Portfolio Management

Joel M. Shulman, Ph.D., CFA

Study Session # 18 – Level I

CFA CANDIDATE READINGS:

Investment Analysis and Portfolio Management,

6th edition, Reilly
Chapter 1, “The Investment Setting” pp.15-29
Chapter 2, “Asset Allocation”
Chapter 3, “Selecting Investments/Global Market” pp. 69-78
Chapter 8, “An Introduction to Portfolio Management”
Chapter 9, “An Introduction to Asset Pricing Models”

© 2003 Shulman Review

All rights reserved.

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 Portfolio Management

About the Author

JOEL M. SHULMAN, PH.D., CFA

PROGRAM DIRECTOR

PROFESSOR OF ETHICS, PORTFOLIO MANAGEMENT, FIXED

INCOME AND ASSET VALUATION (LEVELS I, II AND III)

Dr. Shulman is the Robert F. Weissman Term Chair of

Entrepreneurship at Babson College. His professional
designations include a Finance Ph.D., and CFA. He is also
a CMA and CCM, and holds an MPA from the JFK School of
Government at Harvard University. He has coauthored eight
books on investments and corporate finance and has
published numerous articles in leading journals. He has
consulted for a number of firms including Merrill Lynch,
Salomon Brothers, Morgan Stanley, UNISYS, PDVSA, PMC,
Lucent Technologies and the World Bank. His new book,
Getting Bigger by Growing Smaller (with. T. Stallkamp) is
due to be released in Spring 2003 (Financial
Times/Prentice Hall Publisher).

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“The Investment Setting”

Reilly, Chapter 1
This chapter provides an overview to the basic concepts in investments. Topic coverage
includes basic definitions, measures of risk and return, determinants of required rates of
return and an introduction to portfolio theory. Some of the key topics include topics also
seen in quantitative methods. For example, Learning Outcome Statements in quantitative
methods ask level I candidates to compute holding period returns, arithmetic and
geometric returns, variance and standard deviation and coefficient of variation. These
topics are all covered in this chapter of Portfolio Management and are briefly discussed in
this section. In addition, other topics referencing the nominal and real risk free rate are
addressed along with a discussion on the Security Market Line and Beta.

Describe the real risk-free rate and compute nominal and real risk-free rates of return

The investor is presumed to earn a premium for deferring present consumption for future
consumption. The rate of exchange between future consumption and present consumption
is the pure rate of interest or the pure time value of money. This is also known as the real risk
free rate (RRFR). The real risk free rate is the actual rate of return that the investor earns,
net of inflation. Since the investor typically demands an amount to compensate for the
level of inflation, the rate demanded in the marketplace includes an amount of inflation.
The quoted rate that includes inflation is known as the nominal rate. The nominal risk free
rate (NRFR) would include the real risk free rate plus an amount of inflation.
Consequently,

Key Formula

Nominal risk-free rate = Pure time value of money + Inflation rate

Technically, the nominal risk free rate includes the real risk free rate plus the rate of
inflation plus an amount of inflation on the real risk free rate. This additive measure
complicates the computation slightly as shown below:

Key Formula
NRFR = (1 +RRFR) * (1 + expected rate of inflation) – 1

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Likewise, the true calculation of the real risk free rate is not simply the nominal rate less
the rate of inflation (though at low levels of inflation this is a good proxy). The actual
computation needs to subtract the inflation component on the real risk free rate. This is
shown below as:

Key Formula

RRFR = [(1 + Nominal Risk Free Rate)] – 1

(1 + Rate of Inflation)
Example: Suppose the nominal rate is 12% and the expected inflation rate is 9%, what is
the real risk free rate?

Solution: [(1 + .12)/(1 + .09) – 1] = .0275 or 2.75%

Note: The solution of 2.75% is an amount smaller than the nominal rate less inflation (i.e.
12% - 9% = 3%). This is due to the inflation on the real rate (i.e. 9% inflation rate on
2.75% equals .25%). Proof: (1 + .0275) * (1 + .09) = 12% (nominal rate)

Candidates should realize that the nominal risk free rate is a starting point for determining
a non-treasury security’s required rate of return. In addition to the nominal risk free rate of
return, the investor demands a premium over-and-above the NRFR. This premium
provides compensation for the uncertainty associated with the payments from the
investment (known as the risk premium or investment risk). These are discussed at greater
length later in this chapter.

Professor’s Tip:
Level I candidates should realize that AIMR sometimes asks for the nominal rate without
requiring the extra detail associated with the multiplicative function (i.e. inflation on the
real rate). However, if candidates prepare for this computation, it should be relatively easy
to recognize whenever the precision is not being demanded.

Explain the concept of required rate of return and discuss the three components of an
investor’s required rate of return

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The investor’s Required Rate of Return (RRR) is a function of three components:

Key Formula

RRR = time value of money + inflation rate + risk premium

The time value of money is a pure return, net of all other criteria, that the investor should
receive to compensate for delayed consumption. The additional amounts related to
inflation and risk are determined by the “market” as appropriate compensation for
additional risks inherent with the desired investment.

Holding period return:

Holding period return: the holding period return or HPR is the return the investor receives
for the period that the investment is held. The calculation is the ending value of the
investment divided by the beginning value of investment. This is an important calculation
that leads to the holding period yield, which provides a percentage benchmark.

Key Formula

HPR = Ending value of investment

Beginning value of investment

Example: What is the holding period return of an investment that has an initial price of
$10 and increases to $13?
Solution: The holding period return is $13/$10 or 1.3. As we’ll see below, the holding
period yield provides a percentage rate of return that can be used to compare different
investments.

Holding Period Yield

The Holding Period Yield (HPY) is the annualized percentage rate return. The HPY takes
the HPR and subtracts 1. An annualized HPY examines the yield earned, on average, for a
period of time. With multiple periods, it is important to recognize the compounding effect,
and consequently, the HPR needs to be adjusted for the number of periods as shown
below.

Key Formula
HPY = HPR - 1

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An annualized HPY, requires an annual HPR

Key Formula

Annual HPR = HPR1/n

Where n = number of years the investment is held

Key Formula
Annual HPY = Annual HPR - 1

Example: What is the HPY for an investment that has a beginning price of $10 and an
ending price of $13.50? Assume that the investment is held for 1 period.

Solution: The HPR is $13.5/$10 or 1.35. Consequently, the HPY equals .35 (1.35 –1) or
35%.

Professor’s Tip:
The distinction between the HPY and the HPR is often mistaken. Candidates should
attempt to recall that the HPR (holding period return is unaffected by the time period,
whereas the HPY (holding period yield) usually corresponds with an annualized yield.
From a practical standpoint, most investors typically focus on the HPY as this provides a
basis for comparison among different investments. The HPR provides an interesting
statistic, but without knowing the relevant time period or other relevant benchmarks it
becomes difficult to gauge whether the HPR was strong or weak relative to historical
return benchmarks.

Arithmetic and Geometric returns:

There are two summary measures of return performance. The first measure, arithmetic
mean is measured as the sum of the annual yields divided by the number of years. This is
a simple averaging of annual year performance that does not take into effect the
compounding nature of the yield performance. It is an unweighted method that is used as a
good forecast of future periods of return. The geometric mean is another measure of
return performance. This measure is computed by taking the nth root of the product of the
HPRs for n years. This method takes into consideration the timing of returns and is
therefore considered a time-weighted method. It is used for evaluating the performance of
money managers. The calculation is simply performed with most pocket calculators by
determining the compounded rate of interest between two periods of time. When rates of
return are the same for all years, the geometric and the arithmetic returns are identical.
However, when the returns vary over time, then the geometric returns will be lower than

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the arithmetic returns. As the volatility increases (i.e. as annual rates of return vary) the
difference between the arithmetic and geometric means also increases.

Example: Determine the arithmetic return and geometric return for the investment below:

Beginning Ending
Year Value Value HPR HPY
1 50 100 2.00 1.00
2 100 50 0.50 -0.50

Solution: The arithmetic return is 25% and the geometric return is 0% shown as:

Arithmetic rate of return = [(1.00) + (-0.50)]/2 = 50/2 = 0.25 = 25%

Geometric return = (2.00 x 0.50)1/2 - 1 = 1.00 - 1 = 0%

Professor’s Tip:
Many candidates often feel compelled to calculate everything, particularly financial rates of
return. However, the example above demonstrates the power of good intuitive knowledge.
Since the investment both began and ended with a value of 50, the alert analyst should
realize that no return has been earned. Consequently, there is no need to perform the
geometric computation. The geometric return (or the cumulative interest on interest
return) must be equal to 0%! Candidates need to be careful to review the answer
selections before using a calculator. Wherein possible, if the answer can be inferred
through logic, the candidate will save valuable seconds on the exam for other, potentially
more complicated problems.

Sometimes the rate of return is based on the dollar-weighted or value weighted method.
The weights used in computing the averages are the relative beginning market values for
each investment. The table below shows the calculations for the dollar-weighted or value-
weighted method. Note: just by scanning the table it should be clear that most of the
weighting (75%) is for investment “C”. Thus, investment “C’s” HPY of 10% should
dominate the overall weighted holding period yield, which is shown in the far right column
(weighted HPY = 9.5%).

Computation of Holding Period Return

Investment Number Beg. Beg. End. Ending HPR HPY Market Weighted
of Shares Price Market Price Market Weight HPY
Value Value
A 100 $10 $1,000 $12 $1,200 1.20 20% 0.05 0.01
B 200 $20 $4,000 $21 $4,200 1.05 5% 0.20 0.01
C 500 $30 $15,000 $33 $16,500 1.10 10% 0.75 0.075

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Total $20,000 $21,900 1.0 .095

HPR = 21,900 = 1.095 HPY = 1.095 - 1 = .095 = 9.5%

20,000

Professor’s Tip:
A multiple choice question with data in a table shown above might take a candidate
considerable time in computing the weighted average HPY. Test takers need to be savvy
in eliminating clearly incorrect choices. This will save valuable time on the exam.
Sometimes, questions with the most data require the fewest number of computations. By
understanding the primary drivers of the weighted HPY, candidates might be able to
answer this type of question solely through a cursory review of the table.

Risk
This topic is introduced in both the Quantitative Methods section as well as Portfolio
Management. Generally the concept of risk references the dispersion of expected returns
around a point estimate. The statistical measures of risk (uncertainty) that measure the
dispersion of possible returns are the variance and the square root of the variance or
standard deviation. As the variance of returns increases, the dispersion of expected
returns also increases along with greater uncertainty or risk of the investment. In a world
of perfect certainty, there is no variance of return and therefore no risk or uncertainty. In
situations where there are major differences in the expected rates of return, it is possible to
use a relative variability to indicate risk per unit of return. This relative measure of risk is
known as the coefficient of variation.

For example, suppose an investor has two investments A and B in which the standard
deviation is .10 for “A” and .15 for “B”. In the absence of any additional information the
investor would say that investment “B” is riskier owing to the higher standard deviation.
But what if the expected rate of return for “A” is .05 and the expected rate of return for
“B” is .50? With this information, even the worst-case scenario for “B” is likely to be
better than “A”. Notice that even two standard deviations to the left of the expected
return for “B” will still provide an expected return of .20 or 20% (.50 – 2*.15 = .2). Since
the expected return of “A” is only .05 or 5%, it is highly probable that “B” will almost
certainly be better than “A”.

Investment A Investment B

Standard deviation (σ) σA = .10 σB = .15

Expected return E(R) .05 .50

E(R A) E(R B)
-.05 0 .05 .1 .15 .2 .25 .3 .35 .4 .45 .5

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Expected Return

Coefficient of variation: The coefficient of variation puts this relationship of standard

deviation and expected return in perspective.

The computation is:

Coefficient of Variation (CV) = Standard Deviation of Returns
Expected Rate of Return

In this calculation, investors prefer a relatively low standard deviation of returns

(numerator) and a relatively high-expected rate of return (denominator). Overall, investors
seek a relatively low number. A small coefficient of variation suggests that the investor is
receiving relatively little risk, given the expected rate of return. In the example above, the
coefficients of variation for “A” and “B” are 2 and .3, demonstrating that investment “B”
provides a superior trade-off.

Investment A Investment B
Standard deviation (σ) σA = .10 σB = .15
Expected return E(R) .05 .50
Coefficient of Variation 2.0 .30

Professor’s Tip:
The coefficient of variation computation frequently appears on the examination.
Unfortunately, many students often confuse the numerator with the denominator, thus
inverting the correct solution. Moreover, complicating matters, AIMR may incorporate a
false computation corresponding with the incorrect formula (i.e. showing expected return
in numerator, etc.). Thus, candidates may think they are getting the answer correct when
in fact they are getting it wrong. Participants should try to visualize the distribution of
returns above the X axis. This visualization might make it easier to remember that the
standard deviation (σ) stands above the X axis (rate of return) and provide a handy
reference for memorizing this key formula.

Explain the risk premium and the associated fundamental sources of uncertainty

• Determinants of required rate of return: As the expected or promised yield on an

investment increases, the expected level of risk also increases. The required rate of
return is equal to the rate of return on a safe or risk-free asset plus an amount to
compensate for the risk of the investment (risk premium)

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• The nominal rate of interest is equal to the risk-free rate of interest plus the expected
rate of inflation.
• Nominal risk free rate = (1+ real risk free rate)(1 + expected rate of inflation) -1
• The risk premium is a function of various types of risk including:
• Business risk: the uncertainty of income flows caused by the nature of a firm’s business
• Financial risk: uncertainty introduced by the method in which the firm finances its
investments
• Liquidity risk: uncertainty introduced by the secondary market for an investment
• Exchange rate risk: uncertainty of returns to an investor who acquires securities in a
currency different from his or her own.
• Country risk: this is also referred to as political risk and is the uncertainty caused by a
major change in the political or economic environment of a country
• Risk premium = f (business risk, financial risk, liquidity risk, exchange risk, country risk)
• Systematic risk: also known as the undiversifiable risk, is the risk that measures how an
individual asset moves with the market
• Unsystematic risk: also known as the diversifiable risk, this is the firm specific risk that
can be eliminated in a large, diversified portfolio
• Security market line: this line shows the expected relationship between risk and return.
As perceived risk increases, investors demand more return. As investor’s attitudes
towards risk changes, the slope of the line changes (a greater slope indicates that
investors demand more return for a given unit of risk and vice versa).

Discuss the security market line and illustrate the relationship between risk and return

The security market line (SML) illustrates the relationship between risk and return. The Y
axis (vertical line) begins with the risk-free rate and moves upward as the level of risk
increases. The short-term Treasury Bill is typically used as the risk-free rate, though the
maturity may vary with application (e.g. sometimes a long-term Treasury Bond is used to
correspond with a long-term risk comparison). On the X axis, systematic risk or Beta is
used as a proxy for risk. As an individual asset or asset increases in risk (relative to the
market) than the systematic risk (beta) is presumed to increase along with an associated
increase in expected rate of return. Securities, which are efficiently priced, should fall
directly on the SML line. Those securities that are underpriced are providing more return
than appropriate for the level of risk and will appear above the SML line. Securities that are
overpriced will provide too little return for the associated risk level and will fall below the
SML line.

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RELATIONSHIP BETWEEN RISK AND RETURN

Expected Return Security Market Line

(SML)
Low Average High
Risk Risk Risk

The slope indicates the

required return per unit
NRFR of risk

Risk
(business risk, etc or systematic risk beta)

Professor’s Tip:
The Security Market Line and issues pertaining to this line become critical areas for all
three levels of the CFA examination. This first glimpse into the relationship between risk
and return only provides some basic parameters. AIMR frequently asks questions
pertaining to the slope of the line (i.e. greater the slope the more risk averse the investor),
investments above or below the line (i.e. investments below the line provide less return
than is demanded by the investor) as well as issues related to the risk-return measures
themselves (i.e. is the Security Market Line/Beta the appropriate measure to use?). This
topic is well known and predictable to candidates, but there are plenty of nuances that
make this topic particularly tricky. For example, the risk measure computation (shown
later as Beta) can be provided to candidates or may be calculated from data inputs
(covariance and correlation). The calculations may not be difficult, but to some candidates
these relationships have an intimidating appearance (i.e. Greek symbols based on
mathematical derivations) and may be prone to error or misapplication.

Explain why the slope of the security market line changes over time

If the marketplace becomes more risk averse then the investors will demand more return
for a given level of risk. In these cases the slope of the SML line will increase (shown in
first figure below). If the risk-free rate increases, but the risk aversion does not change,

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then the slope remains the same but the SML line shifts upward. This is shown below in
the second graph. The slope of the line illustrates the required return per unit of risk. It is
constant across the line.

The risk premium for asset j can be illustrated by the following equation:

Key Formula

RPj = E(Rj ) – NRFR

Where:
RPj = the risk premium for asset j
E(Rj) = the expected return for asset j
NRFR = the nominal return on a risk-free asset

Movements along the SML represent changes in the risk of the asset. As investors move
further to the right, the relative business risk or systematic risk is presumed to increase. In
association with this increasing level of risk, the expected return is also expected to
increase. Thus, there is a clear risk-return relationship. As risk increases (movements to
the right) the presumed return level rises in accordance with this higher risk. Otherwise,
no rational investor would pursue the higher risk investment. The situation below
demonstrates a perception in risk level.

CHANGE IN MARKET RISK PREMIUM

Expected Return New SML Original SML

1
Rm

Rm

NRFR

Risk

The graph above demonstrates in increased risk premium in the new SML curve. The new
SML has a greater slope implying a higher risk premium demanded for each unit of risk.
The market risk premium is not constant over time. The yield demanded for differing
levels of risk changes depending upon market conditions. In the situation above, investors
have become more risk averse, implying that they demand more return to compensate for
higher levels of risk. This might happen during poor economic conditions such as a
recession or during periods of economic unrest (i.e. war between nations or civil war). If
the new SML shifted to the right of the original SML it would have a smaller slope and

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indicate that investors are becoming less risk averse. A shift to the right implies that
investors require less return to compensate for higher expected levels of risk. Such a shift
might occur during economic expansion.

