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Security Pricing and Portfolio Selection summary KUL
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INVESTMENTS: CAPITAL MARKET AND PRODUCTS ................................................................. 5Financial markets ............................................................................................................................................. 5
Investment funds ............................................................................................................................................. 6
Investment companies ....................................................................................................................................... 6
Other investment organizations ......................................................................................................................... 7
Mutual funds.................................................................................................................................................... 7
Organization ....................................................................................................................................................... 7
Investment policies ............................................................................................................................................. 8
INVESTMENT CONCEPTS .......................................................................................................10
Characterization of an investment ................................................................................................................. 10
Reward-to-risk .................................................................................................................................................. 10
Portfolios and Indices ..................................................................................................................................... 11
Market indices .................................................................................................................................................. 12
An historic perspective on portfolio returns ................................................................................................... 14
CAPITAL ALLOCATION TO RISKY ASSETS .................................................................................15
Investment opportunity set ........................................................................................................................... 15
Portfolios of one risky and one risk-free asset ................................................................................................. 15
Risk and risk aversion ..................................................................................................................................... 16
Choosing among portfolios ............................................................................................................................... 17
Capital allocation decision.............................................................................................................................. 18
OPTIMAL RISKY PORTFOLIOS .................................................................................................19
Diversification ................................................................................................................................................ 19
Stylized diversification strategy with two risky assets ...................................................................................... 19
A diversification strategy with many risky assets and systematic risks ............................................................ 20
Mean-Variance analysis ................................................................................................................................. 21
Portfolio with two risky assets .......................................................................................................................... 21
Global minimum variance portfolio ............................................................................................................. 22
Portfolio characteristics as a function of portfolio weights ......................................................................... 22
A risk-expected return representation ......................................................................................................... 23
Portfolio with many risky assets ....................................................................................................................... 23
The optimal portfolio ........................................................................................................................................ 24
Mean-variance analysis with a T-bill .............................................................................................................. 24
Portfolio optimization ....................................................................................................................................... 25
1
,Portfolio management in practice .................................................................................................................. 26
Horizon effects of risk ....................................................................................................................................... 27
Life-cycle approach ........................................................................................................................................... 28
INDEX MODELS .....................................................................................................................29
Single index model ......................................................................................................................................... 29
Advantages ....................................................................................................................................................... 30
Portfolio construction in a single-index world ................................................................................................ 31
Portfolio construction in a CAPM world ......................................................................................................... 32
Portfolio construction in a pragmatic way ...................................................................................................... 32
The mean-variance model: a critical note....................................................................................................... 34
MARKET EFFICIENCY .............................................................................................................35
Efficient market hypothesis ............................................................................................................................ 35
Empirical evidence on market efficiency ........................................................................................................ 35
Weak-form efficiency ....................................................................................................................................... 36
Semi-strong-form efficiency ............................................................................................................................. 37
Mutual fund and analyst performance ........................................................................................................... 37
Equity research analysis.................................................................................................................................... 37
Active vs passive funds ..................................................................................................................................... 38
Role of asset management in a EMH world...................................................................................................... 38
BEHAVIOURAL FINANCE AND LIMITS TO ARBITRAGE .............................................................39
Information processing .................................................................................................................................. 39
Representativeness bias ................................................................................................................................... 39
Conjunction fallacy ........................................................................................................................................... 39
Overconfidence ................................................................................................................................................ 39
Anchoring.......................................................................................................................................................... 40
Behavioural biases ......................................................................................................................................... 40
Regret avoidance .............................................................................................................................................. 40
Mental accounting ............................................................................................................................................ 40
Risk aversion ..................................................................................................................................................... 41
Loss aversion..................................................................................................................................................... 41
The weakness of behavioural finance............................................................................................................... 41
Limits to arbitrage .......................................................................................................................................... 42
Fundamental risk .............................................................................................................................................. 42
Implementation costs ....................................................................................................................................... 42
Model risk ......................................................................................................................................................... 43
Law of one price ............................................................................................................................................... 43
2
, Impossibility of strong form EMH ..................................................................................................................... 44
FIXED INCOME INSTRUMENTS ..............................................................................................46
Fixed-income basics ....................................................................................................................................... 46
Bond pricing ................................................................................................................................................... 47
Realized return over a single period ................................................................................................................. 49
Yield to call ........................................................................................................................................................ 49
Default risk ..................................................................................................................................................... 50
Credit ratings .................................................................................................................................................... 50
Credit risk determinants ................................................................................................................................... 51
Default rates ..................................................................................................................................................... 51
Bond indentures ............................................................................................................................................... 51
Stated versus expected YTM ............................................................................................................................ 51
Credit derivatives ........................................................................................................................................... 52
Credit default swap (CDS) ................................................................................................................................. 52
Standard CDS ................................................................................................................................................ 52
Digital CDS .................................................................................................................................................... 52
Basket CDS .................................................................................................................................................... 53
Portfolio CDS ................................................................................................................................................ 53
Collateralized debt obligation (CDO) ................................................................................................................ 53
Traditional CDO ............................................................................................................................................ 53
Synthetic CDO............................................................................................................................................... 54
MANAGING FIXED INCOME PORTFOLIOS ..............................................................................55
The yield curve ............................................................................................................................................... 55
The yield curve under certainty ........................................................................................................................ 55
The expectations hypothesis ........................................................................................................................ 56
The liquidity preference theory.................................................................................................................... 57
Forward rates as forward contracts ............................................................................................................. 58
Interest rate risk............................................................................................................................................. 59
Macaulay’s duration ......................................................................................................................................... 60
Passive bond management ............................................................................................................................ 62
Active bond management .............................................................................................................................. 64
APPLIED PORTFOLIO MANAGEMENT .....................................................................................65
Performance evaluation: traditional approach ............................................................................................... 65
Risk correction .................................................................................................................................................. 65
Absolute performance measures ................................................................................................................. 66
Relative performance measures .................................................................................................................. 66
Information ratio...................................................................................................................................... 67
3
, Treynor ratio ............................................................................................................................................ 67
Industry fund rating systems ........................................................................................................................ 68
Morningstar ............................................................................................................................................. 68
Lipper Leaders .......................................................................................................................................... 68
Challenges ...................................................................................................................................................... 68
Which measure is appropriate?........................................................................................................................ 68
Time-varying risk............................................................................................................................................... 69
Changing portfolio composition ................................................................................................................... 69
Market timing ............................................................................................................................................... 70
Drivers of performance .................................................................................................................................. 71
Style analysis ..................................................................................................................................................... 71
Performance attribution ................................................................................................................................... 72
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