment.
arrow_forward
Answer
arrow_forward
2 i.Discuss the importance of using benchmarks in evaluating portfolio performance
ii. Explain the concept of risk tolerance and how it differs from risk appetite
iii. Describe the difference between inherent risk and residual risk in investing
iv. Explain how the APT differs from the CAPM in terms of underlying assumptions and factors considered
v. Explain the role of diversification in CAPM
arrow_forward
Question # 3. Markowitz theory indicates to create and construct a portfolio of
assets to maximize returns within a given level of risk, or to devise one with a
desired, specified and expected level of return with the least amount of risk. Under
this broader concept, answer the followings:
a) Justify, why an optimal portfolio should lie on security market line curve
b) Being an efficient market investor, justify how an efficient frontier curve can
be helpful for you in portfolio selection process
arrow_forward
Use attachments to answer questions
This question relates to Diagram 5 from the 9.2 diagrams, which shows four different feasible portfolios plotted on a set of risk/return axes.
Which portfolio would a risk-averse investor prefer - Portfolio A or Portfolio G?
Select one:
a.
Portfolio A.
b.
Portfolio G.
c.
The investor would be indifferent between the two portfolios.
d.
We cannot tell without more information about the investors attitude towards risk (i.e. how risk-averse the investor is).
arrow_forward
Familiarity with random variables is essential to understand the basics of portfolio theory. It is about portfolio formation, you need to strengthen your skills in dealing with random variables. Please review and explain the significance of basic concepts about random variables, namely, the mean, the variance, the standard deviation, and the correlation.
arrow_forward
How do you perceive the relationship between risk and return in the context of investment portfolios? Can you provide examples of how an investor might balance the two, and what factors influence their decision-making process in achieving an optimal risk-return profile?
arrow_forward
Q. Markowitz theory indicates to create and construct a portfolio of assets to maximize returns within a given level of risk , or to devise one with a desired,specified and expected level of return with the least amount of risk.Under this broader concept,answer the following:
a) Justify , why an optimal portfolio should lie on security market line curv?
b) Being an efficient market investor , justify how an efficient frontier curve can be helpful for you in portfolio selection process ?
arrow_forward
An investor’s first step of investing in the financial markets is to establish an investment objective aligned with his or her long-term financial goals and needs. The critical part of the investment process is to earn the maximum return possible while minimizing risk. Portfolio diversification is the cornerstone of reducing risk in a portfolio. How would you use the Excel spreadsheet to quantify and reduce the risk in your risky asset investment portfolio?
arrow_forward
An efficient portfolio is one that:
Select one:
a.
maximises return for a given level of risk.
b.
maximises risk for a given level of return.
c.
minimises risk for a given rate of return.
d.
Both A and C. are efficient portfolios.
arrow_forward
b. As an equity portfolio manager, you may use certain risk-adjusted performance
measures.
Describe and discuss the following measures of performance evaluation!
Treynor Index, William Sharpe, Michael Jensen
Using the following table evaluate which is better than other using three different measure of
performance evaluation.
Asset
X
E(R)%
12
beta
Stdv
1.25
16
Y
11
1.0
12
Risk-free
3
0
0
Market index
12
1
12
arrow_forward
Use attachments to answer questions
This question relates to Diagrams 1 - 4 from the diagrams attached , each of which shows a set of portfolios plotted on a set of risk/return axes.
Which diagram shows (in red) the set of feasible portfolios?
Select one:
a.
Diagram 1
b.
Diagram 2
c.
Diagram 3
d.
Diagram 4
arrow_forward
Question 1 Compare and contrast the Markowitz Portfolio Theory (MPT) with the Capital Asset Pricing Model (CAPM) with reference to the following aspects:Risk measurement;Risk-return graphical presentation Capital Market Line (CML) versus Security Market Line(SML);Usage in portfolio management.
arrow_forward
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Related Questions
- Beta is useful in practice because it assists in: Select one: a. designing portfolios suited to investors’ risk preferences. b. eliminating all the risk. c. measuring portfolio manager’s performance. d. Both A and C.arrow_forwardJason Jackson is attempting to evaluate two possible portfolios consisting of the same five assets but held in different proportions. He is particularly interested in using beta to compare the risk of the portfolios and, in this regard, has gathered the following data: LOADING... . a. Calculate the betas for portfolios A and B. b. Compare the risk of each portfolio to the market as well as to each other. Which portfolio is more risky? Question content area bottom Part 1 Data table (Click on the icon here in order to copy its contents of the data table below into a spreadsheet.) Portfolio Weights Asset Asset Beta Portfolio A Portfolio B 1 1.35 17% 29% 2 0.69 26% 8% 3 1.24 10% 22% 4 1.06 11% 20% 5 0.87 36% 21% Total 100% 100% a. The beta of portfolio A is enter your response here. (Round to three…arrow_forwardAy 2. Considering the above risk-adjusted portfolio metrics (Sharpe ratio, Treynor ratio, Sortino ratio, information ratio, alpha), which is the overall best measure for evaluating the performance of an active manager, and why?arrow_forward
- Assess how the Modern Portfolio Theory (MPT) may be used by investors to classify, estimate, and control expected risk to maximize portfolio expected return for a given investment.arrow_forwardAnswerarrow_forward2 i.Discuss the importance of using benchmarks in evaluating portfolio performance ii. Explain the concept of risk tolerance and how it differs from risk appetite iii. Describe the difference between inherent risk and residual risk in investing iv. Explain how the APT differs from the CAPM in terms of underlying assumptions and factors considered v. Explain the role of diversification in CAPMarrow_forward
- Question # 3. Markowitz theory indicates to create and construct a portfolio of assets to maximize returns within a given level of risk, or to devise one with a desired, specified and expected level of return with the least amount of risk. Under this broader concept, answer the followings: a) Justify, why an optimal portfolio should lie on security market line curve b) Being an efficient market investor, justify how an efficient frontier curve can be helpful for you in portfolio selection processarrow_forwardUse attachments to answer questions This question relates to Diagram 5 from the 9.2 diagrams, which shows four different feasible portfolios plotted on a set of risk/return axes. Which portfolio would a risk-averse investor prefer - Portfolio A or Portfolio G? Select one: a. Portfolio A. b. Portfolio G. c. The investor would be indifferent between the two portfolios. d. We cannot tell without more information about the investors attitude towards risk (i.e. how risk-averse the investor is).arrow_forwardFamiliarity with random variables is essential to understand the basics of portfolio theory. It is about portfolio formation, you need to strengthen your skills in dealing with random variables. Please review and explain the significance of basic concepts about random variables, namely, the mean, the variance, the standard deviation, and the correlation.arrow_forward
- How do you perceive the relationship between risk and return in the context of investment portfolios? Can you provide examples of how an investor might balance the two, and what factors influence their decision-making process in achieving an optimal risk-return profile?arrow_forwardQ. Markowitz theory indicates to create and construct a portfolio of assets to maximize returns within a given level of risk , or to devise one with a desired,specified and expected level of return with the least amount of risk.Under this broader concept,answer the following: a) Justify , why an optimal portfolio should lie on security market line curv? b) Being an efficient market investor , justify how an efficient frontier curve can be helpful for you in portfolio selection process ?arrow_forwardAn investor’s first step of investing in the financial markets is to establish an investment objective aligned with his or her long-term financial goals and needs. The critical part of the investment process is to earn the maximum return possible while minimizing risk. Portfolio diversification is the cornerstone of reducing risk in a portfolio. How would you use the Excel spreadsheet to quantify and reduce the risk in your risky asset investment portfolio?arrow_forward
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