The curve below shows a parallel shift upward in the SML curve. This could be a result of:
a) an increase in expected real growth in the economy, b) temporary tightness in the capital
markets, or c) an increase in the expected rate of inflation. These changes in capital
market conditions or expected inflation will affect all investments, irrespective of their
levels of risk.

CAPITAL MARKET CONDITIONS, EXPECTED INFLATION, AND THE

SECURITY MARKET LINE

Expected Return New SML

Original SML

NRFR1

NRFR

Risk

Professor’s Tip:
Candidates should be very familiar with the relationships of the SML curve and
implications associated with changes in slope. At Level I AIMR normally expects that
candidates are familiar with the tools and assumptions inherent in the models. The also
expect candidates to be familiar with the basic relationships in the various formulae and be
able to compute and/or derive one variable from another, related formula or associated
equation. At higher levels (i.e. Levels II and III) AIMR may expect candidates to be able to
critique some of the assumptions inherent in the models and be able to apply to an
investor’s portfolio or staged situation. This material and other material in this study
session provide a base knowledge that carries through all three levels of the AIMR
examination.

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-
Problems: Investment Setting

1. Swapna Rao purchased a security yielding 14%. She believes her security ought to
provide at least a 5% premium over the risk free rate, and that she should receive at
least 4% return to compensate for delayed consumption. To what factor can she
attribute the remaining 5% of the yield?
A. Industry risk
B. Inflation
C. Firm-specific risk
D. Market risk

2. Compute the holding period return (HPR) for Enran Industries shown below.

Beginning Value of Ending Value of

Company Investment Investment
Enran 400 580
Lupenny 300 10

A. 45%
B. $580
C. $180
D. 1.45

3. What is the annual holding period yield (HPY) for the ByeBye Corp. shown below?

Beginning Value of Ending Value of

Company Investment Investment
Sunrise 200 550
ByeBye 200 3

A. -$197
B. –96.7%
C. 1.50%
D. -98.5%

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4. What is the annualized geometric mean return for the three-year cash flows shown
below?

Beg. Value End. Value

Year of Inv. of Inv. HPR HPY
1 $200 $250 1.250 25.00%
2 $250 $400 1.600 60.00%
3 $400 $650 1.625 62.50%

A. 26.40%
B. 62.50%
C. 48.12%
D. 49.17%

5. What is the annualized arithmetic mean return for the three-year cash flows shown
below?

Beg. Value of End. Value of

Year Inv. Inv. HPR HPY
1 $300 $250 0.833 -16.67%
2 $250 $400 1.600 60.00%
3 $400 $300 0.750 -25.00%

A. 18.33%
B. 6.11%
C. -25.00%
D. 0.00%

6. Which of the following items is not considered a fundamental risk component

normally associated with the risk premium of a security?
A. Business risk
B. Obsolescence risk
C. Marketability risk
D. Exchange rate risk

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7. What is the weighted average holding period yield for the portfolio shown below?

Invest # of Beg. Beg. Ending Ending HPR HPY Mkt

Shares Price Market Price Market Weight
Value Value
A 100 $30 $3,000 $36 $3,600 1.2 20% 0.060
B 200 $60 $12,000 $63 $12,600 1.05 5% 0.240
C 500 $70 $35,000 $77 $38,500 1.1 10.0% 0.700

A. 9.40%
B. 10.00%
C. 11.66%
D. 12.53%

8. Given the table below, what is the expected rate of return?

Expected Market Probability Rate of Return

Conditions
Strong Economy 20% 18%
Average Economy 50% 10%
Weak Economy 30% -10%

A. 4.5%
B. 5.6%
C. 7.7%
D. 8.3%

9. What is the real risk-free rate of return for a security assuming the nominal risk-free
rate of return is 14.0% and the rate of inflation is 10%?
A. 5.6%
B. 4.4%
C. 4.0%
D. 3.6%

10. Which of the following statements regarding the security market line is incorrect?
A. The slope of the line represents the required return per unit of risk and is
constant along the line.
B. An increasing slope suggests that investors prefer more risk and are willing
to accept a lower rate of return.
C. A shift in the security market line up represents a change in market
conditions and may represent an increase in the expected rate of inflation

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D. Movements along the SML illustrate a change in the risk characteristics of a

specific investment, such as a change in business risk financial risk or
systematic beta.

11. What is the coefficient of variation for an investment that has an expected rate of
return of .6, a standard deviation of returns of .2, a variance of returns of .04 and a
kurtosis of .7?
A. 0.60
B. 1.80
C. 1.67
D. 0.15

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Answers: Investment Setting

1. B. The investor’s required rate of return (RRR) is a function of three components:

RRR = Time value of money + Inflation rate + Risk premium. Since in this case
both the time value of money and risk premium are provided, the inflation rate
must equal the difference.

TestNet Note:: According to TestNet, our online exam database, approximately 58% of
all test takers answered this question incorrectly. This seemingly simple question can be
deadly. Remember, difficult questions do not necessarily need to have many computations
and complex formulae. Sometimes a complex question has subtle twists to several answers
each appearing to be correct.

2. D. The HPR or holding period return is determined by taking the ending value of
investment divided by the beginning value of the investment. It is NOT a
percentage term or rate. It is not a dollar amount. In order to compute an annual
percentage, the investor needs to first compute an annual HPR and then convert it
to an annual holding period yield (HPY). The HPY equals the HPR minus 1. In
this particular case the HPR for Enran Industries is: HPR = $580/$400 = 1.45.
The HPY equals 45% (1.45 –1 = .45 or 45%). The dollar amount of return is $180
($580 -$400)/

Beginning Value of Ending Value of Holding Period Holding Period

Company Investment Investment Return Yield
Enran 400 580 1.450 45.00%
Lupenny 300 10 0.033 -96.67%

TestNet Update:: According to TestNet, our online exam database, approximately 25%
of all test takers get this simple computation wrong. Be very careful to distinguish between
HPR and HPY. Level I candidates that answer this question incorrectly will be at a
comparative disadvantage relative to the majority of participants. In our database, this is an
“infinite series question” in which the numbers and corresponding answers change each
time.

3. D. The annual holding period yield or HPY equals the HPR minus 1. In this case
the ByeBye Corp stock price has dropped from $200 to $3. The HPR, which is
determined by taking the future value divided by the initial value, equals 3/200 or
.015. Subtracting 1 from .015 equals –98.5%. Hence, the annual HPY for this
stock is –98.5%. The HPR and HPY computations are often mistaken for each
other. Candidates need to be careful to compute a return for HPY and not mistake
a trap answer (i.e. HPR or dollar amount return) for the appropriate selection.

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Beginning Value of Ending Value of Holding Period Holding

Company Investment Investment Return Period Yield
Sunrise 200 550 2.750 175.00%
ByeBye 200 3 0.015 -98.50%

TestNet Update:: In our online database, this is an “infinite series question” in which the
numbers and corresponding answers change each time.

4. C. The geometric rate of return can be computed several ways. Perhaps the easiest
approach is to use the calculator and solve for “i”. The “i” computes the
compounded growth rate which is the same as the geometric mean. Thus, in this
situation the computation follows (using an HP 12C):

N = 3
PV = -200
FV = 650
Solve for “i” = 48.12%

Another approach is to take the third root of the HPR. This equals 650/200 =
3.25 1/3. Taking the third root of 3.25 equals 1.4812 – 1 = 48.12%. Finally, each
HPR can be multiplied by the prior year with the sum taken to the 1/nth power.
Thus, GM = [(1.25)*(1.60)*(1.625)]1/3 = 3.25 1/3 = 1.4812. Subtracting 1 provides
a geometric mean return of 48.12%. Please note: adding up all of the annual HPYs
and dividing by 3 determined the first answer choice of 49.17%. This does not
provide the geometric rate of return, but rather, the arithmetic rate of return. The
arithmetic rate of return provides a simple average, whereas the geometric rate of
return provides a solution with compounded interest (i.e. interest on interest).

Beg. Value End. Value Arithmetic Geometric

Year of Inv. of Inv. HPR HPY Return Return
1 $200 $250 1.250 25.00% 25.00% 25.00%
2 $250 $400 1.600 60.00% 42.50% 41.42%
3 $400 $650 1.625 62.50% 49.17% 48.12%

TestNet Update:: According to TestNet, our online exam database, approximately 21%
of all test takers get this simple computation wrong. Be very careful to distinguish between
Arithmetic and Geometric returns. These questions frequently appear on the Level I exam.
Level I candidates that answer this question incorrectly will be at a comparative
disadvantage relative to the majority of participants. In our database, this is an “infinite
series question” in which the numbers and corresponding answers change each time.

5. B. The arithmetic return is equal to the average annual return for the time period.
This simple average equals the summation of [(-16.67%) + (60.0%) + (-25.0%)]/3
= 18.333%/3 or 6.11%. Please note that the arithmetic return does not include
the interest on interest (compounded interest) found in the geometric return. In
this situation, the geometric return is easy to determine without a calculator. The

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investment begins at $300 and ends at $300 three years later. The geometric return
is equal to 0.00% since no money was made or lost!

Beg. Value End. Value Arithmetic Geometric

Year of Inv. of Inv. HPR HPY Return Return
1 $300 $250 0.833 -16.67% -16.67% -16.67%
2 $250 $400 1.600 60.00% 21.67% 15.47%
3 $400 $300 0.750 -25.00% 6.11% 0.00%

TestNet Update:: According to TestNet, our online exam database, approximately 20%
of all test takers get this simple computation wrong. Be very careful to distinguish between
Arithmetic and Geometric returns. These questions frequently appear on the Level I exam.
Level I candidates that answer this question incorrectly will be at a comparative
disadvantage relative to the majority of participants. In our database, this is an “infinite
series question” in which the numbers and corresponding answers change each time.

6. B. The risk premium is normally associated with business risk, financial risk,
liquidity risk, exchange rate risk and country risk. Sometimes there are other terms
used or substituted from the list above. For example, marketability risk is used
interchangeably with liquidity risk and political risk or sovereign risk are terms
often used in lieu of country risk. Although obsolescence risk may be a non-trivial
matter within many industries, it is most likely categorized within the business risk
component and not distinguished as a separate risk component within the risk
premium of a security.

7. A. The portfolio weighted average return equals 9.40%. The weighted average
examines each investment based on the return earned for that security relative to
it’s respective weight to the portfolio. Consequently, investment “A” has the
highest holding period return of 20% but also has the lowest relative market weight
(.060). Investment “C” has the largest weighting (.70) and a return that is between
A & B. The weighted holding period yield can be determined by dividing the
ending market value ($54,700) by the beginning market value ($50,000) and
subtracting 1. This equals .0940 or 9.40%. Alternatively, each HPY can be
multiplied by its respective market weight to give a “weighted HPY”. Adding each
investment’s weighted HPY also provides the overall weighted HPY of 9.40%.
Finally, the astute candidate will notice that most of the answer options for this
question are all above or near “10%” (e.g. 10.00%. 11.66% or 12.53%). Since
investment “C” is at 10% and since investment “B” provides the second highest
weighting (.24) and offers a meager 5% yield, the overall weighted HPY must be
below 10%. Another way of looking at this question would be to recognize that
Portfolio “A” is exactly ¼ (i.e. 25%) of Portfolio “B”. Thus, “A” & “B” will
provide the same weighted HPY into the portfolio return. Upon reflection of this
coincidence (actually we set this up intentionally to show how to answer this
intuitively) “A” and “B” contribute 1.2% each for a combined 30% weighting (i.e.
.06 + .24 weight = .30 or 30% weighting). Since the average return for both “A”
and “B” equals 8% (i.e. 2.4% return divided by 30% weight) the combination of
“A” and “B” must reduce the portfolio average below “C’s” 10% return. Only

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answer “A” at 9.40% satisfies these conditions. Thus, a clever candidate should be
able to answer this question without the use of a calculator! (Note: There are other
intuitive approaches to take on this question for which we only provide one of
them).

Invest # of Beg. Beg. Ending Ending HPR HPY Mkt Weighted

Shares Price Market Price Market Weight HPY
Value Value
A 100 $30 $3,000 $36 $3,600 1.2 20% 0.060 1.20%
B 200 $60 $12,000 $63 $12,600 1.05 5% 0.240 1.20%
C 500 $70 $35,000 $77 $38,500 1.1 10.0% 0.700 7.00%
Total 800 $50,000 $54,700 1.00 9.40%

TestNet Update:: According to TestNet, our online exam database, approximately 15%
of all test takers get this simple computation wrong and approximately another 10% choose
to not even attempt this question. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

8. B. This is a relatively straightforward computation that frequently appears on the

AIMR exam. The expected return is a weighted average of each state of the
economy multiplied by the expected rate of return. The expanded computation
appears as:

E(Ri) = [(0.20)*(.18) + (0.50)*(.10) + (0.30)*(-.10)] = .036 + .05 - .03 = .056 =

5.6%

Expected Market Probability Rate of Return Expected Return

Conditions
Strong Economy 20% 18% 3.6%
Average Economy 50% 10% 5.0%
Weak Economy 30% -10% -3.0%
Total 100% 5.6%

TestNet Update:: According to TestNet, our online exam database, more than 90% of all
test takers get this simple computation correct. Consequently, those individuals that make
a silly error and get this wrong will be in a distinct minority. In our database, this is an
“infinite series question” in which the numbers and corresponding answers change each
time.

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9. D. The real risk-free rate of return (RRFR) =

RRFR = [(1+ Nominal Risk-Free Rate of Return)] - 1
(1 + Rate of Inflation)

RRFR = [((1 + .14)/(1 + .10)) – 1] = .036 = 3.6%

Nominal Risk-Free Rate Inflation Rate Real Risk Free Rate

14.0% 10.0% 3.6%

Note: the real risk-free rate is not equal to 14.0% less 10% (e.g. 4.0%) since the
nominal rate has inflation included as well as the influence of inflation on the real
risk free rate. Thus, the real-risk free rate must be less than the absolute difference
(i.e. must be less than 4.0%). The astute candidate will recognize that the only
available solution less than 4.0% is answer “D” (3.6%). Thus, this problem can be
solved without the use of a calculator!

TestNet Update:: Did you get this question wrong? If so, you are in large company.
According to TestNet, our online exam database, only 30% of all test takers get this
computation correct. Approximately 2/3 of all test takers forget to compute the effect of
inflation on the real risk-free rate. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

10. B. Increasing the slope of the line (i.e. a steeper slope which would be a shift up
and to the left) suggests that investors are becoming increasingly risk averse and
demand more return for the same level of risk. Likewise, a flatter curve (i.e. shift
down to the right) suggests that investors are becoming more aggressive and do not
demand the same premium of return for increasing levels of risk. A steeper slope
may occur during a recession in which investors will pursue a “flight to quality”.
This means that they will abandon risky securities and move into safer securities.
Riskier securities will therefore have to offer a higher implied yield to attract
investors. An increasing slope represents this higher level of risk.

11. A. The coefficient of variation is determined by dividing the standard deviation of

returns by the expected rate of return. Since the standard deviation is .3 and the
expected rate of return is .5, the coefficient of variation is 0.60. Do not be fooled
into using extraneous information. AIMR frequently provides extra information to
trap unwary candidates. The kurtosis (fourth movement around the mean) and the
variance are not necessary to answer this question. Moreover, answer “C” at 1.67
was designed to catch candidates who put the expected return above the standard
deviation. Remember this formula and remember that investors prefer a small
coefficient of variation rather than a large number. This will help with the
placement of the numbers in the numerator and denominator.

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TestNet Update:: According to TestNet, our online exam database, approximately 80%
of all test takers get this computation correct. In our database, this is an “infinite series
question” in which the numbers and corresponding answers change each time.

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“The Asset Allocation Decision”

Reilly, Chapter 2

Overview: This chapter deals with individual and institutional investor objectives and
constraints. The concept of asset allocation is discussed in the context of an overall
portfolio management process. Investor objectives are usually categorized in the context
of return requirements and risk tolerance, whereas the constraints focus on limitations of:
liquidity, time horizon, taxes, legal/regulatory considerations and unique circumstances.

• Individuals versus institutions: Individual investors differ from institutional

investors in the following manner:
• Individuals define risk as “losing money”, while institutions view risk as variance
(or standard deviation) of returns.
• Individuals are categorized according to their personalities and unique
circumstances, whereas institutions are categorized by the investment
characteristics of those that have a beneficial interest in the portfolios of pension
funds, endowment funds, banks, insurance companies and mutual funds.
• Individuals are defined financially by their assets and goals (particularly as they
related to their life cycle), while institutions are typically concentrated within
precise asset and liability parameters.
• Individuals have great flexibility in selecting their investments, whereas institutions
are managed and regulated by ERISA (Employee Retirement Income Security Act)
as well as other legal constraints.
• Individuals are subject to income and estate taxes, whereas institutions generally
invest without concern of taxation issues.

Pre-Investment Needs: Prior to starting an investment plan, an individual should ensure

that sufficient income exists to cover living expenses and provide an adequate safety net
for unexpected circumstances. Moreover, a comprehensive life insurance package should
protect survivors from the additional hardship associated with the loss of any necessary
earnings. Life insurance generally takes the basic form of term or universal. Term
insurance provides only a death benefit and must be renewed each period. While it is the
least expensive form of insurance in the early years, the premium does increase as the
insured ages. Universal and variable insurance policies provide both a death benefit as well
as a savings plan. The annual premium exceeds the cost of the death benefit with the
excess going towards the accumulated savings position.

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Identify the various phases of wealth accumulation and describe the investment objectives
investors usually pursue in each phase (i.e. the investor life cycle).

Life Cycle View: Individual investors experience four distinct phases of how they
view their wealth: 1) Accumulation phase, 2) Consolidation phase, 3) Spending
phase, and 4) Gifting phase.

Life Cycle View

B A
Consolidation Accumulation
Return (mid career) (early career)

C
Spending Stage
Gifting Stage

Risk

• Accumulation phase: In the Accumulation or early career stage (“A”), net worth is
typically small relative to liabilities, with home equity forming the largest asset.
Individuals have a long time horizon with a potentially growing stream of discretionary
income and can undertake a high-return, high-risk capital gain-oriented investment.

