CFA COURSE PPA FEUI

Key Concepts : Portofolio Risk and Return : Part I

LOS 52.a

Holding petiod return is used to measure an investment's return over a specific period.
Arithmetic mean return is the simple average of a series of periodic returns. Geometric mean
return is a compound annual rate.

Money-weighted rate of return is the IRR calculated using periodic cash flows into and out of
an account and is the discount fate that makes the ptesent value of cash inflows equal to the
present value of cash outflows.

Gross return is total return after deducting commissions on ttades and other costs necessary to
genetate the returns, but before deducting fees for the management and administration of the
investment account. Net teturn is the return after management and administration fees have
been deducted.

Pretax nominal return is the numetical percentage return of an investment, without

considering the effects of taxes and inflation. After-tax nominal return is the numerical return
after the tax liability is deducted, without adjusting for inflation. Real teturn is the increase in
an investors purchasing power, roughly equal to nominal return minus inflation. Leveraged
return is the gain or loss on an investment as a percentage of an investor's cash investment.

LOS 52.b
As predicted by theoty, asset classes with the greatest average returns have also had the
highest risk.
Some of the major asset classes that investors consider when building a diversified portfolio
include (ranked from most risk and return to least) small-capitalization stocks, large-
capitalization stocks, long-term corporate bonds, long-term Treasury bonds, and Treasury
bills.

In addition to risk and return, when analyzing investments, investors also take into
consideration an investment's liquidity, as well as non-normal charactetistics such as
skewness and kurtosis.

LOS 52.c
We can calculate the population variance, cr , when we know the return R for period t, the
total number T of periods, and the mean ft of the population's distribution:

population variance =

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In finance, we typically analyze only a sample of returns, so the sample variance applies
instead:

Sample Variance :

Covariance measures the extent to which two variables move together over time. Positive
covariance means the variables (e.g., rates of return on two stocks) tend to move together.
Negative covariance means that the two variables tend to move in opposite directions.
Covariance of zero means there is no linear relationship between the two variables.

Correlation is a standardized measure of co-movement that is bounded by —1 and +1

LOS 52.d

A risk-averse investor is one that dislikes risk. Given two investments that have equal
expected returns, a risk-averse investor will choose the one with less risk. However, a risk-
averse investor will hold risky assets if he feels that the extra return he expects to earn is
adequate compensation for the additional risk. Assets in the financial markets are priced
according to the preferences of risk-averse investors.

A risk-seeking (risk-loving) investor actually prefers more risk to less and, given investments
with equal expected returns, will choose the more risky investment.
A tisk-neutral investor has no preference regarding risk and would be indifferent between two
investments with the same expected return but different standard deviation of return.

LOS 52.e

The standard deviation of returns for a portfolio of two risky assets is calculated as
follows:

LOS 52.f

The greatest portfolio risk will result when the asset returns are perfectly positively
correlated. As the correlation decreases from +1 to -1, portfolio risk decreases. The lower the
correlation of asset returns, the greater the risk reduction (diversification) benefit of
combining assets in a portfolio.

LOS 52.g

For each level of expected portfolio return, the portfolio that has the least risk is known as a
minimum-variance portfolio. Taken together, these portfolios form a line called the
minimum-variance frontier.

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On a risk versus return graph, the one risky portfolio that is farthest to the left (has the least
risk) is known as the global minimum-variance portfolio.

Those portfolios that have the greatest expected return for each level of risk make up the
efficient frontier. The efficient frontier coincides with the top portion of the minimum
variance frontier. Risk-averse investors would only choose a portfolio that lies on the
efficient frontier.

LOS 52.h

An indifference curve plots combinations of risk and expected return that an investor finds
equally acceptable. Indifference curves generally slope upward because risk-averse investors
will only take on more risk if they are compensated with greater expected returns. A more
risk-averse investor will have steeper indifference curves.

Flatter indifference curves (less risk aversion) result in an optimal portfolio with higher risk
and higher expected return. An investor who is less risk averse will optimally choose a
portfolio with more invested in the risky asset portfolio and less invested in the risk-free
asset.

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 CFA COURSE PPA FEUI
Concepts Chekers : Portofolio Risk and Return : Part I

1. An investor buys a share of stock for $40 at time t = 0, buys another share of the same
stock for $50 at t = 1, and sells both shares for $60 each at t = 2. The stock paid a
dividend of $1 per share at t = 1 and at t = 2. The periodic money-weighted rate of return
on the investment is closest to:
A. 22.2%.
B. 23.0%.
C. 23.8%.

2. Which of the following asset classes has historically had the highest returns and standard
deviation?
A. Small-cap stocks.
B. Large-cap stocks.
C. Long-term corporate bonds.

3. Which of the following characteristics of a return distribution would most likely be

associated with a low frequency of downside deviations from the mean?
A. Kurtosis.
B. Fat tails.
C. Positive skew.

4. In a 5-year period, the annual returns on an investment are 5%, -3%, —4%, 2%, and 6%.
The standard deviation of annual returns on this investment is closest to:
A. 4.0%
B. 4.5%
C. 20.7%

5. A measure of how the returns of two risky assets move in relation to each other is the:
A. range.
B. covanance.
C. standard deviation.

