3. Basic Financial Theory

Question 1

What are some of the fundamental features of Markowitz’s Modern Portfolio Theory?

Answer 1

• There must be a reward for bearing risk. The greater the potential reward, the greater the risk: the risk-return trade-off.
• Diversification reduces risk.
• Investors should select assets for inclusion in the portfolio based on the asset’s contribution to the overall risk-return profile of the portfolio.

Question 2

What is the basic measure of risk in the market?

Answer 2

Volatility measured by standard deviation

Question 3

Why are equities riskier than bonds?

Answer 3

Because bonds carry seniority over equity

Question 4

What are the limitations of the Modern Portfolio Theory?

Answer 4

1. Unrealistic assumptions:
   - Perfect information
   - Unlimited ability to sell shares short
   - All investors have the same time horizon
   - No transaction costs
   - Portfolios are recalculated continuously
2. Market portfolios:
   - Impossible to create a market portfolio.
   - In reality weighted average of all stocks in an exchange is used instead.
3. Portfolio managers:
   - Karceski (2002) finds that portfolio managers chase returns rather than optimise risk-return profiles.

Question 5

According to the CAPM model, risk consists of which two types of risk?

Answer 5

Systematic risk: Affects the whole market and cannot be diversified.
Unsystematic risk: Affects a particular asset and can be neutralised through diversification.

Question 6

CAPM model says you should only be compensated for the systematic risk. Why is unsystematic risk not included?

Answer 6

Because you can diversify unsystematic risk away

Question 7

What is Beta a measure of?

Answer 7

Systematic Risk

Question 8

What is the Multiple R output on the Regression Analysis?

Answer 8

the correlation coefficient (how the asset’s returns correlate to the market return). The market return and the asset return move in the same direction, but not all of the time.

Question 9

What is the R Squared output on the Regression Analysis?

Answer 9

How much of the asset’s return variability can be determined / explained by the variability of the returns in the market? Therefore – how much of the asset’s returns are subject to systematic risk.

Question 10

What is the Beta of the Risk Free Rate?

Answer 10

Always Zero