• Consolidation phase: During the Consolidation or mid-to-late career phase (“B”),

income is larger than expenses, and the investor is able to accumulate an investment
portfolio. The time horizon to retirement is still 10 to 20 years away so the investor is
attempting to preserve part of the capital while also pursuing some risky investments.
Investors in this phase will pursue a portfolio of capital gain investments that are also
balanced with lower-risk assets.

• Spending phase: This phase (“C”) is characterized by the period in which the
individual is financially independent and living expenses are paid from accumulated
investments and retirement programs, not earned income. Since the investor depends
on personal investments in this phase, the focus is on assets with secure values and
emphasis on dividend, interest and rental income.

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• Gifting phase: This is the final life cycle stage (“C”) in which the individual realizes
that he has more assets than he will ever need for personal spending and personal
security. While the risk/return preference does not change from the previous stage, the
attitudes about the purpose of investments do change. Investments are seen as having
the potential to influence the change for the individual, to support a charitable cause or
to foster the growth of high-risk new businesses.

• Rise and fall of personal net worth: The graph below shows how the accumulation
phase begins at an early age, whereas the spending and gifting phases occur much later
in life. The risk orientation of the investor corresponds in an inverse relationship to the
investor’s net worth. Consequently, as the investor approaches retirement (spending
and gifting phases) he/she typically becomes more cautious with investment return
requirements and assumption of risk.

RISE AND FALL OF PERSONAL NET WORTH OVER A LIFETIME

Net Worth

Accumulation phase Consolidation phase Spending phase

Long term: Long term: Gifting phase
retirement retirement Long term:
children's college estate planning
needs Short term:
vacation Short term:
Short term: children's college lifestyle needs
house needs gifts
car

25 35 45 55 65 75
Age

Types of Goals: Investors have several different goals, such as near-term high priority
goals to meet new home or educational expenses, or long-term high priority goals, such as
financial independence. Finally, investors may also have lower priority goals such as
immediate luxury purchases or entertainment of the investment process.

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Discuss the inputs to the policy statement, including the process of identifying goals,
constraints, and objectives of individual investors.

The exhibit shown below demonstrates the basic portfolio management process.

THE PORTFOLIO MANAGEMENT PROCESS

1 Policy Statement
Focus: Investor's short-term and long-
term needs, familiarity with capital
market history, and expectations.

2 Examine current and projected financial

economic, political, and social conditions
Focus: Short-term and intermediate-term
expected conditions to use in
constructing a specific portfolio

3 Implement the plan by constructing the

portfolio.
Focus: Meet the investor's needs at
minimum risk levels

4 Feedback Loop: Monitor and update

investor needs, environmental
conditions, evaluate portfolio performance

Portfolio Management Process: The first step is to develop a policy statement. The
statement covers the types of risks the investor is willing to assume along with the
investment goals and constraints. Periodically the investor will need to review, update and
change the policy statement, but this is incorporated in the “Feedback loop” discussed
below.

Portfolio Management Process

1. Policy Statement: Focus on short-and-long-term needs, familiarity with capital market history, and
investor expectations and constraints. The policy statement is primarily the responsibility of the
investor. Investors articulate their realistic needs and goals and familiarize themselves with financial
markets and investing risks. The portfolio manager takes the policy statement and then constructs a
portfolio that satisfies the client’s needs.

2. Examine current and projected financial, economic and political conditions. Focus on short-and-long
term expected conditions in constructing the specific portfolio.

3. Construct the portfolio: Focus on meeting the investor’s needs at minimum risk levels.

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4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance.

Policy Statement—The policy statement should address the following issues:

• What are the risks of an adverse financial outcome?

• What are the emotional reactions to an adverse financial outcome?
• How knowledgeable is the investor to investments and markets?
• What other capital or income sources does the investor have? How
important is the portfolio to the overall financial position?
• What legal restrictions may affect the investment needs?
• What unanticipated consequences of interim fluctuations in portfolio value
may affect investment policy?

Moreover the policy statement should attempt to answer the following questions:

• Does the policy statement meet the specific needs and objectives of this
investor?
• Does the policy statement enable a competent stranger to manage the
portfolio in compliance with the client’s needs?
• Does the client understand the investment risks and the need for a
disciplined approach to the investment process?
• Does the portfolio manager have the discipline and flexibility to maintain
the policy during an adverse market?
• Does the policy statement, if implemented, meet the client’s needs and
objectives?

Portfolio Performance Standard: The portfolio should be compared to guidelines

specified in the policy statement rather than judged on the portfolio’s overall return. In
particular, the policy statement should specify a benchmark portfolio as an appropriate
comparison standard. The risks of the benchmark and the assets included in the
benchmark should be similar to the risks and assets of the investor’s portfolio.

Determination of Portfolio Policies: Portfolio policies typically follow under the

headings of income, income and growth, growth and aggressive growth. The policy
decisions that need to be evaluated in a multi-asset, total return approach includes: asset
selection (composition of debt and equity), flexibility in the asset mix, specific security
selection, and tradeoffs regarding withdrawals and reinvestment. Clearly, asset allocation is
the most influential criterion in determining the overall portfolio return. Depending on the investor’s
mix of asset classes, flexibility and individual issue selection, the investor might weigh cash
and bonds more heavily or move towards stocks and foreign investments. Generally, the
investment allocation depends on the primary goal (which for most investors is financial
independence at retirement), and the psychological profile (described earlier).

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Professor’s Tip:
Candidates’ at all three levels should realize that asset allocation is one of the most
important determinants in achieving an overall portfolio return. Lots of issues pertain to
increasing or decreasing risk, or attempting to improve the portfolio return, but again, the
portfolio allocation and decisions surrounding the composition of the portfolio, are among
the most critical. This material provides a base knowledge that carries through all three
levels of the AIMR examination.

Compare the investment objectives, constraints, and policies of institutional investors, such
as pension funds, endowment funds, insurance companies, and banks

Investment Objectives: Before investing, the client should clearly identify the overall
risk and return objectives. The client needs to weigh all risks including the possibility of
loss, prior to any discussion of return objectives. After the investor has disclosed her risk
tolerance, the portfolio manager can assist with the appropriate asset allocation. The risk
tolerance includes factors associated with the investor’s life cycle, but also psychological
factors, capacity to earn income and existing wealth. Return objectives follow such stated
goals as follows:

Capital preservation—minimize risk of loss, used for risk-averse investors

Capital appreciation—growth in capital, aggressive strategy for investors willing and able to
assume risk

Current income—focus on income (fixed income) versus capital gains, more appropriate for
older investors that may depend on income for living expenses

Total return—focus on return through both capital appreciation and fixed income, this
approach is a hybrid of returns and risk of the other approaches

Investment Constraints:
The constraints vary by the following criteria:
• Liquidity of assets - Liquidity addresses the ability to convert to cash in a short
time period, at fair market value. Individuals may desire liquidity to meet
emergency cash needs. Generally, individuals should hold two to three months’
spending money depending on the volatility of the individual’s source of income.
Holding liquid reserves also enable investment flexibility. Liquid assets allow an
investor to take advantage of unique investment opportunities.

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• Time horizon - this addresses the expected holding period of the investor.
Depending on the investor’s investment goals, liquidity needs and risk tolerance,
the time horizon will vary greatly.
• Legal and Regulatory Factors - Individual investors are generally not affected by
regulations, but professional and institutional investors need to be aware of
regulations.
• Tax considerations - High net worth individuals as well as certain non-taxed
funds (such as pensions) are very sensitive to tax issues. The investor tends to
focus on the net after tax return as a final determinant of success. Income taxes
which require lump sum payments, need to be set aside. Investors should attempt
to defer taxes as long as legally possible. Unrealized capital gains grow much faster
than realized capital gains since the investor receives benefit associated with the
appreciation of the deferred tax payment. Estate transfer taxes require lump sum
tax payments and need to be paid out of liquid reserves.
• Unique needs and Preferences - There may be a number of unusual
considerations that affects the investor’s risk-return profile. For example,
investment requirements may depend on goal spending. Thus, individuals will
require adequate funds to be set aside to meet known spending demands.
Moreover, many investors may want to exclude certain investments from the
portfolio based on personal preferences. For example, investors may specify that
no investments in their portfolio be affiliated with the manufacture or distribution
of alcohol, pornography, tobacco or environmental harmful products.

Professor’s Tip:
This section regarding the investment objectives and constraints are critical in setting
portfolio parameters. At Level I, candidates simply need to know the basic parameters
regarding Portfolio Management objectives/constraints. At Levels II and III (particularly
Level III) candidates need to be able to apply these objectives and constraints to specific
situations. This section is extremely important material (overall) as it sets a base level
knowledge for CFA charterholders as they build and monitor client portfolios.

Income Tax Considerations: While tax law changes frequently, the investment manager
should maintain three basic tenets as they relate to taxation: 1) defer taxes, 2) avoid taxes,
or 3) have a taxable item treated at a favorable rate. Investors need to weigh tradeoff
regarding the sale of low cost basis stocks (with high concentration due to appreciation),
tax-free investments, year-end tax planning, and retirement plans (such as 401-k plans).
When investors consider municipal or tax-free investments, they need to balance the after-
tax return from a taxable security relative to the tax-free rate of return. Comparing the
taxable return with the municipal rate divided by (1-tax rate), gives a simple, but accurate
benchmark to judge a taxable with a tax-free investment.

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Key Formula
Equivalent Taxable Yield = Municipal Yield
1 – Marginal tax Rate

Example: Suppose an investor in the 40% marginal tax bracket has an opportunity to
purchase a municipal bond with a 7% yield. What is the equivalent taxable yield that will
make the investor indifferent between a municipal bond and the taxable bond?

Solution: This question can be easily solved by dividing the municipal bond yield by (1-
tax rate). Since the tax rate equals 40%, the solution becomes: .07/(1-.4) = .07/.6 =
.1166 or 11.66%.

Municipal Bond Equivalent Taxable

Tax Rate Yield Bond Yield
40% 7.00% 11.67%

Professor’s Tip:
This simple section frequently appears on AIMR examinations. Candidates need to be
careful to understand the computation both ways. For example in the question above, the
request desires the equivalent taxable bond yield. Frequently, AIMR will provide the
taxable bond yield and request the municipal bond yield equivalence. In this particular
situation, if AIMR provided a taxable bond yield of 11.67% and an investor with a 40%
marginal tax rate, the equivalent municipal bond yield would be 7%. In this situation, the
candidate simply multiplies the taxable bond yield by (1-tax rate). Or, 11.67% * (1-.4) =
7%. Note: in one case the candidate needs to divide by (1 – tax rate) and in the other case
the candidate needs to multiply by (1 – tax rate). This is a simple formula in which some
candidates often confuse. We recommend that candidates think through the logic of the
equation. If a bond is “taxable” the net return equals the amount after tax. Consequently,
the 11.67% taxable yield provides a net return (i.e. amount after tax) of 7% since 4%
(11.67 * 40% = 4%) needs to be paid in taxes. Again, this is not very complex material,
but a section in which many candidates make “silly” errors either due to sloppiness or due
to a quick read of solutions which provide computations associated with incorrect
approaches.

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Tax Deferral Plans

Whenever possible, investors are encouraged to use tax-deferral retirement plans such as
IRAs, KEOGHs, SRAs, etc. that enable individuals to accumulate funds on a pre-tax
basis. Contributions to these retirement plans are made with non-taxed dollars. This single
feature is one of the best vehicles and incentives for encouraging individuals to commit to
long-term planning. It also enables individuals to reduce an existing tax burden. Investors
should be sensitive to permanent contributions as the penalty for early withdrawal may
more than offset the immediate tax benefits using pretax contributions.

Discuss the importance of asset allocation in determining overall investment performance.

Historical data demonstrates the importance of the asset allocation decision and the
investment policy statement process. The exhibit below illustrates how over an extended
period of time (1926—1998) common stocks clearly outperformed investments in L-T
bonds, Treasury Bills or Municipal bonds on an after-tax basis. The investment strategy
should consider four basic criteria:
1. Which asset classes should be included in the portfolio?
2. What weights should be allocated to each asset class?
3. What allocation ranges should be allowed for each asset class?
4. What specific securities should be selected for each asset class?

THE EFFECT OF TAXES AND INFLATION ON INVESTMENT RETURNS,

1926-1998
Before
Compound Annual Returns: Taxes and After After Taxes
1926-1998 Inflation taxes and Inflation
Common Stocks 11.0% 8.1% 4.9%
Long-Term Govt. Bonds 5.2% 3.6% 0.4%
Treasury Bills 3.8% 2.7% -0.5%
Municipal Bonds (est.) 6.0% 6.0% 2.9%

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0.12

0.1

0.08

0.06

0.04

0.02

0
Before Taxes and Inflation After taxes After Taxes and Inflation
-0.02

Common Stocks Long-Term Govt. Bonds

Treasury Bills Municipal Bonds (est.)

Discuss the inputs to the policy statement, including the process of identifying goals,
constraints, and objectives of individual investors.

Optimal Allocation

• One of the most important factors in policy determination is the asset allocation.
Empirical studies consistently demonstrate that over a long-period of time, the
most important consideration is the percentage allocation in fixed income, equities
and cash. Moreover, within each sector, it is important to take into consideration
the allocation to high yield, emerging markets or international securities. The focus
of the asset allocation will focus on some of the asset classes including: money
market instruments, fixed income, securities, stocks or equities, real estate,
domestic or emerging market securities, precious metals, collectibles, other.
• Expectations of capital market conditions may influence the allocation of the funds
in several of the sectors. However, market-timing considerations are very difficult
to achieve.
• Determining the optimal mix: This is not an easy decision. Much of the asset
allocation depends on the needs of the client and the portfolio manager’s
expectations of performance for asset class. Typically, the portfolio manager will
focus on the risk aversion of the investor and the specific income and growth needs
of the client. Moreover, the portfolio manager will diversify the portfolio
investment so as to minimize the risk related to a single investment vehicle.

Returns and Risks of different asset classes:

Category Geometric Mean Arithmetic Mean Standard Dev.
Large Comp Stocks 11.2% 13.2% 20.3%
Small Comp. Stocks 12.4% 17.4% 33.8%
L-T Corp. Bonds 5.8% 6.1% 8.6%
L-T Gov. Bonds 5.3% 5.7% 9.2%

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Med T Gov Bonds 5.3% 5.5% 5.7%

U.S. Treasury Bills 3.8% 3.8% 3.2%
Inflation 3.1% 3.2% 4.5%

• Small cap stocks had the highest historical return

• Small cap stocks had the largest historical deviation in return
• Returns generally follow the relationship of risk/return
• Treasury Bills basically provide the same return as inflation
• Arithmetic mean returns always exceed the geometric mean
returns

The table above shows the mean and standard deviation of basic capital market and money
market instruments. The historical relationship between risk and return seems to hold.
Small cap securities, over time, exhibit the largest standard deviation and the highest
returns. Similarly, T-bills have the lowest expected return and lowest historical standard
deviation. Generally speaking, equities are recommended for long holding periods.

The policy statement determines the types of assets that should be included in a portfolio.
It is important to note that the asset allocation decision determines the bulk of the
portfolio’s returns over time. This is much more important than the selection of specific
stocks and bonds. While risky, investors interested in pursuing capital appreciation over
long time periods would do well to include a significant allocation to an equity allocation in
their portfolio. However, the strategy imposed on the investor’s portfolio allocation
depends on the investor’s goals and time horizon. Investors that invest primarily in
Treasury Bills may have lower volatility and default risk, but may be a riskier strategy than
investing in common stocks due to reinvestment risks and the hazard of not meeting long-
term investment return goals.

Professor’s Tip:
This is an important section as it lays the basic foundation for risk and return. Generally
speaking the securities with higher risk (i.e. greater return variance) have historically
provided higher returns. Although candidates many not be required to know the precise
rate of return provided by each category over the years, a basic familiarity and order
ranking would be helpful for not only general knowledge (i.e. outside the AIMR
examination) but also for higher levels of the examination. At Levels II and III candidates
may be required to build portfolios based on assessment of expected risk and return.

EQUITY RISK: LONG-TERM and SHORT-TERM PERSPECTIVES

Historically, the S&P 500 has posted healthy gains.
Total returns, by decade, including share price gains and reinvested dividends, in percent

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500 466.5
450
403.7
400
339.9
350

300
250

200
140.5
150 112.1
100 76.7

50

0
1940s 1950s 1960s 1970s 1980s 1990s

• Stocks have historically had strong returns

• Stocks have traditionally had wide variations in returns
• Stocks frequently have negative annual returns
• 5 of the past 6 decades have provided stock returns in excess of 100%
• Each decade has had a positive return ranging from 77% (1970s) to 487% (1950s)

COMPARISON OF INCOME PAYOUTS FROM COMMON STOCKS AND TREASURY

BILLS, 1926-1998

During the past 71 years, stocks have been a more reliable source of income than either bonds or Treasury Bills. The figures below
presume that each year an investor spent all dividned and interest income kicked off by the securities, but left the capital intact.