6. Which of the following statements about correlation is least accurate?

A. Diversification reduces risk when correlation is less than +1.
B. If the correlation coefficient is 0, a zero variance portfolio can be constructed.
C. The lower the correlation coefficient, the greater the potential benefits from
diversification.

7. The standard deviation of returns is 0.30 for Stock A and 0.20 for Stock B. The
covanance between the returns of A and B is 0.006. 1 he correlation of returns between A
and B is:
A. 0.10.

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 B. 0.20.
C. 0.30.
8. Which of the following statements about risk-averse investors is most accurate1? A risk-
averse investor:
A. seeks out the investment with minimum risk, while return is not a major
consideration.
B. will take additional investment risk if sufficiently compensated for this risk.
C. avoids participating in global equity markets.

Use the following data to answer Questions 9 and 10.

9. A portfolio was created by investing 25% of the funds in Asset A (standard deviation =
15%) and the balance of the funds in Asset B (standard deviation = 10%). If the
correlation coefficient is 0.75, what is the portfolio's standard deviation?
A. 10.6%.
B. 12.4%.
C. 15.0%.

10. If the correlation coefficient is -0.75, what is the portfolio's standard deviation?
A. 2.8%.
B. 4.2%.
C. 5.3%.

11. Which of the following statements about covariance and correlation is least accurate?
A. zero covariance implies there is no linear relationship between the returnson two
assets.
B. If two assets have perfect negative correlation, the variance or returns for a
portfolio that consists of these two assets will equal zero.
C. The covariance of a two-stock portfolio is equal to the correlation coefficient times
the standard deviation of one stock's returns times the standard deviation of the other
stock's returns.

12. A portfolio manager adds a new stock to a portfolio. The stock has a correlation
coefficient with the returns of the existing portfolio that is less than +1. As the new stock
is added, the portfolio's standard deviation will initially:
A. decrease.
B. not change.
C. increase by less than the amount of the new stock's standard deviation.

13. Which of the following available pottfolios most likely falls below the Markowitz
efficient frontier?
Expected Expected
Portfolio return standard deviation
A. A 7% 14%
B. B 9% 26%
C. C 12% 22%

14. The capital allocation line is a straight line from the risk-free asset through the:
A. global maximum-return portfolio.
B. optimal risky portfolio.

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 C. global minimum-variance portfolio.

CFA COURSE PPA FEUI

Answers : Portofolio Risk and Return : Part I

1. C Using the cash flow functions on your financial calculator, enter CFO = - 40; CFl
= 50 + 1 = -49; CF2 = 60 x 2 + 2 = 122; CPT IRR = 23.82%.

2. A Small-cap stocks have had the highest annual return and standard deviation of
return
over time. Large-cap stocks and bonds have historically had lower risk and return
than small-cap stocks.

3. C Positive skew reflects a tendency towards a higher frequency of upside deviations.

Fat tails and positive excess kurtosis reflects frequent extreme deviations on both
the upside and downside.

4. B Mean annual return = (5% - 3%-4% + 2% + 6%) / 5 = 1.2%

Squared deviarions from the mean :

5%- 1.2% = 3.8%

-3% -1.2% = -4.2%
-4%-1.2% = -5.
2% 2%-1.2% = 0.8%
6%-1.2% = 4.8%

Sum of squared deviations = 14.44 + 17.64 + 27.04 + 0.64 + 23.04 = 82.8

Sample variance = 82.8 / (5 - 1) = 20.7

Sample standard deviation = = 4.55%

5. B The covariance is defined as the co-movement of the returns of two assets, or how
well the returns of two risky assets move together. Range and standard deviation
are measures of dispersion and measure risk, not how assets move together.

6. B A zero-variance portfolio can only be constructed if the correlarion coefficient

between assets is — 1. Diversification benefits can be had when correlation is less
than t-1, and the lower the correlation, the greater the potential benefit.

7. A Correlation = 0.006/[(0.30)(0.20)] = 0.10

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8. B Risk-averse investors are generally willing to invest in risky investments, if the
return of the investment is sufficient to reward the investor for taking on this risk.
Participants in secutities markets are generally assumed to be risk-averse investors.

9. A =

10. C

11. B If the correlation of returns between the two assets is —I, the sec of possible
portfolio risk/return combinations becomes two straighc lines (see Figure 2). A
portfolio of these two assets will have a positive returns variance unless the
portfolio weights are those that minimize the portfolio variance. Covariance is
equal to the correlation coefficient times the product of the standard deviations of
the returns of the two stocks in a two-stock portfolio. If covariance is zero then
correlation is also zero, which implies that there is no linear relationship between
the two stocks' returns.

12. A There are potential benefits from diversification any time the correlation coefficient
with the existing portfolio is less than one. Because the correlation coefficient of
the asset being added with the existing porrfolio is less than one, the portfolio
standard deviation will decrease initially as the asset is added to the portfolio.

13. B Portfolio B must be the portfolio that falls below the Markowitz efficient frontier
because there is a portfolio (Portfolio C) that offers a higher return and lower risk.

14. B An investor's optimal portfolio will lie somewhere on the capital allocation
line,which begins at the risk-free asset and runs through the optimal risky portfolio.