Two types or Risk - ANSWER ✔ Systematic and Unsystematic
Examples of Systematic Risk - ANSWER ✔ Purchasing Power
Reinvestment Rate
Interest Rate
Market
Exchange
Examples of Unsystematic Risk - ANSWER ✔ Business
Financial
Political
Purchasing Power Risk - ANSWER ✔ Inflation risk
Reinvestment Risk - ANSWER ✔ the risk that market interest rates may have
decreased at the time payments from an investment are received.
Interest Rate Risk - ANSWER ✔ Caused by fluctuations in the general level of
interest rates
, Market Risks - ANSWER ✔ Most apparent systematic risk, caused from tangible
and intangible risk
Exchange Rate Risk - ANSWER ✔ Caused by changes in relative value of foreign
currency compared to value of home currency
Business Risk - ANSWER ✔ Specific to nature of individual business
How to eliminate business risk with stock - ANSWER ✔ Own 15+ stocks in
different sectors
Financial Risk - ANSWER ✔ Associated with the use of debt in the financing of a
firm or property
Political Risk - ANSWER ✔ Associated with investing in foreign countries
Standard Deviation - ANSWER ✔ common statistical measure of total risk that
measures the dispersion of all sample data points (returns) around the average of
the points (average returns), measures total return w/ all possible risks
Volatility/Standard Deviation relationship - ANSWER ✔ Higher the volatility,
higher the standard deviation
Levels of Standard Deviation - ANSWER ✔ 1 Level = 68%
2 Levels = 95%
3 Levels = 99%
Example: If investment mean return is 10%, and standard deviations are 15%,
what are the possible returns at each level of Standard Deviation - ANSWER ✔ 1
SD: -%5 - 25%
2 SD: -20% - 40%
3 SD: -35% - 55%
Beta - ANSWER ✔ it is a measure of a security's systematic risk—risk that cannot
be diversified. The beta coefficient is a measure of the volatility of an individual
asset relative to the volatility of an appropriate benchmark index.
Beta < 1 - ANSWER ✔ stocks less volatile
,Beta > 1 - ANSWER ✔ stocks more volatile
Example: What would be approximate price movement of $A if beta is .85 and
comparable bench mark return is 15%? - ANSWER ✔ 12.75%
Sharpe Ratio - ANSWER ✔ Relates the return on an investment or portfolio to the
degree of total risk taken. The higher the index quotient, the greater is the return
for each unit of risk. Measures amount of reward for amount of risk
Sharpe Ratio Formula - ANSWER ✔ (Return of security - Risk Free
Rate)/Standard Deviation
Treynor Index - ANSWER ✔ relates the return of an investment or portfolio to the
degree of systematic risk taken, as measured by beta.
Treynor Index Formula - ANSWER ✔ (Return - Risk Free Rate)/Beta
Jensen Index - ANSWER ✔ Compares the expected return of an investment with
the actual return, more commonly known as alpha. It indicates the additional
return, if any, earned by the portfolio manager after adjusting for risk, as measured
by beta. If number is positive, manager is doing a good job.
Jensen Index Formula - ANSWER ✔ Return of Investment - [Risk Free Rate +
(Return of Market -Risk Free Rate) x Beta]
Asset Allocation Definition - ANSWER ✔ The apportioning of available funds
among a number of different categories—or classes—of assets, such as stocks,
bonds, cash
Factors that determine asset allocation - ANSWER ✔ Time Horizon
Risk Tolerance
Need for current income
Liquidity needs
Taxation priorities
Priorities & Financial goals
Need for inflation hedge
, What happens with diversification when you add different assets to a portfolio -
ANSWER ✔ It will get closer and closer to the market
What diversification can and cannot eliminate - ANSWER ✔ Can: Unsystematic
Risk
Can't: Systematic Risk
How to measure amount of diversification - ANSWER ✔ Correlation range is -1
to 1. Further from 1 = more diversified.
Steps of Asset Allocation Process - ANSWER ✔ 1. Select asset classes to be
represented
2. Determine % that each asset class should represent in total portfolio
3. Select individual securities
4. Review and rebalance
Core-satellite approach - ANSWER ✔ the 70% to 80% (core) portion of the
portfolio is invested in broad-based index funds or exchange-traded funds while
the remaining portion (satellite) consists of actively managed mutual funds. The
satellite portion attempts to generate above-average returns and/or to provide
additional diversification to the core portfolio.
Strategic Asset Allocation - ANSWER ✔ Attempts to achieve the best long-term
risk/return balance with the assets in the portfolio. First the asset classes to be
included are identified and the percentages of each asset class are determined. If,
through market fluctuations, these percentages change outside a certain range, the
portfolio is rebalanced back to the target allocation.
Social Security- Fully insured - ANSWER ✔ - having 10 years of employment
covered by social security; expressed as "40 quarters of coverage"
- Must be fully insured for retirement benefits
- fully insured workers are also eligible for disability if he has earned at least 20
work credits in last 10 years
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