1926 To 1998

Worst One-
Years When Years When Year Drop in Change in Value Change in Value
Payout Rose Payout Fell Income of Income of Principal
Stocks 58 13 39% 1824.6% 5152.4%
20-Year Treasury Bonds 39 32 9.5 78 9.4
5-Year Treasury Bonds 41 30 36.9 62.4 25.7
Treasury Bills 42 29 76.6 60.9 -

• Stocks have provided the greatest change in value of principal—51X in the past 72
years (5,152%)
• Long-Term Treasury bonds have historically had a poor increase in principal over a
long time period

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Asset Allocation and Cultural Differences

Non-U.S. investors confront different social, economic, political and tax environments
compared to U.S. investors. Consequently, foreign investors have different asset allocation
preferences. The United States has the largest equity and debt markets, however, the asset
allocations vary compared to investors in the U.K, Germany and Japan. In the United
States foreign and domestic equities comprise approximately 45% of invested assets
compared to 72% in the United Kingdom, 11% in Germany and 24% in Japan. The
environment explains much of the differences. The population is oldest in Germany and
youngest in the United Kingdom and United States. Moreover, Germany and Japan have
strong banking sectors that invest directly into the private sector and Germany has
restrictions preventing insurance companies from investing more than 20% of their assets
in equities. Not surprisingly, Germany holds the largest percentage of their investable
assets in bonds—45%, compared to only 29% in the United States. Some of the
differences follow:

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PORTFOLIO MIXES, VARIOUS COUNTRIES, 1990-1991

United States (Pension Funds) United Kingdom (Pension Funds)
United States (Pension Funds) United Kingdom (Pension Funds)

Other Other Cash

Cash
Other Other
2% Cash5% Real Estate
8% Cash
10%
2% 5% Real Estate
9%
8% 10% Real Estate
Real 9%
8% Estate
8%
Bonds
Bonds
12%
12%
Domestic
Domestic
Domestic
Equities Domestic
Equities
Equities
41% Bonds Equities
54%
41% Bonds Foreign
29% 54% Foreign
Equities
29%
Equities
18%
Foreign 18%
Foreign
Equities
Equities
4%
4%

Germany (Insurance & Mutual Japan (Life Insurance

Germany (Insurance & Mutual Japan (Life Insurance
Funds)
Funds)

Cash
CashReal Estate
6%
Cash Real Estate
Cash4% 6% Real
6% Estate
Real Estate
5% 6%
4% 5%
Other
Other
Other
35% Other
42% Bonds
35% Bonds
42% 22%
22%

Bonds
Domestic Bonds
45% Foreign
Domestic 45% Foreign
Equities
Equities
Equities Equities
2%
9%
9% Domestic 2%
Domestic
Equities
Foreign
Foreign Equities
22%
Equities
Equities 22%
2%
2%

• U.S. investors (pension funds) allocate most of their funds in domestic equities
(41%)
• U.K. pension funds place a larger percentage in equities than any other investor
(54% versus 41% in U.S.)
• U.S. pension funds place more in bonds than any other country except Germany
(approximately 29% versus 45% in bonds)
• U.S. pension funds place 8% in real estate compared to 5% to 9% in the other
countries
• The average age is highest in Germany and Japan and lowest in the U.S. and U.K.

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Professor’s Tip:
Level I Candidates do not necessarily need to know the precise breakdown of these
different markets, but should be familiar with the general orientation of the major markets
(i.e. U.S., Japan and Germany) and direction of investable capital (i.e. U.S. equities provide
the largest market, though despite their increase, have become a smaller part of the world’s
total portfolio over the past 30 years).

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“Objectives and Constraints of

Institutional Investors”
Chapter 2 Appendix
Overview:
This section of the chapter focuses on five classes of institutional investor and examines
the relative objectives and constraints. The five groupings include: pension funds,
endowment funds, insurance companies, commercial banks and mutual funds.

Describe a mutual fund and the two basic constraints faced by mutual funds

Mutual funds pool sums of money from investors, which in turn are invested in financial
assets. Each fund has its own objective, e.g. capital appreciation, high current income or
money market income, and investors select funds based on the stated objectives. Mutual
funds face two constraints, some of which are addressed in the prospectus that must be
given to all prospective investors before they purchase shares in a mutual fund. The two
constraints follow:

1. Constraints created by law to protect mutual fund investors

2. Constraints created by the mutual fund’s managers (discussed in the fund’s
prospectus)

Compare the investment objectives, constraints, and policies of institutional investors, such
as pension funds, endowment funds, insurance companies, and banks.

Institutional investors: This category includes a range of non-profit and for-profit entities
such as endowments, pension plans, insurance companies, banks and mutual funds.
Management of institutional funds requires an established investment policy that clearly
defines objectives, risk tolerance and investment constraints. The investment policy
should be long-term in nature such that short-term pressures do not have undue influence.
The investment policy should be designed to meet the following objectives:

• Meets the needs and objectives of the client

• Could be understood by an independent, competent manager
• Would be attainable during a variety of economic conditions similar to those
experienced in the recent past

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• Fits within the legal and regulatory constraints of the client

• Fit within the risk tolerance and return requirements demanded by the client

Integrating Policies and Expectations: Perhaps the most important and difficult phase of
the investment process for many portfolio managers, is the integration of the macro and
micro expectations with the investor’s constraints, objectives and desires. The portfolio
manager’s first step in the process is forming capital market expectations. The second step
is forming micro or individual asset expectations (covered in greater detail in CFA levels II
and III). Making the investment decision involves subdividing the major steps of
objectives, constraints and policies into concrete considerations. The process of the
investment decision involves three basic steps.

1. Assessing the client’s objective return requirements and risk tolerance.

2. Assessing the client’s constraints of liquidity, investment horizon, regulations, taxes
and other unique needs.
3. Determining the relevant policies of asset allocation, diversification, risk
positioning, tax positioning and income generation.

Objectives: The objectives primarily focus on the risk-return trade-off. These vary
depending on the investor.

Pension funds are a major component of retirement planning for individuals. Assets total
more than $6.4 trillion. Fund assets need to be invested to meet the needs of the retirees,
with the benefits depending on a variety of factors including the worker’s salary or time of
service, or both. There are two types of pension plans, a defined-benefit plan and defined-
contribution plan.

Contrast the objectives and constraints of defined-benefit and defined-contribution pension

plans

• Pension funds—The objectives of the pension plan depend on the type of plan being
managed.

• Defined contribution plan—These plans are tax-deferred retirement savings accounts

established by the firm for its employees, with the employees assuming the risk of the
investment. These plans are becoming more popular among firms and employees need
to manage their own risk-return objectives.

• Defined benefit plans—These plans are tax-deferred retirement savings accounts

established by the firm for its employees, with the firm assuming the risk of the
investment. If a plan has insufficient funds to meet the retirement needs of its
employees the fund plan is considered to be underfunded. Many analysts watch the
liability of a large firm and the extent to which a firm may have inadequate funds in its
retirement accounts. On the other hand, overfunded plans (in which the present value
of the pension liabilities is less than the plan’s assets) enable the fund’s portfolio

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managers to invest funds in a more aggressive investment strategy. The plan’s return
objective is to meet the actuarial rate of return which is the discount rate used to find
the present value of the plan’s future obligations and therefore determines the size of
the firm’s annual contribution to the pension plan. The actuarial rate of return is set by
actuaries who estimate future pension obligations based on assumptions regarding
future salaries (and increases), retirement patterns, age of worker, worker life
expectancies and the firm’s benefit formula.

• Pension funds generally have a long-term viewpoint. Organizations with an older

workforce require greater liquidity to pay current pension obligations to retirees. Taxes
are not a major concern to the plan as they are tax-exempt. The legal constraints are
mandated by ERISA (Employee Retirement and Income Security Act) and follow the
“prudent expert” standard. Portfolio managers have wide discretion in the types of
investments to make. Frequently, a large percentage of the portfolio will be in equities
and longer-term assets such as real estate and even private equity (i.e. venture capital).
The actual percentages will vary depending upon the age of the workforce and the
liquidity needs of the fund’s participants.

• Endowment funds—Endowments are set up to finance non-profit entities. Examples

include museums, hospitals, schools, churches, etc. The needs vary, but oftentimes
attention is placed on the preservation of capital and the annual need for a fixed
income. Endowment fund managers hold a long-term viewpoint in managing assets.
However, there is some tension between the organization’s need for current income
and the desire to plan for future spending needs. The institution’s operating budget
requires a spending rate incorporating expected inflation. Constraints depend on the
current income needs and state level regulatory and legal constraints. Short-term
capital gains are taxable, however long-term capital gains are not taxed. Many
endowments, particularly religious or college endowments, often have strong social
investing preferences. Portfolio managers have the ability to invest in a wide range of
investment products including venture capital and real estate. However, they will
probably hold enough fixed income products to meet liquidity needs.

• Life insurance companies—Insurance companies invest the funds to manage the

liabilities. The investment needs will vary by product. For example, a whole life
insurance company combines a death benefit with a savings plan. Term insurance on
the other hand only provides a death benefit. A variable life insurance policy buys a
fixed death benefit plus investments in mutual funds. A universal life insurance policy
allows the insured to alter the premium and death benefits. A guaranteed insurance
contract (GIC) promises to pay a fixed rate of return on a firm’s pension assets.

• An insurance company attempts to earn a positive “spread” which examines the

difference between the rate of return on investment minus the rate of return it credits
its various policyholders.

• The constraints for the insurance company depend on the liquidity needs, which have
increased over the years due to policy mix changes and policy surrenders. Life

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insurance policies generally require longer-term investments compared to GICs and

shorter-term annuities.

• Life insurance companies, unlike pensions and endowments, pay income and capital
gains taxes (corporate rates) on returns exceeding the amount necessary to cover
reserves. The actuarial rate of return earned on invested funds necessary to fund
reserves is not taxed.

• Life insurance companies are regulated by the NAIC (National Association of

Insurance Commissioners). The NAIC mandates that companies with excessive
holdings of higher-risk investments must set aside additional funds in a mandatory
securities valuation reserve (MSRV). Thus, insurance company portfolio managers will
tend to hold a smaller percentage of high-risk investments compared to pension fund
portfolio managers.

• Non-Life insurance companies have less predictable cash flows than life insurance
companies and therefore tend to have greater liquidity and shorter maturities.
Therefore, non-life insurance company portfolio managers probably hold larger
percentages of fixed income in their portfolios.

• Non-life insurance companies are not as heavily regulated as life insurance companies.
Consequently, insurers can invest in many different types and qualities of investments.

• Bank fund managers need to earn a rate of return greater than the cost of funds.
Moreover, bank officers are often focused on matching the maturities of assets and
liabilities, though they may position investments longer or shorter depending on their
expectations of the movement of interest rates. At all times, banks must meet high
liquidity needs. Liquidity needs can be met from selling assets within the investment
portfolio or by borrowing funds from the Federal Reserve Bank (discount window), or
by selling certificates of deposit.

• Banks are regulated by a number of state and federal agencies including the Federal
Reserve Board, the Federal Deposit Insurance Corporation and the Comptroller of
Currency. Moreover, the Glass-Steagall Act generally restricts the equity investments
that banks can pursue. Banks have unique circumstances depending on their size,
market and other management skills.

Professor’s Tip:
Level I candidates should be familiar with the basic risk-return differences between the
different institutional investors. At higher levels of the AIMR exam, candidates will need
to apply portfolio management techniques to meet relevant criteria mentioned in each
investor’s scenario.

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Problems: Asset Allocation Decision

1. Which of the following statements regarding individual and institutional investors is

incorrect?

A. Individuals define risk as “losing money”, while institutions view risk as

variance (or standard deviation) of returns.
B. Individuals are categorized according to their personalities and unique
circumstances, whereas institutions are categorized by the investment
characteristics of those that have a beneficial interest in the portfolios of
pension funds, endowment funds, banks, insurance companies and mutual
funds.
C. Individuals are defined financially by their assets and goals (particularly as
they related to their life cycle), while institutions are typically concentrated
within precise asset and liability parameters.
D. Institutions have great flexibility in selecting their investments, whereas
individuals are managed and regulated by ERISA (Employee Retirement
Income Security Act) as well as other legal constraints.

2. According to the Life Cycle View of individual investing, which stage is the
investor most likely to shift assets from equities to fixed income?
A. Consolidation phase
B. Spending phase
C. Gifting phase
D. Accumulation phase

3. According to the Life Cycle View of individual investing, the Gifting phase is
characterized by all of the following, except?
A. The individual has more assets than required for personal spending and
security.
B. The investor has increasing focus on charitable causes
C. The investor has a shift in risk orientation to become more conservative
D. The investor has a change in attitude about the purpose of investments

4. Rank the following Portfolio Management Processes steps in the appropriate order:
A. Prepare policy statement, examine economic conditions, construct the
portfolio, monitor and update investor needs.
B. Examine economic conditions, construct the portfolio, prepare the policy
statement, gather feedback.
C. Prepare policy statement, construct the portfolio, monitor investor needs,
examine economic conditions.
D. Examine economic conditions, prepare policy statement, construct the
portfolio, gather feedback.

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5. Which of the following issues does a policy statement not address?

A. Existing knowledge that the investor has in investments and capital markets
B. Additional capital or income sources available to the investor
C. Emotional reactions and risks to a positive financial outcome
D. Any legal restrictions affecting the investment needs

6. Which of the following ranking of security returns does not reflect the appropriate
ordering from lowest to highest?
A. Treasury Bills, Medium term government bonds, L-T government bonds
B. Medium-term government bonds, large capitalization common stocks, small
capitalization common stock
C. Large capitalization common stock arithmetic returns, large capitalization
common stock geometric returns, small capitalization common stock
geometric returns
D. Medium-term government bond geometric returns, medium-term
government arithmetic returns, L-T government bond geometric returns

7. Which of the following asset classes has the highest risk, as measured by standard
deviation of annual returns?
A. Large capitalization common stocks
B. Small capitalization common stocks
C. Long-term government bonds
D. Long-term corporate bonds

8. Since 1940, which of the following statements regarding stock performance and
asset allocation is (are) untrue?

I) Long-Term Treasury bonds have historically had a poor increase in

principal over a long time period
II) Stocks have provided the greatest change in value of principal—51X in
the past 72 years (5,152%)
III) Each decade has had a positive return ranging from 77% to 487%
IV) Accurate stock selection is the most influential criterion in determining
the overall portfolio return.

A. I and II
B. II only
C. III and IV
D. IV only

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9. An investor in the 30% marginal tax bracket buys a municipal bond yielding 8.5%.
What is the taxable equivalent yield of this investment?

A. 5.95%
B. 11.54%
C. 12.14%
D. 17.34%

10. An investor in the 40% marginal tax bracket buys a taxable bond yielding 10.5%.
What is the municipal bond equivalent yield for this investment?
A. 4.2%
B. 6.3%
C. 8.6%
D. 17.5%

11. Making the investment decision involves subdividing the major steps into several
concrete considerations. The process of the investment decision involves all of the
following except:

A. Assessing the client’s objective return requirements and risk tolerance.

B. Assessing the client’s constraints of liquidity, investment horizon, regulations,
taxes and other unique needs.
C. Determining the relevant constraints of security selection and investor
preference along with accumulated investor experience and historical
investment benchmarks.
D. Determining the relevant policies of asset allocation, diversification, risk
positioning, tax positioning and income generation.

12. Defined-benefit plans, and issues surrounding these plans, have all of the following
characteristics, except:

A. Defined benefit plans are tax-deferred retirement savings accounts established

by the firm for its employees, with the firm assuming the risk of the investment.
B. If a plan has insufficient funds to meet the retirement needs of its employees
the fund plan is considered to be underfunded. This occurs when the present
value of the pension liabilities is less than the plan’s assets.
C. The plan’s return objective is to meet the actuarial rate of return which is the
discount rate used to find the present value of the plan’s future obligations and
therefore determines the size of the firm’s annual contribution to the pension
plan.
D. The actuarial rate of return is set by actuaries who estimate future pension
obligations based on assumptions regarding future salaries (and increases),
retirement patterns, age of worker, worker life expectancies and the firm’s
benefit formula.

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Answers: Asset Allocation Decision

1. D. Individuals have great flexibility in selecting their investments, whereas institutions

are managed and regulated by ERISA (Employee Retirement Income Security Act)
as well as other legal constraints.

2. B. The Spending phase is characterized by the period in which the individual is

financially independent and living expenses are paid from accumulated investments
and retirement programs, not earned income. Since the investor depends on
personal investments in this phase, the focus is on assets with secure values and
emphasis on dividend, interest and rental income. Thus, during this phase the
investor is most likely to shift assets from equities to fixed income.

TestNet Update:: Did you get this question wrong? If so, you answered with the
majority. According to TestNet, our online exam database, only 47% of all test takers get
this seemingly simple question correct. Many participants (36%) thought that
Consolidation Phase. However during the Consolidation Phase investors are thinking
about a 20-30 year investment horizon along with short-term vacations and education
(college) for their children. Their income exceeds their expenses so they are not yet
thinking about shifting their assets from equities to fixed income.

3. C. The Gifting phase is the final life cycle stage in which the individual realizes that
he has more assets than he will ever need for personal spending and personal
security. While the risk/return preference does not change from the previous stage,
the attitudes about the purpose of investments do change. Investments are seen as
having the potential to influence the change for the individual, to support a
charitable cause or to foster the growth of high-risk new businesses.

TestNet Update:: According to TestNet, our online exam database, only 43% of all test
takers get this seemingly simple question correct. Many participants (32%) believe that the
investor has a change in attitude about the purpose of investments, but this is incorrect.
During the Gifting Phase individuals are focused on setting up charitable trusts or become
focused on providing financial assistance to friends and relatives. Their investment strategy
is no longer a direct concern as they have more than enough income to meet expenses, plus
have plenty of additional reserves to cover any uncertainty.

4. A. The first step requires a development of the policy statement, followed by a

close examination of current and projected financial economic, political and social
conditions. The third step implements the plan by constructing the portfolio and
then afterwards, monitoring and updating is conducted through a feedback loop.

5. C. The policy statement does not worry about the emotional reactions or risks
related to exceptional or strong performance (the investor should be so lucky!). The
policy statement should address the following issues:

• What are the risks of an adverse financial outcome?

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• What are the emotional reactions to an adverse financial outcome?

• How knowledgeable is the investor to investments and markets?
• What other capital or income sources does the investor have? How
important is the portfolio to the overall financial position?
• What legal restrictions may affect the investment needs?
• What unanticipated consequences of interim fluctuations in portfolio value
may affect investment policy?

TestNet Update:: According to TestNet, our online exam database, about 72% of all test
takers get this question correct. Level I candidates that hope to pass the AIMR exam, need
to answer questions like this correctly if they plan to be among the top one-half of the
AIMR population.

6. C. Geometric returns are always equal to or less than arithmetic returns. Therefore
the ordering of the third grouping would be inaccurate. Small company stocks have
the highest historical return (based on either arithmetic or geometric return,
followed by large cap. Common stocks, L-T corporate bonds, and government
bonds (from long-term to short term maturities). Government treasury bills are the
least risky securities providing the lowest returns. The rates are shown below.

