FINM7008/2003 (Applied) Investments Week 12 Revision Xiaoting Wei RSFAS, Australian National University For this lecture, we will review the concepts covered throughout the semester. 2 We commenced the course by recognising that an investment involves an entity: Directly or indirectly placing wealth in real or financial assets that are expected to generate returns in the future; Assuming a certain level of risk, or probability that the investment will yield a lower than expected return; and, Foregoing consumption of the invested wealth today with the hope of generating further funds for future consumption. 3 Segmentation of Financial Markets Money market Capital market How securities are trades 4 Primary market vs. secondary market Privately held v.s. publicly traded companies As investors are primarily concerned with risk and return, it is important to understand how to calculate each measure. Norminal interest rate vs. real interest rate 5 Holding period return (HPR) Geometric mean vs. Arithmatic mean Risk and risk premium Measures of return Expected return and standard deviation Sharpe Ratio Recalling the assumption that investors prefer more wealth to less but are also risk averse, we discussed how portfolio managers aim to achieve the best tradeoff between risk and return. Doing this involves: Deciding what fraction of money to invest in the risky versus riskless assets, or making the capital allocation decision. This step represents the first part of the asset allocation decision; and, Thereafter, deciding which particular securities to invest in within each asset class, or making the security selection decision. 6 We saw how the capital allocation decision can be broken down into two distinct stages, namely: Identifying the risk-return tradeoff involved in choosing between risky and riskless assets; and, Deciding the optimal mix of risky and riskless assets given risk aversion. In doing this, we derived the Capital Allocation Line, (“CAL”), which plots the complete portfolio characteristics for a given weighting of risky assets. Thereafter, we graphically depicted how an investor uses indifference curve analysis to select the optimal portfolio in which to invest. 7 Next, we: Asked what happens when the risky asset is actually a portfolio comprised of multiple assets and the weights in these assets have the potential to change ; Discussed how investors can identify the optimal risky portfolio in both the simple situation where there are only two risky assets as well as when multiple risky assets exist; Saw that, once the optimal risky portfolio has been constructed, the individual investor’s degree of risk aversion will determine the optimal proportion of the complete portfolio to invest in the risky assets. 8 Next, we examined the implications of portfolio theory for the equilibrium structure of expected returns on risky assets. More specifically, we first reviewed the Sharpe-Lintner CAPM and its assumptions and, in doing so, also discussed how: Researchers have sought to extend the model so as to make it applicable to the real world by relaxing its assumptions. By way of example, relaxing the assumption of unlimited borrowing and lending at the risk free rate lead to the development of the Zero-Beta CAPM; and, It is implemented in practice using index models. 9 We then saw how we can combine the no-arbitrage argument with the concept of factor models to derive a multifactor asset pricing model known as the APT. More specifically, we: Derived a single-factor APT and showed that it implied an SML equivalent to the CAPM; Extended the model to a multi-factor setting so as to account for the existence of more than one risk; and, Discussed work that offers some insight into what risk factors should be included in a multi-factor asset pricing model, namely tha
t of Chen, Roll and Ross and Fama and French. 10 While some argue the CAPM cannot be truly tested unless the composition of the true market portfolio is known and reflected in all tests, others use a market proxy to test the model. The results of these tests were mixed. Specifically: Early empirical evidence was inconsistent with the CAPM; but, More recent testing has provided greater support for the model. In considering empirical evidence in relating to both the CAPM and APT, it is also important to note that many of their implications have been accepted in practice. 11 Next we discussed whether the markets in which investors make decisions are informationally efficient. More specifically, we: Were introduced to the three versions of the EMH; Considered evidence relating to the profitability of momentum strategies, the ability of publicly available information to predict positive abnormal risk-adjusted returns and the occurrence of information leakages in the lead up to the release of public information; and, Discussed how the evidence noted in the previous point at least casts some doubt on the weak, semi-strong and strong form versions of the EMH hypotheses respectively. 12 Thereafter, we discussed how evidence on market inefficiency has led to the emergence of the behavioural finance literature. More specifically, the literature argues that: A lack of profitable strategies within the market does not necessarily imply prices are correct; and, Prices are not reliable signals as to how investors should allocate capital; however, The impact of investor irrationality on asset pricing is still being debated; and, Therefore, it is too soon to know whether asset pricing models incorporating behavioural components will gain ongoing acceptance. 13 For the following two lectures, we focused on fixed- interest securities. More specifically, we: Reviewed and extended the bond pricing approach first introduced in your prior studies; and, Discussed the term structure of interest rates, which is a collection of theories that seek to explain the relationship between time to maturity and yield to maturity. Theories we discussed include the Expectations Hypothesis and Liquidity Preference Theory. 14 We then considered the numerous strategies that are available to managers of bond portfolios, stratifying those discussed into active and passive management approaches. In discussing bond management strategies, we also considered how: Duration can be used as a measure of the sensitivity of bond prices to changes in interest rates; A convexity adjustment can be made to duration measures to improve their accuracy; Duration-matching can be used as a tool to immunise bond portfolios from interest rate risk; and, Duration can be employed in other aspects of bond management. 15 We then returned our discussions to portfolio management in general, considering the: Various approaches available to measure portfolio performance; Importance of adjusting performance measures to take into account the risk associated with the investment under consideration; 16 Range of risk-adjusted measures available when assessing performance and the appropriateness of each. Some of the measures we covered include Sharpe’s measure, Treynor’s measure, Jensen’s measure or the portfolio’s alpha and the information or appraisal ratio; and, Techniques that are used to attribute portfolio performance to certain parts of the investment decision making process. 17 Next, we introduced hedge funds. In particular, we: Distinguished hedge funds from mutual funds; Discussed some of the strategies which hedge funds may employ; Illustrated how to hedge a positive alpha portfolio from market risk, via portable alpha and pure play; and Discussed some of the issues which may arise with performance measurement and hedge fund fee structure. 18