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Level 91

Diversify the Portfolio


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Total risk
Refers to the overall variability of the returns of financial assets.
Dominance
investors universally prefer one alternative over another, including investment perspectives
Stochastic dominance
theory of dominance based on the likelihood of realizing a outcome below a certain level
Security Universe
The security universe is the collection of all possible investments. For some institutions, only certain investments may be eligible.
Markowitz diversification
portfolio construction with security covariances
efficient frontier
developed by Prof Harry Markowitz 1952
minimum variance portfolio
smallest variance among all portfolios with identical expected return
CML
line drawn from risk free rate to the market portflio
Market Portfolio
The portfolio of all risky investments, held in proportion to their value.
Lending portfolio
any risky portfolio partially invested in risk free asset
Borrowing portfolio
efficient portfolio that has purchased market portfolio
SML
trade off between systematic risk and expected return
Market Price of Risk
Quantifes the extra return that investors demand to bear portfolio risk
Corner portfolio
the addition or subtraction of a security in a portfolio
Naive diversification
Refers to the selection of portfolio components randomly without any serious security analysis.
Systematic Risk
Cannot be diversified and is relevant. Measured by beta. Beta determines the level of expected return on a security or portfolio (SML)
Unsystematic Risk
The risk that effects at most a small number of assets; it is also called unique or asset-specific risk. For example, oil strike by a single company.
Superflous diversification
addition of unnecessary components to an already diversified portfolio
CAPM
a model that simplifies a complex investment environment and which allows investors to understand the relationship between risk and return
Equity Risk Premium
Refers to the difference in the average return between stocks and some measure of the risk-free rate. The equity risk premium in the CAPM is the excess expected return on the market. Some researchers…
APT
no presence of arbitrage, a stock's return comes from a variety of factors
Foreign exchange risk
the risk of loss due to fluctuations in currency exchange rates
Spot Rate
Exchange rate requiring delivery of the traded currency within two business days.
Real rate
rate of return investors demand for giving up the current use of funds
Inflation premium
reflection of change in general price level
risk premium
the component of a return that compensates for risk (credit risk premium compensates for borrower's risk)
Forward Rate
Exchange rate at which two parties agree to exchange currencies on a specified future date.
Interest Rate Parity
Interest rate parity states that differences in national interest rates will be reflected in the currency forward market
Covered Interest Arbitrage
Covered interest arbitrage is possible when the conditions of interest rate parity are violated. If the foreign interest rate is too high, convert dollars to the foreign currency and invest in the foreign country…
PPP
exchange rates reflected in ratio of domestic and foreign prices
Absolute PPP
law of one price
Relative PPP
PPP adjusted for inflation
Translation exposure
exposure that comes from holdings of outside currencies
Economic exposure
exposure that comes from risk that the value of a security will decline due to an unexpected change
Hedging
Technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing or selling futures contracts on an organized exchange.
Futures Contract
an arrangement for delivery of an item at some date in the future, where the delivery details are determined when the contract is created
Country Risk
Refers to a country's ability and willingness to meet its foreign exchange obligations, especially important in emerging markets. Country risk has two components: political risk and economic risk.
Economic function
function of market that facilitates the transfer of money
Continuous pricing function
function of market that allows for up to the date pricing
Fair price function
function of market that allows investors to believe they are getting right price
EMH
theory that market prices are fair
Operational efficiency
how well markets operate in terms of execution and accuracy
Informational efficiency
measure how quickly market reacts to new information
SEMH
the theory that the market prices some stocks more efficiently than others
Random Walk
No discernible pattern to the path that a stock price follows through time. This is related to weak-form market efficiency.
Low-PE effect
lower pe stocks provide higher returns
Optimum trading range
the best price range for a stock
small-firm effect
savers could have earned above-normal profits by investing in stocks of small firms, even with greater risk taken into account
Neglected-firm effect
tendency for lesser-known firms to perform better than well known ones
january effect
people rebalance portfolios each january, possibly to avoid taxes they get rid of their losses in December too
Day-of-the-week effect
certain days have higher returns than others
Chaos theory
theory that random behavior is deterministic
Fundamental analyst
tries to discern logical worth of security from anticipated earnings
Technical analyst
believes that changes in price are a result of changes in supply and demand
Dividend rights
like owning a stock, right to sell or buy
Thin trading
a stock that has a limited number of shareholders and low trading volume
Best of class investing
recognizes that all firms potentially could have a reason that faults them in social practice
Indenture
contract between the issuer of a bond and the bond holders
Debenture
long term bond that isn't secured by mortgage on a property
Revenue Bond
used to fund projects that generate revenues that are used to make interest payments and repay principals
Assessment bond
certain group of people pay assessment to help pay off bond
Collateral trust bond
backed by other securities, like investments held by firm
Income bond
interest only paid if money is made to pay it
Consol
perpetual interest rate, income stream never ends
Convertible bond
a debt security that can be converted into a firm's stock at a specified price.
Bearer bond
bond without owner's name on it
interest rate risk
the risk that a change in interest rates may affect the net worth of a financial intermediary because of a mismatch in the maturity of its assets and liabilities.
Default Risk
Risk that counterparty doesn't honour obligation (payment obligation, supplier doesn't deliver promised goods, contractor doesn't render promised service, etc.). Context is wide. No tx free of default risk
Convenience risk
risk that management will have less time dedicated because of unforeseen events
Call risk
risk that the bond will be called
reinvestment risk
lower coupon rate increases duration but decreases reinvestment risk. Instances of reinvestment risk:
Marketability Risk
An investor may be unable to close out a position at a reasonable price
Credit risk
possibility that borrower will not meet the scheduled repayments and default on their loan
Real Asset
"physical asset", typically tangible; physically observable or touchable item
Regulatory risk
risk that comes from limitations on management of an asset
Naive strategy
strategy that involves predetermined and static model
CPPI
investment portfolio where manager increases percentage as stock prices rise
Constant mix
strategy where manager makes adjustments to maintain relative weighting of different classes
Tracking error
when portfolio deviates from its intended behavior
TAA
shifting investments from asset classes as the perspectives of these different classes change
Asset class appraisal
determining merits of certain asset classes
Swing component
part of portfolio whose asset class can change
Normal mix
the benchmark proportions of portfolio
Mix range
specifications about how this mix can deviate and the degree to which it can deviate
Yield curve inversion
short term yields rising faster than long term yields
Bullet strategy
bond maturities cluster around one particular maturity on yield curve
Flight to Quality
investors looking for safer investments--gov't bonds shown to be risky now
Confidence index
ratio on AAA bonds / BBB bonds