Category Geometric Mean Arithmetic Mean

Large Comp Stocks 11.2% 13.2%

Small Comp. Stocks 12.4% 17.4%
L-T Corp. Bonds 5.8% 6.1%
L-T Gov. Bonds 5.3% 5.7%
Med T Gov Bonds 5.3% 5.5%
U.S. Treasury Bills 3.8% 3.8%

7. B. Small capitalization stocks are the riskiest of the listed asset classes as
determined by the standard deviation of returns. The exhibit below shows how
small capitalization equities, followed by large cap equities are the riskiest. Longer-
term government and corporate bonds follow with the shortest term Treasury Bills
being considered the least risky (or risk-free rate).

Returns and Risks of different asset classes:

Category Standard Dev.

Large Comp Stocks 20.3%

Small Comp. Stocks 33.8%
L-T Corp. Bonds 8.6%
L-T Gov. Bonds 9.2%
Med T Gov Bonds 5.7%
U.S. Treasury Bills 3.2%
Inflation 4.5%

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8. D. Although security selection is important, it is asset allocation that is the most

influential criterion in determining the overall portfolio return. The remaining
statements are all true.

TestNet Update:: Did you get this question wrong? If so, you answered with the
majority. According to TestNet, our online exam database, only 37% of all test takers get
this question correct. Many participants believe that stocks have had a decade below 77%,
but they have not. Again, Level I candidates need to be careful with qualitative questions.
Sometimes the most difficult questions, are the subtle narrative questions with several
close answers.

9. C. The formula for determining the equivalent tax yield is:

Equivalent Taxable Yield = Municipal Yield

1 – Marginal tax Rate

Since the marginal tax rate is 30% and the municipal bond yield is 8.5%, the
formula reduces to 8.5/.70. This equals 12.14%. Notice that if an investor begins
with 12.14% and pays a 30% tax on proceeds (12.14 * .30 = 3.64), the net result
becomes 8.5% [check: 12.14% - 3.64 = 8.5%].

Municipal Bond Taxes (Taxable Equivalent Taxable

Tax Rate Yield Yield *Tax Rate Bond Yield
30% 8.50% 3.64% 12.14%

TestNet Update:: According to TestNet, our online exam database, most test takers
(85%) answer this question correctly. This is a popular question that candidates should
view as “free points” if it appears on their examination. In our database, this is an “infinite
series question” in which the numbers and corresponding answers change each time.

10. B. The formula for determining the equivalent tax yield is:

Equivalent Taxable Yield = Municipal Yield

1 – Marginal tax Rate

Since the marginal tax rate is 40% and the equivalent taxable yield is 10.5%, the
formula reduces to 10.5% * (1-.4). This equals 6.3%. Notice that if an investor
begins with 10.5% and pays a 40% tax on proceeds (10.5 * .40 = 4.2%), the net
result becomes 6.3% [check: 10.5% - 4.2% = 6.3%].

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Municipal Bond Taxes (Taxable Equivalent Taxable

Tax Rate Yield Yield *Tax Rate Bond Yield
40% 6.30% 4.20% 10.50%

TestNet Update:: According to TestNet, our online exam database, most test takers
(85%) answer this question correctly. This is a popular question that candidates should
view as “free points” if it appears on their examination. In our database, this is an “infinite
series question” in which the numbers and corresponding answers change each time.

11. C. Making the investment decision involves subdividing the major steps into
objectives, constraints and policies into concrete considerations. The process of
the investment decision involves an assessment of the client’s objective return
requirements and risk tolerance as well as the client’s constraints (e.g. liquidity,
horizon, regulations, taxes and unique needs). Further, the investment decision
considers relevant policies of asset allocation, diversification, risk positioning, tax
positioning and income generation. The investment decision involving objectives,
constraints and policies do not contend directly with the relevant constraints of
security selection and investor preference or accumulated investor experience and
historical investment benchmarks.

12. B. If a plan has insufficient funds to meet the retirement needs of its employees
the fund plan is considered to be underfunded. This occurs when the present
value of the pension liabilities is more than the plan’s assets. When the present
value of the pension liabilities is less than the plan’s assets, the plan is considered
overfunded.

TestNet Update:: According to TestNet, our online exam database, 43% of all test takers
answer this question incorrectly. This type of question difficulty may be critical in deciding
who passes and who fails.

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“Selecting Investments in a Global

Market”
Reilly, Chapter 3, (pp. 69-78)
Overview:
This chapter provides analysis of the basic benefits and risks associated with international
investment. Level I candidates should focus on issues related to portfolio diversification
and how that reduces the risk, while also recognizing that international investment may
expand the opportunity set and overall portfolio return.

The notion of international diversification addresses the risk-return trade-offs inherent in

expanding the investment universe beyond the United States. Investors follow the basic
premise that broader diversification results in more stable investment returns and lower
risk. As a general rule, a diversified portfolio of U.S. based organizations, is less risky
compared to an individual stock holding (much of the risk has been eliminated).
International diversification further reduces the variability in returns. Moreover,
international investing provides more opportunity. The percentage of the world’s stock
market capitalization outside of the U.S. has grown considerably over the past thirty years.
Approximately 60% of the world’s stock market capitalization is now outside the U.S.
(readers note: this is a statistic from the textbook and may no longer be accurate given the
relative surge in NASDAQ price levels and offerings since1996).

Discuss the reasons why investors should consider constructing global portfolios.

International diversification:
In general as diversification increases the returns become more stable. Approximately ¾ of
all risk can be eliminated in a fully diversified U.S. portfolio (compared to an individual
stock holding) and even more variability can be reduced through international
diversification. International diversification provides the possibility of a better risk-return
trade-off compared to portfolios without this attribute.

There are three primary reasons U.S. investors should consider constructing a global
portfolio. These include:

1. By ignoring stock and bond investments outside the U.S., investors would
reduce their investment opportunities by over 50%. Expanding the investment
opportunity set to include foreign securities broadens the risk-return selection
range.
2. Rates of return in international markets frequently exceed the returns on U.S.-
only securities. These superior returns are often attributed to the higher growth
in foreign markets and are often achieved on a risk-adjusted basis.

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3. Investing in foreign markets maximizes the diversification benefits and reduces

the risk in the portfolio. The benefits of diversification are even greater with
foreign markets since a low correlation exists among asset returns.

[Note: This information on Efficient Frontier is from the Foundations of

Multinational Financial Management by Shapiro—required reading for 2002 exam.
We include it in this section as it enhances the explanation from the required text.]

Efficient Frontier:
The combined effect of international diversification implies an increasing expected return
and reduction in portfolio risk. The combined effect in essence causes the efficient frontier
to be pushed out to a superior level. Thus, rational investors should prefer an international
portfolio compared to a portfolio of domestic stocks only (see Exhibit below).

INTERNATIONAL DIVERSIFICATION PUSHES OUT

THE EFFICIENT FRONTIER

Efficient frontier--
US and foreign stocks
C Efficient frontier--
D US stocks only
B A
Expected return

Relative to portfolio A:
1. Portfolio B has the same expected return
but less risk.
2. Portfolio C has the same risk but higher
expected return.
3. Portfolio D has higher expected return
and less risk.

Standard deviation

• International diversification pushes out the efficient frontier

• International diversification provides investors lower risk and higher returns
• Correlations between countries are generally lower in 1990s compared to 1970s
• When markets are most volatile, investors pursue safe havens
• Markets are more highly correlated when markets fall (not when they rise)
• Markets moving in synchrony during bear markets (not bull) reduce some benefits
related to international diversification

Diversification issues:
Research shows that the correlation of the U.S. markets relative to other developed
countries, while higher than in the 1970s, has been dropping in recent years. However,
studies show that during periods of high volatility the markets move in synchrony. The
correlations tend to be highest when the market volatility is at its highest, but this seems to
occur only when the markets are falling, not rising. Apparently bear markets and not bull

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markets move in synchrony thus reducing some, but not all of the benefits related to
international diversification.

As the Exhibit below shows that despite the problems with falling markets, there are still
clear benefits with international diversification. The portfolio returns are expected to rise
along with a declining risk level, with combinations of the S&P 500 Index and the EAFE
Index. As the percentage in the EAFE Index increases beyond levels of 40%, the portfolio
risk rises along with the return.

Compare the relative size of the U.S. market to other global stock and bond markets.

Prior to 1965 securities traded in the U.S. comprised about 2/3 of all securities available in
the world capital markets. At that time it may not have been worthwhile to expend the
time and energy to pursue investments in foreign markets. However, in the past 30 years
the size of the total investable capital markets have grown from $2.3 trillion to over $58.2
trillion. Much of the growth can be traced to the growth in the U.S. markets. However, on
a relative basis, foreign markets have grown much faster, and the pattern doesn’t appear
likely to slow down in the foreseeable future. U.S. markets now comprise about 47% of
the total (compared to 65% 30 years earlier). Ignoring securities offered in foreign markets
would cause the investor to not only forego the potential returns and risk reduction from
international diversification, but would also exclude more than ½ of all investable capital
products.

All Other
Equities
11%
Japan Equity
2% Japan Bonds
1%
U.S. Equity
31% All Other Bonds
14%
Private Markets
0%
Dollar Bonds
U.S. Real Estate
22%
12%

Cash Equivilant
7%
1969
$2.3 Trillion

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All Other Bonds

Emerging Market 18%
Japan Equity
Equity
4% Emerging Market
All Other Equity 1%
Debt
15% 2%
U.S. Equity Japan Bonds
22% 8%
Private Markets
0% Dollar Bonds
Cash Equivilant 20%
High Yield Bonds
U.S. Real Estate
5%
4% 1%

1998 (Preliminary)
$58.2 Trillion

• Total investable capital has grown from $2 trillion to $58 trillion in the past 30 years.
• U.S. composition of debt and equity securities has declined from 65% to 47%.
• All capital markets are growing, with foreign markets growing fastest.
• U.S. investors need to recognize the importance of international securities for effective
portfolio management

Rates of return on U.S. and Foreign Securities:

Global bond markets:

The table below shows the rates of return for several major international bond markets.
The exhibit shows domestic returns, or returns earned by an investor in domestic
currency, as well as returns adjusted for changes in the currency exchange rates during a
stated time period.

The U.S. bond market ranked fourth out of six countries on the basis of domestic
returns (i.e. return earned by a U.S. investor), and sixth (i.e. last) when adjusted for
exchange rate fluctuations. Consequently, U.S. investors that pursued bond
investments in the foreign markets listed below, during the 1987-1996 time period,
would have earned a superior return on a currency-adjusted basis. This demonstrates
how U.S. investors can benefit from international investments.

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INTERNATIONAL BOND MARKET COMPOUND ANNUAL RATES OF RETURN

1987-1996

COMPONENTS OF RETURN
Total Domestic Return Total Return in U.S. $ Exchange Rate Effect

Canada 10.89 10.98 0.01

France 10.52 12.73 2.00
Germany 7.41 9.79 2.22
Japan 6.49 9.9 3.20
United Kingdom 11.3 12.91 1.45
United States 8.1 8.1 -

• U.S. bond markets ranked 4th out of 6th in domestic returns

• U.S. bond markets ranked last (6th) in total return adjusted for exchange rate effect
• Bond returns ranged from 8.1% (U.S.) to 12.91%

Demonstrate how changes in currency exchange rates can affect the returns that investors
earn on foreign security investments.

Global equity market returns:

The prior section demonstrated the impact that exchange rate effects would have on total
returns to a bond portfolio. The exhibit below shows the total returns, in local currency and
adjusted for currency fluctuations (relative to a U.S. investor), for 12 equity markets. The
U.S. equities ranked 3rd on a local currency level, but fell to 5th after adjusting for currency
enhancements in other markets. For the time period shown, 1986-1998, Spain (18.2%),
Sweden (17.2%), Netherlands (16.1%) and Switzerland (14.6%) all exceeded the returns
on U.S. equities (14.5%) after adjusting for appreciation on local currency markets. The
currency effect only cost U.S. investors in Australia, Canada and Sweden, with the overall
effect less than 1% in each of these markets (the U.S. dollar was strong relative to these
currencies). Alternatively, the U.S. investor would have gained in currency appreciation in
the remaining markets (i.e. the U.S. currency was weak relative to these markets). The
currency appreciation in the eight other markets ranged from 0.1% in Italy to 4.5% in
Japan. It is interesting to note that the currency return was greater than the underlying
security return in Japan (.8% equity return versus 4.5% for currency appreciation). In many
of the other markets (5 of 11) the currency return was more than 1/5 of the total return,
thus demonstrating its significance.

The exhibit below demonstrates the importance of international investment. A U.S.

investor that ignores investment opportunity outside the U.S. may lose the potential for
superior investment returns on both a local currency and a currency-adjusted basis.

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FT-ACTUARIES WORLD EQUITY TOTAL RETURN PERFORMANCE: GEOMETRIC

AVERAGE YEARLY RETURNS IN LOCAL CURRENCY AND U.S. DOLLARS,
1986-1998

LOCAL CURRENCY US DOLLARS

Percent Rank Percent Rank

Australia 9.0% 9 8.1% 10

Canada 6.9% 11 6.2% 11
France 11.8% 5 14.4% 6
Germany 7.5% 10 10.7% 9
Italy 10.8% 8 10.9% 8
Japan 0.8% 12 5.3% 12
Netherlands 12.7% 4 16.1% 3
Spain 17.5% 2 18.2% 1
Sweden 17.8% 1 17.2% 2
Switzerland 11.0% 7 14.6% 4
United Kingdom 11.4% 6 12.7% 5
United States 14.5% 3 14.5% 7

• U.S. markets earned 14.5% on a local currency and currency-adjusted basis (host
currency)
• Australia, Canada and Sweden had currencies that lost relative to the U.S. currency
• 7 markets had currencies that appreciated relative to the U.S. market (U.S. currency
was weak)
• U.S. equities ranked 4th out of 12 world markets on a total return basis
• The currency return was significant in 5 of 11 markets

Individual Country Risk and Return:

It is important to qualify returns adjusted for risk. In the exhibit below, returns are
adjusted and illustrated on a relative ranking given the standard deviation of daily returns.
After adjusting all of the equity returns on a relative basis, the ranking of U.S. equities
improved. However, this relative ranking adjusts for return given a variance of those
returns. As the next section will show, it is also important to examine the correlation of
returns among holdings within a portfolio.

INTERNATIONAL BOND MARKET RETURN-RISK RESULTS: LOCAL CURRENCY AND

U.S. DOLLARS, 1987 - 1996

LOCAL CURRENCY US DOLLARS

Return Risk Return/Risk Return Risk Return/Risk

Canada 10.89 6.58 1.66 10.98 9.08 1.21

France 10.52 4.26 2.47 12.73 10.94 1.16
Germany 7.41 3.18 2.33 9.79 11.74 0.83
Japan 6.49 4.91 1.32 9.90 14.08 0.70
United Kingdom 11.30 6.49 1.74 12.90 13.60 0.95
United States 8.10 4.77 1.70 8.10 4.77 1.70

• High return/risk measure is desired

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• U.S. ranked 5th/6 on local currency

• U.S. ranked 1 st after adjusting for currency variability

Risk of Combined Country Investments:

When collecting securities for a portfolio, it is helpful to combine different assets that have
a low positive correlation, a zero correlation or ideally a negative correlation with each
other. The exhibits below show the relative stock returns and variation of major stock
markets in local currency and adjusted for U.S. markets.

ANNUAL RATES OF RETURN AND RISK FOR MAJOR STOCK MARKETS IN LOCAL
CURRENCY: 1986 - 1997

Rate of Return
27
Sweden
Spain
22

Netherlands
17 United States France
North America Australia Switzerland Italy
World
12 Canada Germany
United Kingdom Europe & Pacific

7 Europe Pacific Basin

Japan

2
10 15 20 25 30 35 40
Standard Deviation

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• Spain and Italy had the highest variability of returns

• Sweden had the highest return for the period
• Canada offered the lowest variability of returns
• Japan offered the lowest absolute returns on a local currency basis
• Investors want markets above the line in the left quadrant (upper left)

ANNUAL RATES OF RETURN AND RISK FOR MAJOR STOCK MARKETS IN

U.S. DOLLARS: 1986 - 1997

Rate of Return
27
Spain

22 Sweden
Netherlands France
United Kingdom Switzerland
17 United States Australia
Europe Italy
North America
12 World Germany
Europe & Pacific
Canada Pacific Basin
7 Japan

2
10 15 20 25 30 35 40
Standard Deviation

• U.S. investors need to adjust all returns net of currency effects

• Investors want markets above the line (upper left)
• Netherlands had a high return with relatively low risk
• Japan had a very low return with relatively high risk (standard deviation of returns)
• Spain had a relatively high return coupled with high relative risk

Professor’s Tip:
Currency issues are very important in the overall returns provided to investors with assets
representing a diverse international portfolio mix. Oftentimes the positive or negative
returns contributed from the currency risk more than offset the actual returns on the
underlying assets. This section ties in with other materials from the International
Economics and Derivatives (Swaps) section. At this juncture, Level I Candidates need to
recognize the significance of currency risk and how it may sway overall portfolio returns.
In other sections of Level I (and more advanced applications at Levels II and III)
Candidates will need to compute the impact of currency changes and possibly how to
hedge against currency risk. This is an important section that provides base knowledge for
more advanced applications at Levels II and III.

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Example: Computing the one-period return of a foreign bond or stock investment

The total dollar return can be decomposed into three separate elements: dividend/interest
income, capital gains/(losses), and currency gains/(losses).

Key Formula

Bonds: Dollar return = Foreign currency return * Currency gain/(loss)

1 + R$ = [ 1 + B(1) – B ( 0) + C] (1 + g)
B(0)

Where B(t) = foreign currency (FC) bond price at time t

C = foreign currency coupon income
g = percent change in dollar value of the foreign currency

Assume that the initial bond price is FC 96, the coupon income is FC 7, the end-of-period
bond price is 98, and the local currency appreciates by 3% against the dollar during the
period.

R$ = [ 1 + B(1) – B (0) + C] (1 + g)
B(0)

R$ = [1 + (98 – 96 + 7)/96] (1+.03) –1 = 12.7%

The 3% currency gain applies to both the local currency principal and to the local currency
return. Consequently, the FC 7 coupon return and FC 2 return on the principal
appreciation, provided an effective return of 9.4% (9/96). When this 9.4% return is
multiplied by a 3% appreciation in local currency, the total return equals 12.7% (1.094 *
1.03 = 1.127 = 12.7%).

Key Formula

Stocks: Dollar return = Foreign currency return * Currency gain (loss)

1 + R$ = [ 1 + P(1) – P (0) + Div] (1 + g)

P(0)

Where P(t) = foreign currency (FC) bond price at time t

Div = foreign currency dividend income
g = percent change in dollar value of the foreign currency

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Assume that the beginning stock price is FC 72, the dividend income is FC 2, the end-of-
period stock price is 68, and the local currency depreciates by 4% against the dollar during
the period. The total return can be calculated as follows:

R$ = [ 1 + P(1) – P (0) + Div] (1 + g)

P(0)

R$ = [1 + (68 – 72 + 2)/72] (1-.04) –1 = [1-.028](.96) – 1 = -6.7%

Note: The investor received a net loss on the stock (- 4 FC net of 2 FC dividend), as well
as a 4% loss on the foreign currency. Consequently, the net loss on the stock investment
of 2.8% was exacerbated by the currency depreciation (.972)*(.96) – 1 = 6.7% loss (-
6.7%).

Professor’s Tip:
This is an important topic that appears in the International Economics section as well as
here. Although the required readings (in 2003) do not provide the specific reference to this
computation, in prior years this has been a very important topic. Moreover, the LOS in
Portfolio Management specifies that candidates “demonstrate how changes in currency
exchange rates…”, thus making clear that candidates should know how to decompose a
return from an international security investment. While the income return, capital gain
return and currency returns should all be straight forward to even the naïve investor, the
effect of currency adjustments to the gains, might be overlooked. Obviously, in
environments with high currency adjustments these additional percentage returns may be
significant.

Discuss the changes in risk that occur when investors add international securities to their
portfolios.

Global Bond Portfolio Risk:

The table below shows how returns are correlated between the United States and major
foreign markets. These correlations are determined on a domestic return and a U.S. dollar
basis. Only the Canadian markets have a correlation above 50%. Perhaps more
importantly, even though the volatilities for these markets increased substantially after
returns are converted to U.S. dollars, the correlations among returns in U.S. dollars
declined. The low positive correlations suggest that U.S. investors have a substantial
opportunity for risk reduction through global diversification of bond portfolios.

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While the U.S. to Canada correlation is relatively high (.57), the correlation between the
U.S. and Japan is relatively low (.15). Many factors may contribute to this correlation
including: different international trade patterns, fiscal policies, monetary policies, and
economic growth. Level I candidates should recognize that the low correlations reduce the
portfolio risk. However, these correlations between a pair of countries are not static, they
change over time.

CORRELATION COEEICIENTS BETWEEN RATES OF RETURN ON BONDS IN THE

UNITED STATES AND MAJOR FOREIGN MARKETS: 1987 - 1996 (MONTHLY DATA)

Domestic Returns Returns in US Dollars

Canada 0.72 0.57
France 0.47 0.32
Germany 0.44 0.27
Japan 0.34 0.15
United Kingdom 0.40 0.23

• Canada has the highest correlation

• Japan has the lowest correlation
• The correlations are lower when based on the returns in U.S. dollars
• Variability for these markets increase after adjusting for currency risk—correlation is
lower

The risk-return trade-off for a portfolio comprised entirely of U.S. bonds can be improved
upon through international diversification. The exhibit below shows how the return
increases while standard deviation decreases as foreign bonds are added to a portfolio
comprised 100% of U.S. bonds. After a while, increasing the amount of foreign assets into
the portfolio both increases the expected risk and the expected return. For example, after
the amount of foreign assets in the portfolio reaches a level equal to 40% of total
contribution, the overall returns for the bond portfolio increases, but risk increases as well.
This is shown in the exhibit below.

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Risk Return Trade-off for International Bond Portfolios

Percent per Year

10 100% Foreign
90% Foreign

8 60% U.S 40% Foreign

7
100% U.S.

6
7 8 9 10 11 Risk (d)
Percent per Year

The exhibit above shows how the risk of the domestic bond portfolio decreases (i.e. moves
left) as the portfolio composition moves from 100% U.S. to some portion of U.S. and
foreign investment. Moreover, the return also increases initially (shown by the upward
movement). This curve demonstrates that it is possible to reduce risk and increase returns.
This is a relatively rare, yet desirable situation. After the curve reaches about 70% U.S.
and 30% foreign, the risk begins to increase with corresponding increases in returns. This
increase in expected return with an increase in expected risk is the more common trade-off
in the risk-return graph. Candidates should recognize that it is the movement towards the
upper-left quadrant that makes this exhibit unique. More return with less risk is a dream for
all investors that is not often achieved or documented. [Note: a few years ago, Level I and
II Candidate readings showed investments in international portfolios increased returns but
also increased risks, demonstrating the non-static relationship of correlations in
international markets].

Some general conclusions of international diversification:

• International diversification improves the overall return for a U.S. portfolio

• International diversification reduces risk and increases return up to 40% contribution
of foreign bonds
• After foreign bonds exceed 40% of total bond portfolio, the overall return continues to
increase, however overall risk now increases as well

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Global Equity Portfolio Risk:

The correlation of world equity markets follows a pattern similar to that for the bond
markets. The correlation between the U.S. and major foreign stock markets were generally
low, and were reduced further after adjusting for currency effects. The highest correlation
and the lowest correlation for the equity markets are the same as shown before with the
bond markets. Canadian market demonstrated the strongest correlation (.75) and Japan
demonstrated the lowest correlation (.28). Please note that while the direction of the
correlations were the same as before, the actual correlations were different.

CORRELATION COEEICIENTS BETWEEN PRICE RETURNS ON COMMON STOCKS

IN THE UNITED STATES AND MAJOR FOREIGN MARKETS: 1986 - 1998
1986-1998

LOCAL CURRENCY US DOLLARS

PRICE RETURNS PRICE RETURNS
Australia 0.53 0.46
Canada 0.77 0.75
France 0.58 0.50
Germany 0.53 0.44
Italy 0.35 0.29
Japan 0.36 0.28
Netherlands 0.66 0.61
Spain 0.58 0.51
Sweden 0.49 0.48
Switzerland 0.64 0.53
United Kingdom 0.72 0.62

• Canadian markets had the highest correlation with U.S. equity markets
• Japan had the lowest correlation with U.S. equity markets
• The correlations after adjusting for currency effects were always lower
• Investors can reduce the overall risk of their portfolio by including foreign stocks

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The figure below shows how the standard deviation declines within the investor’s own
country (domestic diversification) as more securities are added. A U.S. investor gains
additional diversification benefits by adding international securities.

RISK REDUCTION THROUGH NATIONAL AND INTERNATIONAL DIVERSIFICATION

Standard Diversification of Portfolio Relative to

Standard Diversification of Typical Stock
1.0

0.75

U.S.
0.50
International

0.25

10 20 30
Number of Securities in Portfolio

Adding international stocks generally benefits the risk-reduction attributes of a portfolio.

With both domestic and international portfolios, most of the benefit is usually derived with
the first 20-30 stocks.

Some general observations:

• Adding international stocks and bonds will reduce the risk in a portfolio and may also
improve the return
• International diversification reduces the risk of a portfolio, even if it is already
diversified within its host country
• Most diversification benefits accrue with 20-30 selected securities
• Global investment perspective is important and part of a continuing trend among
investors
• Adding foreign stocks to a U.S. only portfolio will usually reduce the risk of the
portfolio (as measured by standard deviation of total portfolio returns) and oftentimes
increases the average return

Professor’s Tip:
The issue of diversification becomes extremely important in the development of asset
composition and risk management. Some of the findings regarding correlations between

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different assets changes in the readings from year-to-year. For example, in some years,
international diversification has been viewed as increasing risk whereas in other years
studies suggest that international diversification decreases risk. The current readings
suggest, that based on recent evidence, international diversification both reduces risk and
increases return. Candidates should be sensitive to these findings as it is likely that over
the years new empirical data offers different conclusions (just as with past readings). More
importantly, Candidates should be aware of the importance of portfolio combinations and
the purpose of assessing asset correlations. Irrespective of historical correlations,
candidates should recognize that by adding diverse, non-related assets to a portfolio can
reduce the total variability. In the situation above, international securities reduce the risk
(and may possibly increase the return) compared to a U.S. based portfolio alone.

Barriers to International Diversification

Lack of liquidity, or the ability to buy and sell securities efficiently, is the largest risk
related to investing overseas. However, there are a number of barriers to investing
overseas besides liquidity risk. These include legal, informational, currency controls, tax
regulations, exchange risk and custodial issues. Although some of these problems are being
eroded, they continue to prevent U.S. investors from investing more abroad.

Investing Abroad
Investors have the option to buy foreign securities in their home markets, but buying
stocks on listed foreign exchanges is expensive due to high brokerage costs. Moreover,
owners of foreign stocks need to contend to complicated foreign tax laws and the nuisance
of converting dividend payments into dollars.

Most individual investors generally buy foreign equities through American Depository
Receipts (ADRs) or an internationally diversified mutual fund. These funds allow an
investor to invest anywhere in the world, with regional and country specific options usually
available.

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Problems: Selecting Investments in a Global Market

1. All of the following are reasons to construct a global portfolio, except?

A. International investment opportunities can expand a domestic stock and bond

investment set by 100% and extensively broaden the risk-return selection range.
B. Rates of return in international markets frequently exceed the returns on U.S.-
only securities.
C. The benefits of diversification are even greater with foreign markets since a
high correlation exists among asset returns.
D. Superior returns are often attributed to the higher growth in foreign markets and
are often achieved on a risk-adjusted basis.

2. Which of the following statements does not accurately reflect the relative size of the
U.S. market compared with other global stock and bond markets?

A. Prior to 1965 securities traded in the U.S. comprised about 2/3 of all securities
available in the world capital markets.
B. In the past 30 years the size of the total investable capital markets have grown from
$2.3 trillion to over $58.2 trillion.
C. U.S. markets now comprise about 47% of the total investable capital in the world
D. All capital markets are growing, with domestic markets growing fastest.

3. Which of the following statements regarding the total return of the U.S. bond market is
incorrect?

A. The U.S. bond market domestic return (earned by a U.S. investor) is often less
than the return provided by European bonds
B. Foreign bonds typically have lower nominal yields than domestic bonds, but do
not usually yield superior returns on a currency-adjusted basis
C. After adjusting for exchange rate fluctuations, U.S. domestic bonds frequently
yield a lower return than international bonds
D. U.S. bond investors can often improve their portfolio returns by investing in
foreign bonds

4. A global bond portfolio has which of the following characteristics?

I. The volatility among non-U.S. bonds increases substantially after

converted to U.S. dollars
II. International bond returns usually have a high correlation with U.S. bonds
returns though they are usually not static over time
III. The correlation among U.S. bond returns with international bond returns
decreases after being converted to U.S. dollars
IV. The high positive correlations among international bonds suggests that
U.S. investors have an opportunity for portfolio risk reduction through
global diversification

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A. I and III above

B. I and II above
C. II and IV above
D. IV only

5. International diversification has all of the following characteristics, except?

A. Adding international stocks and bonds will reduce the risk in a portfolio and may
also improve the return.
B. International diversification reduces the risk of a portfolio, even if it is already
diversified within its host country
C. Adding foreign stocks to a U.S. only portfolio will usually increase the risk of the
portfolio (as measured by standard deviation of total portfolio returns) though it
usually also increases the average return
D. Most diversification benefits accrue with 20-30 selected securities

6. Roberto Fez from Old England Insurance Advisors purchased a foreign bond for a
price of £43.75. Roberto received £8.25 coupon income and an end of period bond
price of £62.50. The local currency changed by 34.10% against the dollar during this
time period. What is the total dollar return earned by Roberto during this time period?

A. 116.86%
B. 151.92%
C. 210.35%
D. 81.80%

7. Nickey Carolla prepared an international portfolio for her U.S.--based clients. Which
of the following is NOT a rationale for international investing?

A. U.S. investors can expand their investment opportunity set by 100% by

considering foreign securities
B. Rates of returns in international markets frequently exceed the returns of U.S.
only securities
C. Investing in foreign markets maximizes the diversification benefits and reduces
the risk in the portfolio
D. International diversification tends to increase return by an amount suitable to
offset the higher risk compared to a U.S--only portfolio

8. Derek Murfee of Northwest Fund Consultants is reviewing a client’s portfolio of large

capitalization U.S. equities. Which of the following investments is most likely to both
reduce risk and increase returns?

A. International bonds
B. Venture capital
C. Commodities

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D. Treasury bonds

9. International diversification has all of the following features, except:

A. Emerging markets have traditionally experienced less risk and return than
developed countries
B. As diversification increases the returns become more stable
C. Approximately ¾ of all risk can be eliminated in a fully diversified U.S.
portfolio (compared to an individual holding)
D. International diversification provides the possibility of a better risk-return
trade-off

10. Which of the following statements regarding international diversification is inaccurate?

A. Some European countries have a very low correlation with U.S. markets (e.g.
less than .30)
B. Canada has among the highest correlation with the U.S. markets of any country
C. M.S. World Index has lower level of risk compared to U.S. markets alone
D. The standard deviation of a domestic-only portfolio drops slightly when adding
international securities

11. Which of the following statements regarding U.S. and international investment returns
are true?
I From 1970 to 1996 the EAFE index outperformed the U.S. market (on
compounded return basis)
II Returns from international countries frequently out-perform the returns in the
U.S. market
III The U.S. market has consistently had the best returns of any developed nation
from 1950 to 1990
IV The U.S. market dominates all other capital markets for returns based on an
annual, compounded basis

A. I and II only
B. II only
C. II and III only
D. IV only

12. Which of the following statements describes the efficient frontier after international
diversification is added to a U.S. domestic-only portfolio?

A. International diversification pushes in the efficient frontier providing lower risk

and higher returns
B. International diversification provides investors lower risk but not higher returns
C. Markets are more highly correlated when markets fall (not when they rise)
D. When markets are most volatile, investors pursue risky havens

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13. Emerging markets have all of the following characteristics except?

A. Emerging markets offer high annualized returns

B. These markets have extraordinary volatility and liquidity
C. Funds flows into emerging markets have increased considerably over the past
twenty years
D. Most emerging markets have low correlation with U.S. market

14. Barriers to international diversification include all of the following reasons, except?

A. Illiquid ADRs that deny access to foreign markets

B. Legal and informational problems with emerging markets
C. Currency controls, tax regulations and complicated foreign tax laws
D. Exchange risk, custodial issues and conversion of dividend payments into
dollars

15. The one-period total dollar return on a foreign bond or stock investment includes all of
the following except:

A. Dividend and interest income

B. Capital gain or loss
C. Sovereign gain or loss
D. Currency gain or loss

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Answers: Selecting Investments in a Global Market

1. C. The benefits of diversification are even greater with foreign markets since a low
correlation exists among asset returns. The remaining statements are true. Expanding
the investment opportunity set to include foreign securities broadens the risk-return
selection range and maximizes the diversification benefits (reducing risk).

2. D. All capital markets are growing, with international markets growing fastest. The U.S.
markets have dropped from about 66% before 1965 to less than 47% today. The U.S.
markets are still the largest capital markets in the world, with the total investable
capital (in the world) approximating $58 trillion (based on 1998 figures).

3. B. Domestic bonds frequently have lower returns than international bonds and during
the 1987-1996 time periods were well below the overall returns for international bonds.
The U.S. ranked fourth out of six countries on the basis of domestic returns (i.e. return
earned by a U.S. investor), and sixth (i.e. last) when adjusted for exchange rate
fluctuations. Consequently, U.S. investors that pursued bond investments in the
foreign markets listed below, during the 1987-1996 time period, would have earned a
superior return on a currency-adjusted basis.

TestNet Update:: According to TestNet, our online exam database, approximately 70%
of all test takers answer this question correctly.

4. A. Although the volatilities for international markets increased substantially after

returns are converted to U.S. dollars, the correlations among returns in U.S. dollars
declined. The low positive correlations suggest that U.S. investors have a substantial
opportunity for risk reduction through global diversification of bond portfolios. While
these low correlations reduce the portfolio risk, investors should remember that these
correlations between a pair of countries are not static, they change over time.

TestNet Update:: According to TestNet, our online exam database, approximately 66%
of all test takers answer this question correctly. This question difficulty provides strong
insight into how a relatively short question can be missed by 1/3 of the population.

5. C. Adding international stocks generally benefits the risk-reduction attributes of a

portfolio. With both domestic and international portfolios, most of the benefit is
usually derived with the first 20-30 stocks. Adding international stocks and bonds will
reduce the risk in a portfolio and oftentimes also improves the return.

6. A. The dollar return = Foreign currency return * currency gain (loss)

1 + R$ = (1 + P1 – P0 + interest) * (1 + g)
P0
R$ = [(1 + ( 62.50 – 43.75 + 8.25)/43.75) * ( 1 + 0.341)] – 1

R$ = 116.86%

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The total return is a function of the:

Income return 8.25/43.75 18.86%
Capital gain (loss) (62.50 – 43.75)/43.75 42.86%
Currency gain (loss) 0.341 34.10%
In addition, to the currency gain (loss) on the
principal there is
Also a currency gain (loss) on the income and
capital gain (loss)
This equals [(((income return (loss) + capital
gain (loss)) * (percentage currency gain
(loss))/orig inv.] 20.98%
((8.25+62.5-43.75)*.341)/43.75= 9.207/43.75
Total percentage dollar return 116.80%
(Note: Difference due to rounding

TestNet Update:: According to TestNet, our online exam database, more than 2/3 of our
candidate population do not even answer this question. This topic frequently appears on
the exam and is considered by AIMR students to be difficult. In our database, this is an
“infinite series question” in which the numbers and corresponding answers change each
time.

7. D. International diversification generally does not necessarily increase risk, and in fact,
may reduce risk as it increases return. There are three primary reasons U.S. investors
should consider constructing a global portfolio. These include 1) the opportunity to
expand the investment opportunity set by 100% over a domestic-only portfolio (the
U.S. market is now about 50% of the total), 2) rates of return on international markets
frequently exceed U.S. securities, and 3) investments in international markets
maximizes the diversification benefits. This is true since foreign markets tend to have
a low correlation with U.S. securities.

8. A. Venture capital investments and commodities may increase a portfolio’s return but
will also, most likely also increase the variability of returns and portfolio risk. The
Treasury bills will almost certainly reduce the risk of the portfolio, but in so doing will
also reduce the overall return of the portfolio. Only the international bonds are likely to
both increase the expected return of the portfolio and reduce the risk associated with
the total portfolio. This occurs through the low correlations associated with
international diversification.

9. A. Emerging markets (less developed or developing countries) have traditionally

experienced greater risk and return than developed countries (e.g. U.S., Japan, Australia,
New Zealand, Western Europe).

10. D. By formulating an internationally diversified portfolio, the standard deviation drops

by more than one-half of the prior level for a domestic-only portfolio (from 27% to
11.7% of the standard deviation of individual stocks. Some European countries, such

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as Austria, have a very low correlation with the U.S. (.12). Canada, on the other hand,
has a high correlation with the U.S. (.70). The M.S. World Index has the lowest level
of risk (σ of returns equals 48.75 compared to 49.52 for U.S.).

11. A. The EAFE index frequently out-performs the U.S. market and returns from
international countries frequently out-perform the returns in the U.S. market. From
1970 to 1997 the EAFE Index outperformed the U.S. market in 19 out of 30 years.
Moreover, from 1949 to 1990, the Japanese market increased by 25,000%.

12. C. Markets moving in synchrony during bear markets (not bull) reduce some benefits
related to international diversification. This is due to the occurrence of investors
pursuing safe havens in unison during volatile time periods. In general, the combined
effect of international diversification implies an increasing expected return and reduction
in portfolio risk. The combined effect in essence causes the efficient frontier to be
pushed out to a superior level.

13. B. Emerging markets are extremely volatile and illiquid. These markets have
considerable economic and political risks but also provide some of the greatest
potential diversification benefits and returns. Over the past few decades, private
capital flows to these markets have increased from $10 billion per year to $80 billion
per year.

14. A. ADRs are extremely liquid, though most emerging market investments are not.
Most individual investors generally buy foreign equities through American Depository
Receipts (ADRs) or an internationally diversified mutual fund. These funds allow an
investor to invest anywhere in the world, with regional and country specific options
usually available.

15. C. The sovereign risk addresses the economic and political risk of a sovereign state.
The actual gain or loss comes in the form of dividends, interest, capital gains (losses)
and currency gains (or losses). Increasing levels of sovereign risk will probably result in
greater currency fluctuations as well as greater risk with the investment. However,
there is no sovereign gain or loss, per se.

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“An Introduction to Portfolio

Management”
Reilly, Chapter 8

Overview:
This chapter provides considerable detail, some of which is often not covered on the
CFA Level I exam. However, periodically some of the most difficult questions on the
AIMR exam derive from this section. Within the Portfolio Section, this area has
historically provided a large proportion of the total number of questions. CFA
candidates should focus on the broad picture, but recognize that AIMR can bring in a
few computational questions that require fancy, complicated formulae. Further, some
of this material may also be included in the quantitative methods section of the exam.
This topic covers standard deviations, portfolio variances, correlations, covariances,
diversification and regression. This is an important topic that provides base knowledge
for Levels II and III as well. Key points of this chapter are summarized below along
with a few detailed computations.

Describe risk aversion and discuss its implications for the investment process.

Risk aversion: risk aversion relates to the notion that investors as a rule would rather
avoid risk. Consequently, investors will demand a risk premium for taking on
additional levels of risk and the more risk averse the investor the more of a premium
he/she will demand prior to taking on the level of risk. Investors that do not demand a
premium for risk are said to be risk neutral (i.e. those that will be willing to place both
a large and small bet on the flip of a coin and be indifferent) and those investors that
enjoy risk are said to be risk seekers (i.e. people that buy lottery tickets despite the
knowledge that for every $1 spent, on average they will get less than $.1 back.

Example: Three investors Sam, Mike and Mary are considering two investments A &
B. Investment A is the less risky of the two requiring an outlay of $1,000 with an
expected rate of return at 10%. Investment B also requires an investment of $1,000
and has an expected return of 10% but appears to have considerably more variability in
potential returns compared to A. Sam requires a return of 14%, Mike requires 10% but
Mary seeks only 8% expected return.

Question: Given the information above, which of the three investors is considered
risk-averse?

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Solution: Only Sam would be considered risk-averse. He is the only investor that
demands a premium of return given the higher risk level. Mike would be considered
risk-neutral since he demands no premium in return (despite the higher risk) and Mary
would be considered a risk-seeker since she, in fact, will accept less return for a riskier
situation.

Discuss the inputs required for Markowitz portfolio optimization.

Markowitz portfolio theory: Harry Markowitz, who was awarded a Nobel prize in
economics (in part due to his portfolio theories), introduced the basic concept of
portfolio theory. He argued that the value of an additional security to a portfolio ought
to be measured with its relationship to all of the other securities in the portfolio. Thus,
he calculated the movement of each security to all of the others. This was a very
challenging assignment back in the late 1950’s, and began the existence of modern
portfolio theory. He showed that the variance of the rate of return was a meaningful
measure of portfolio risk under a set of assumptions and derived a formula for
computing the variance of a portfolio.

The Markowitz model depends on a few assumptions listed below:

1 Investors consider each investment as a probability distribution of expected

returns over a period of time
2 Investors maximize a one-period expected utility curve with inherent
diminishing marginal utility of wealth
3 Investors use the variability of expected returns as the basis of determining risk
4 Investors base their investment decisions exclusively on the basis of expected
risk and return
5 For a given risk level, investors prefer more return to less. Similarly, for a given
return level, investors desire less risk.

An important point of the Markowitz portfolio theory is that portfolio optimization

occurs when no other asset or portfolio of assets offers higher expected return with the
same (or lower) risk, or lower risk with the same (or higher) expected return.

The following inputs are included in the Markowitz portfolio optimization process:

These include: variance, standard deviation of returns, range of returns and semivariance.
Standard deviation measures the dispersion of returns around the expected value
(variance is the standard deviation squared), with larger dispersion associated with
higher risk. The range of returns presumes that a larger range generates greater
uncertainty. The semivariance approach addresses the likelihood of falling below a
specified minimum rate of return. This measure only considers deviations below the
mean.

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• Measures of risk: Risk is often defined as uncertainty of future outcomes, or as the

probability of an adverse outcome.

Describe and compute the covariance between two assets, given their standard deviations
and the correlation coefficient.

• Variance: a measure of dispersion around an expected return.

Key Formula
n
Variance (σ 2 ) = ∑ [ Ri − E ( Ri )] 2 Pi
i =1
where Pi is the probability of the possible rate of return, Ri

Standard
Possible Expected Variance (R- Deviation
Probability Return Return E( R)2 * p ((R- E( R)2 * p)
1/2

15% 20% 3.0% 0.0036

20% -25% -5.0% 0.0174
65% 10% 6.5% 0.0020
100% 4.5% 0.0230 0.1516

The table above illustrates the formula and computation of variance. First, the expected
return is computed. In this example it is 4.5%. Then, the difference between the possible
return and the expected return is computed and squared. After adding up all of the squared
differences (.0036 + .0174 + .0020) we have the variance (σ 2) which equals .0230.

• Standard deviation: is the square root of the variance

Key Formula
n
Standard deviation (σ) = ∑[R
i =1
i − E ( Ri )] 2 Pi

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Standard
Possible Expected Variance (R- Deviation
Probability Return Return E( R)2 * p 2
((R- E( R) * p)
1/2

15% 20% 3.0% 0.0036

20% -25% -5.0% 0.0174
65% 10% 6.5% 0.0020
100% 4.5% 0.0230 0.1516

In the example above, the standard deviation is simply the square root of the variance.
Since the variance (σ 2) has already been computed as .0230, the standard deviation (σ) or
square root of the variance equals .1516.

Covariance
Covariance of returns is a measure of the degree to which two variables “move together”
over time. In portfolio analysis we usually refer to the covariance of rates of returns.
Portfolio theory is particularly concerned with the covariance of securities with each other
as this enables us to compute the correlation. The covariance has a similar computation as
the variance, however it takes the difference between the security return minus expected
return multiplied by the same difference of another security. If there are different
probability states, then this computation will be adjusted based on those probabilities. The
equation is shown below, but in order to familiarize oneself with this computation (in case
it falls on an examination) candidates are encouraged to actually work through an example.

Key Formula
Covik = E{[Ri - E(Ri )][Rj - E(Rj)]}

The relationship between the standard deviation of two securities, i and j along with the
correlation and covariance are shown below. This is an extremely important equation for
Candidates at all three levels of the AIMR examination. The table below shows
probabilities, possible returns, expected returns, variances and standard deviations. These
terms are used to compute the covariance between securities i and j.

The table below demonstrates how to apply the different probability states and expected
returns in computing the covariance. For example, the first probability (shown to be 50%)
for Security i has a possible return of 20% and an expected return (the weighted average of
all three situations) of 5%. Thus the difference between the possible return and the
expected return equals 15% (20% - 5%). Similarly, there is a 50% likelihood that Security j
will have a possible return of 30% although the expected return overall for Security j is
15%. The difference between the possible return and the expected return for security j
when there is a 50% probability of the event occurring equals 15% (30% - 15%).

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Consequently, the first row of the covariance table equals the probability of .5 multiplied
by the two expected differences (i.e. 15% and 15%). This calculation in the first row equals
.01125. Continuing this same computation for the other probability states (i.e. second and
third rows) and summing the totals provides a covariance computation equal to .02750.

Security i Security j
Standard Standard
Possible Expected Variance (R- Deviation ((R- Possible Expected Variance (R- Deviation ((R-
2 1/2 2 1/2
Probability Return Return E( R) *p) E( R)2 *p) Probability Return Return E( R) *p) E( R)2*p)

50.0% 20.00% 10.00% 0.01125 50.0% 30.00% 15.00% 0.0113

25.0% 10.00% 2.50% 0.00063 25.0% 5.00% 1.25% 0.0025
25.0% -30.00% -7.50% 0.03063 25.0% -5.00% -1.25% 0.0100
100.0% 5.00% 0.04250 0.2062 100.0% 15.00% 0.0238 0.1541

COVij =
Probability [Ri-E(Ri)] [Ri-E(Rj)] E{[Ri - E(Ri )][Rk - E(Rk)]}

50.0% 15.00% 15.00% 0.01125

25.0% 5.00% -10.00% -0.00125
25.0% -35.00% -20.00% 0.01750
100.0% 0.02750

Standard Deviations, Covariance, Correlation

The standard deviations, covariance term and correlations can all be connected through the
equation shown below:

Key Formula
σ I σ j rij = Covij
The equation above is very useful. It demonstrates that the covariance equals the product
of the security standard deviations multiplied by the correlation. Consequently, given a
covariance and standard deviations of two securities, the correlation may be computed.
Alternatively, if an analyst has the standard deviations of two securities and the
correlation, then the covariance may be computed. The examples below demonstrate the
applications of this equation.

Example:
What is the covariance of an investment that has two assets with σi = .2062, σj = .1541
and rik = .8656?

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Solution: The Cov ij = σi σj rij = 0.2062 * 0.1541 * 0.8656 = 0.02750.

Note: The equation between the correlation, covariance and asset standard deviations can
be altered to create a variety of questions. For example, given the data from the tables
above a question could be asked to find the Cov ij, the rij, the s i or the s j. The table below
shows how a “missing link” could be asked given the data from the other three categories.
However, so long as an analyst understands the basic equation σ I σ j r ij = Covij then the
missing part should be relatively easy to compute.

si sj r ij Covij
0.2062 0.1541 ? 0.02750
0.2062 0.1541 0.8656 ?
? 0.1541 0.8656 0.0275
0.2062 ? 0.8656 0.0275

Professor’s Tip:
This section provides the potential for several types of questions. First, questions related
to standard deviation might exist. While this topic is also addressed in the Quantitative
Section, it appears here as well. Thus, if a question on standard deviation appears on the
exam it could technically arrive from either (or both locations). Candidates should know
how to compute standard deviation given a set of data (i.e. returns, expected returns and
portfolio probability). Moreover, candidates absolutely need to understand the
interrelationships among the various terms. Questions could potentially be asked about
covariance, given a set of standard deviations and correlation coefficient. Alternatively, a
candidate could be asked to compute the correlation, given the covariance and standard
deviations of two securities. The computations are not difficult, nor is the equation
deriving each of these terms cumbersome. However, if candidates confuse the individual
terms, or if candidates confuse the expression related the individual terms (i.e. confuse the
correlation or covariance terms) then a simple computation (or computations) will be lost.
Given the importance of this section, and the ease by which AIMR can prepare questions,
candidates should absolutely memorize the expression above and be prepared for solving a
missing part of the equation.

Describe and compute the correlation coefficient of two assets, given their standard
deviations and the covariance.

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• Correlation: is the standardization of the covariance term. The correlation is defined as

the covariance of two securities divided by the standard deviation of each security
multiplied by the other. A correlation coefficient ranges in values from -1 to +1. A
correlation of -1 is considered perfectly negatively correlated with one another, whereas
a correlation of +1 is an example of perfect positive correlation. If one security went
up 100% then the other security should also rise

Key Formula
rik = Cov ik
σi σk
where,

rik = the correlation coefficient of returns

σI = the standard deviation of Rit
σk = the standard deviation of Rkt

Example: What is the correlation coefficient of rik given the following information:
Cov ik = .02, σi = .15 σk = .20?

si sk rik Covik
0.1500 0.2000 ? 0.02000

Solution: Since the rik = Cov ik then, .02/(.15 *.20) = .667

σiσk

Professor’s Tip:
This section illustrates an important twist to the formula given above σ i σ k r ik = Covik.
Note: by dividing the covariance by the asset standard deviations, the regression
coefficient becomes the determinant in the equation r ik = Covik/(σi σ k) . Consequently,
candidates need to be capable of interchanging the terms in these equations.

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Explain the concept of diversification and discuss the special role that the correlation
between asset returns plays in determining a portfolio’s risk.

Standard deviation of a portfolio: The standard deviation of a portfolio is a function

of the weighted average of the individual variances, plus the weighted covariances
between all the assets in the portfolio. The important factor to consider when adding
an investment to a portfolio is not the investment’s own variance, but its average
covariance with all the other investments in the portfolio. Adding securities to a
portfolio that are not perfectly, positively correlated with each other will reduce the
standard deviation of the portfolio. The ultimate benefit of diversification occurs when
the correlation between two assets is -1.00. The graph below shows an overall
standard deviation of a portfolio of zero, thus creating a risk-free portfolio. This occurs
when two assets are combined, each moving in an opposite direction. For example,
imagine a portfolio of investments, one of which moves with sun-related activities (i.e.
sunglasses) and the other moving in the direction of rain-related activities (i.e.
umbrellas). The combined portfolio of sunglasses and umbrellas ought to negate
weather-related issues (theoretically speaking) as the two assets move in opposite
directions.

TIME PATTERNS OF RETURNS FOR TWO ASSETS WITH PERFECT NEGATIVE

CORRELATION

Return

Returns from Asset A over Time

Mean Return from Portfolio of Assets A & B

Returns from Asset B over Time

• Returns from “A” move in the opposite direction from returns on “B”.
• The mid point between “A” and “B” represents the mean return with no variability
in returns
• The overall standard deviation of this portfolio is “zero”
• This is considered a “risk-free” portfolio

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Professor’s Tip:
In a two asset portfolio, the ideal scenario provides a contrast in asset returns similar to the
“saw tooth” diagram shown above. Thus, one asset would completely offset the other
asset (in terms of risk) providing a smooth rate of return with no variability. This, of
course, could only occur if the two assets had a perfect, negative correlation and is the
subject of periodic inquiry throughout the AIMR program.

Describe the characteristics of the efficient frontier and explain why investment portfolios
on this frontier are superior to all other available portfolios.

Efficient frontier: the efficient frontier represents the set of portfolios that has the
maximum rate of return for every given level of risk, or the minimum risk for every
level of return. Any point beneath the efficient frontier is inferior to points above.
Moreover, any points along the efficient frontier, by definition, are superior to all other
points for that combined risk-return tradeoff.

EFFICIENT FRONTIER FOR ALTERNATIVE PORTFOLIOS

E(R )

A
C

Standard Deviation of Return

• Efficient frontier represents that set of portfolios that provides the maximum rate of
return for every given level of risk.
• Efficient frontier provides the minimum risk for each level of return.
• Both points “A and B” dominate point “C”
• Point “A” provides lower risk for the same return as point “C”
• Point “B” provides higher return for the same risk as point “C”

Candidates should recognize the relevance of incorporating two different assets into a
portfolio with differing correlations and standard deviations. The graph below

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demonstrates that when combining assets of equal weights and returns the lowest risk
“Point E” occurs when two assets are combined with perfect negative correlation. The
highest level of risk (as measured by standard deviation of returns) occurs with “Point A”
that combines two assets with perfect positive correlation.

RISK RETURN PLOT FOR PORTFOLIOS WITH EQUAL RETURNS AND STANDARD
DEVIATIONS BUT DIFFERENT CORRELATIONS

E(R )
0.25

0.20 E D C B A

0.15

0.10

0.05

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10
Standard Deviation of Return

• Combining assets with different correlations does not affect the expected return
(returns are same for all portfolios and weights are equal), but does change the risk of
the combined portfolio.
• Portfolio “E” has two assets with perfect negative correlation.
• Portfolio “A” has two assets with highest positive correlation (in this case its perfect
positive correlation).

The graph below shows what happens when the weights are equal but standard deviations
change. Points E, D, C, B and A all have two assets with differing standard deviations.
The returns are the same because the presumption in this case is that the weights are equal.
However, points “1” and “2” have differing weights and standard deviations.
Consequently, they no longer fall on the same line of return as the other points shown
below. Candidates should attempt to remember that differing standard deviations of
returns may not affect expected return, but rather the standard deviation of the portfolio.

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RISK RETURN PLOT FOR PORTFOLIOS WITH DIFFERENT RETURNS, STANDARD

DEVIATIONS, AND CORRELATIONS

E(R )

2
0.20

0.15 E D C B A

0.10 1

0.05

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10
Standard Deviation of Return

• Assets “A” through “E” represent portfolios with different returns and standard
deviations.
• Returns are all equal because the weights are all .50--.50
• Perfect negative correlation (E) does not result in zero standard deviation because
individual standard deviations are not equal
• Portfolios “1” and “2” have different returns because weights are different (0—100%)

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Identify the optimal portfolio on an efficient frontier.

Optimal Portfolio: is the efficient portfolio that has the highest utility for a given
investor. It is the point of tangency between the efficient frontier and the curve
with the maximum utility.

SELECTING AN OPTIMAL RISKY PORTFOLIO ON THE EFFICIENT FRONTIER

E(Rport)
U31

U21
1
U1

U3 X
U2

U1

E(Oport)

• The utility curves represent the preferences of different individual investors.

• Two investors will select the same portfolio from the efficient set only if their utility
curves are identical.
• Utility curves to the right represent less risk-averse investors; utility curves to the left
represent more risk-averse investors
• The optimal portfolio is the point on the efficient frontier that has the highest utility
for a given investor (X for a risk-averse investor; Y for a less risk-averse investor).
• The optimal portfolio is the point of tangency between the efficient frontier and the
curve with the highest possible utility.

Describe and calculate the expected return and variance of a two-asset portfolio.

Over the past few years, Level I candidates have been tested on the two-asset
portfolio. Given the extensive number of calculations, it is unlikely that the AIMR will
require Level I candidates to compute the variance for a three asset portfolio (though
this information is included in the chapter), though the expected return for a two asset
portfolio is a relatively simple calculation.

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Key Formula
E(Rp ) = E(Rj)(Wj)+ E(Rk)(Wk)
where,

E(Rp) = expected return for the portfolio, and,

(W) = weights of each asset

The variance of the portfolio is a combination of the weights, standard deviations and
correlations of the assets contained therein.

Key Formula
n n n
σ port = ∑w σ 2
i i
2
+ ∑∑ wi w jCov ij
i =1 i =1 i =1

Standard Deviation of Portfolio = (wj2σj2 + wk2σk2 + 2wjwkCovjk).5

Example with perfect positive correlation (assume equal weights)

´ What is the standard deviation of a portfolio (E) assuming the following data?

si wi sj wj Cov ij rij s port

0.1000 0.5000 0.1000 0.5000 0.0100 1.0000 0.1000

R12=1; Cov 12 =(1)(.1)(.1)=.01

[E(R1)=.20; E(σ1)=.10] [E(R2)= .20; E(σ2)=.10]

Standard Deviation of Portfolio = (wj2σj2 + wk2σk2 + 2wjwkCov jk ).5

Answer:σport = [(.5)2(.1)2+(.5)2(.1)2+2(.5)(.5)(.01)]1/2 =.10 (perfect correlation)

====================================================
=
Formula for portfolio variance

σ2p = [W2jσ2j + W 2kσ2k +W2lσ2l] + [2WjWkσjσkr jk + 2WjWlσjσlr jl +2WkWlσkσlr kl]

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As the number of securities increase, the number of correlation estimates increase by a

substantial amount (portfolio of 100 securities requires 4,950 estimates). That is why a
single index market model was created: it significantly reduces the number of calculations,
and estimates how a security correlates with a common market index rather than each
individual security contained within the portfolio

Key Formula
Rj = aj + bjRm + ej

where,

Rj = expected return for security j

a j = intercept
bj = the slope coefficient that relates the returns for security j to the
returns for the aggregate stock market
Rm = the returns for the aggregate stock market

Professor’s Tip:
This is a tricky area that frequently appears on the exam. Candidates should recognize
what happens to the portfolio standard deviation under extreme scenarios. For example, if
the assets have perfect positive correlation or perfect negative correlation the portfolio
standard deviation will range from the standard deviation of either security (with perfect
positive correlation) to zero (with perfect negative correlation). Moreover, if one of the
two assets is the risk free rate, candidates should recognize that two terms drop out (either
the first or second term in addition to the third or final term). This happens as a result of
the risk free rate experiencing zero standard deviation which also causes the covariance
term to equal zero. Note: if either security i or security j is the risk free rate then the σ for
either i or j becomes “0” causing both the correlation and the covariance to become “0”
(e.g. σi σj rij = Cov ij). This is a subtle, but important concept throughout all three of the
AIMR exams.

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Problems: An Introduction to Portfolio Management

1. Three investors Jen, Sarah and Matt are considering two investments A & B.
Investment A is the less risky of the two investments, requiring an outlay of $5,000
with an expected rate of return at 12%. Each investor is satisfied with this expected
return. Investment B also requires an investment of $5,000 and has an expected return
of 12% but appears to have considerably more variability in potential returns compared
with A. Jen now requires a return of 16%, Sarah is still satisfied with 12% and Matt
seeks only an 8% expected return.

Question: Given the information above, which of the three investors, would be
considered risk-averse?

A. Jen
B. Jen and Sarah
C. Sarah and Matt
D. None of the investors are risk-averse

2. Which of the following statements is (are) inconsistent with the Markowitz theory of
portfolio management?

I Investors maximize a one-period expected utility curve with inherent

diminishing marginal utility of wealth
II Investors use the risk measure of beta as the basis of determining risk
III Investors base their investment decisions exclusively on the basis of expected
risk and return
IV a single asset or portfolio of assets is considered to be efficient if no available
asset has a superior return for a given risk level, or lower risk given a return
level.

A. I only
B. II only
C. III and IV only
D. I and III only

3. Given the standard deviations for securities J and K and a correlation of rik = -0.875,
what is the Cov ik ?
si sj rij Cov ij
0.3250 0.6370 -0.875 ?

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A. 0.0870
B. -0.1811
C. -0.2366
D. -4.2267

4. Given the standard deviations for securities J and K and a covariance (e.g. Cov jk ) =
0.05, what is the correlation coefficient (e.g. rjk ) between these two securities?

si sj rij Cov ij
0.4000 0.2000 ? 0.05000

A. 0.0040
B. 0.6250
C. 0.8330
D. 0.9750

5. What is the standard deviation of a two-asset portfolio assuming the following

information?

si wi sj wj Cov ij
0.2500 0.5000 0.2500 0.5000 0.0625

A. 0.0025
B. 0.0625
C. 0.2500
D. 1.0000

6. What is the standard deviation of a two-asset portfolio assuming the following

information?

si wi sj wj Cov ij
0.3000 0.5000 0.3000 0.5000 -0.0900

A. 0.0001
B. 0.1000
C. 0.0005
D. 0.0000

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7. What is the standard deviation of a two-asset portfolio consisting of a risky asset J and
a Treasury bill? Assume that Security J has a standard deviation of 0.35 and that there
is an equal weighting of each security.

A. 0.0000
B. 0.0035
C. 0.1750
D. 0.3500

8. What is the standard deviation of a two-asset portfolio assuming the following

information?

si wi sj wj Cov ij
0.3500 0.2000 0.7500 0.8000 0.1235

A. 0.4856
B. 0.0764
C. 0.6359
D. 0.3198

9. An investor is preparing the selection of two assets in her portfolio. The first asset “X”
has already been selected. Given the correlation with the four investments shown
below, which investment should be selected in order to minimize the portfolio risk?

Investment Correlation with X

V 0.00
W 1.00
Y -0.45
Z 0.50

A. Investment V
B. Investment W
C. Investment Y
D. Investment Z

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10. Which of the following statements regarding the efficient frontier are incorrect?

I Efficient frontier represents that set of portfolios that provides the maximum rate
of return for every given level of risk.
II Efficient frontier provides the maximum risk for each level of return.
III Points along the efficient frontier dominate all points beneath the curve
IV Points along the curve to the right of any other point on the curve must have a
higher expected return and higher level of risk

A. I only
B. II only
C. III and IV only
D. II and IV only

11. The optimal portfolio includes all of the following characteristics except which of the
following?

A. The optimal portfolio has the highest utility for a given investor
B. The optimal portfolio lies at the point of tangency between the efficient frontier
and the highest possible utility curve
C. The optimal portfolio may be different for each investor
D. Utility curves may be different for individual investors even though the optimal
portfolio for each investor is presumed to be the same

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Answers: An Introduction to Portfolio Management

1. A. Only Jen would be considered risk-averse. She is the only investor that demands a
risk-premium to entice her into this riskier venture. Sarah would be considered risk-
neutral as she is content with the same rate of return despite the higher risk levels and
Matt would be considered a risk seeker as he is demanding a return that is less than the
return offered for a lower risk investment.

TestNet Update:: According to TestNet, our online exam database, only 62% of all test
takers answer this question correctly.

2. B. Investors use the variability of expected returns as the basis of risk. Beta is not a
risk measure in the Markowitz portfolio theory. The contributions of Markowitz
addressed the covariance of returns from differing investments and the value of
portfolio diversification. He demonstrated how it was possible to reduce portfolio risk,
as measured through variability of expected returns by investing in assets that did not
move in the same direction. All of the remaining statements are true.

3. B. The covariance between J and K is equal to the formula: Cov ik = (rik * σj * σk).
Since the rik = -0.875 and the σj = 0.325 and the σk = 0.637, the Cov ik must equal
= -0.875 * 0.325 * 0.637 = -0.1811.

si sj rij Cov ij
0.3250 0.6370 -0.875 -0.1811

TestNet Update:: According to TestNet, our online exam database, more than 75% of all
test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

4. B. Level I candidates need to know how to interchange these variables and equations.
The AIMR frequently has questions such as this on the exam. Since the formula for the
correlation coefficient is rik = (Cov ik )/σjσk and the variables for Cov ik = 0.05, σi =
0.40 σj = 0.20, the solution becomes the following computation of.05/(.40 *.20) =
0.6250.

si sj r ij Covij
0.4000 0.2000 0.6250 0.0500

TestNet Update:: According to TestNet, our online exam database, more than 75% of all
test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

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5. C. This appears to be a difficult question, but no calculation is required!

Level I candidates should recognize the impact of a two asset portfolio in which the
assets are equally weighted and are perfectly positively correlated with each other.
Since each standard deviation of returns = .25, the only way that the covariance can
equal 0.0625 is if the correlation is perfectly positively correlated (e.g. = 1.0). [Note
Cov ij = rij *σi *σj, implying 0.0625 = .25 * .25 * 1.0]. Since the assets are perfectly
positively correlated, and since each asset has the same standard deviation, the
portfolio standard deviation remains unchanged.

The standard deviation for a two asset portfolio =

Standard Deviation of Portfolio = (wi2σi2 + wj2σj2 + 2wiwjCov ij).5

since,
wi = 0.50
wj= 0.50
σi =0.25
σj = 0.25
Cov jj = 0.0625
Standard Deviation of this portfolio = [((0.50)2*(0.25)2+ (1-0.50)2*((0.25)2)+
2*0.50*0.50*0.0625)].5 = 0.250

si wi sj wj Cov ij rij s port

0.2500 0.5000 0.2500 0.5000 0.0625 1.0000 0.2500

TestNet Update:: According to TestNet, our online exam database, more than 75% of all
test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

6. D. Don’t be intimidated by the appearance of a difficult question. No calculation is

required! Level I candidates should recognize the impact of a two asset portfolio in
which the assets are equally weighted and are perfectly negatively correlated with each
other. Since each standard deviation of returns = .30, the only way that the covariance
can equal -0.090 is if the correlation is perfectly negatively correlated (e.g. = -1.0).
[Note Cov ij = rij *σi *σj, implying -0.09 = .30 * .30 * -1.0]. Since the assets are perfectly
negatively correlated, and since each asset has the same standard deviation, the
portfolio standard deviation goes to zero! Picture the saw-tooth diagram with one
investment going up at the same time another is going down (i.e. investments in
sunglasses and umbrellas). This is a desirable situation for an investor.

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si wi sj wj Cov ij rij s port

0.3000 0.5000 0.3000 0.5000 -0.0900 -1.0000 0.0000

The standard deviation for a two asset portfolio =

Standard Deviation of Portfolio = (wj2σj2 + wk2σk2 + 2wjwkCov jk ).5

since,
wi =0.50
wj= 0.50
σi =0.30
σj =0.30
Cov ij = -0.0900
Standard Deviation of this portfolio = [((0.50)2*(0.30)2+ (1-0.50)2*((0.30)2)+
2*0.50*0.50*-0.0900)].5 = 0.000

TestNet Update:: According to TestNet, our online exam database, the vast majority of
our test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

7. C. This is a common question by AIMR. Level I candidates should realize that the
covariance between a risky asset and a Treasury Bill = 0. Note: the standard deviation
of a Treasury Bill = 0 so the covariance = 0 (the covariance equals the correlation
multiplied by the respective standard deviations of each security or Cov ij = rij*0.35 *
0.00). Thus, the only relevant term in the equation is the first term! The second and
third terms in the equation drop out completely. The only relevant risk is the risky asset
and the contribution to the portfolio is a function of the (weight of the risky asset
squared multiplied by the variance of the risky asset).5.

si wi sj wj Cov ij rij s port

0.0000 0.5000 0.3500 0.5000 0.0000 0.0000 0.1750

Variable J Treasury Bill Combined

Weight in 50% 50%
portfolio
Standard 0.35 0.00 (implied)
Deviation (σ)
Covjk 0.000 (implied)

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The standard deviation for a two asset portfolio =

Standard Deviation of Portfolio = (wi2σi2 + wj2σj2 + 2wiwjCov ij).5

since,
wj = 0.50
wj= 0.50
σi =0.00
σj = 0.35
Cov jk = 0.0000
Standard Deviation of this portfolio = [((0.50)2*(0.00)2+ (1-0.50)2*((0.35)2)+
2*0.50*0.50*0.0000)].5 = 0.1750

TestNet Update:: According to TestNet, our online exam database, the vast majority of
our test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

8. C. This is a complicated question that requires the candidate to memorize the two-
asset formula and apply each calculation. Candidates need to be sensitive to the
unequal weightings of each asset and the varying standard deviations.

The standard deviation for a two asset portfolio =

Standard Deviation of Portfolio = (wj2σj2 + wk2σk2 + 2wjwkCov jk).5

since,
wi = 0.20
wj= 0.80
σi =0.35
σj = 0.75
Cov jk = 0.1235
Standard Deviation of this portfolio = [((0.20)2*(0.35)2+ (1-0.20)2*((0.75)2)+
2*0.20*0.80*0.1235)].5 = 0.6359

si wi sj wj Cov ij rij s port

0.3500 0.2000 0.7500 0.8000 0.1235 0.0324 0.6359

TestNet Update:: According to TestNet, our online exam database, the vast majority of
our test takers do not even bother to answer this question. This is a popular question that
candidates should attempt to solve. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

9. C. Investors attempting to reduce the risk in a portfolio will select the lowest
correlation. In this particular case, the lowest correlation to investment “X” is also the
only negative correlation among the choices. Investment “Y” which has a correlation

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with “X” of - .45, which suggests that it will actually reduce the risk of the portfolio
with its addition.

10. B. The efficient frontier provides the minimum risk for each level of return. Points
along the efficient frontier dominate all points beneath the curve and must have an
increasing expected rate of return as they move along the curve to the right. The
expected risk level also corresponds with movement to the right.

TestNet Update:: According to TestNet, our online exam database, only 42% of all test
takers get this seemingly “easy” question correct. The answers to this question may each
seem correct, but they are not. Candidates need to be careful with these types of subtle
questions and responses. On exam day, they will make a big difference in outcome.

11. D. The optimal portfolio varies for each investor depending on the investor’s utility
curve. The optimal portfolio occurs at the point of tangency between the efficient
frontier and the investor’s highest possible utility curve. However, some risk-averse
investors may have a utility curve which demands a lower expected return/lower
expected risk trade-off compared to others.

TestNet Update:: According to TestNet, our online exam database, approximately 75%
of all of our respondents answer this question correctly.

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“An Introduction to Asset Pricing

Models”
Reilly, Chapter 9
Overview:
This chapter has a number of definitions and theories. CFA Level I candidates should
understand and be able to apply the basic theories. This material provides the foundation
for all three exams. AIMR frequently tests the theoretical concepts in this chapter,
particularly at Levels I and II. This section addresses a number of key Asset Pricing
concepts, such as:

• Assumptions of the CAPM

• Risk-free asset
• Capital Market Line
• Separation theorem
• Security Market Line
• Overvalued securities
• Undervalued securities
• Arbitrage Pricing Theory

Assumptions of the CAPM: There are a number of limiting assumptions regarding the
Capital Asset Pricing Model (CAPM). Candidates do not need to memorize the
assumptions. However, you should remember that most of the assumptions assume a
perfect market that is unaffected by considerations such as transactions costs or undue
influence by a single investor. Consequently, in a perfect market there would be no
transactions costs, numerous investors with homogeneous expectations and the ability to
borrow and lend at the risk-free rate.

Explain how the presence of a risk-free asset changes the characteristics of the Markowitz
efficient frontier.

The risk free asset is important to the capital asset pricing model. It is assumed to have an
expected return commensurate with an asset that has no standard deviation (i.e. zero
variance) around the expected return. This assumption allows us to derive a generalized
theory of capital asset pricing under conditions of uncertainty from the Markowitz portfolio
theory. The standard deviation of a portfolio that combines the risk-free asset with risky
assets is the linear proportion of the standard deviation of the risky asset portfolio.

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PORTFOLIO POSSIBILITIES COMBINING THE RISK-FREE ASSET AND RISKY

PORTFOLIOS ON THE EFFICIENT FRONTIER

E(Rport)

M D

C B

RFR A

E(O port)

• Any combination between the Risk Free Rate and a point on the efficient frontier (e.g.
“A” or “B” dominates all points on the efficient frontier below the line (equal variance
higher return)
• Line RFR-M dominates all portfolios below Point M
• Point C provides a risk-return combination between RFR and Point M (i.e. ½ in risk-
free asset and ½ in risky portfolio M)
• Points beyond risky portfolio M, require leverage

Identify the market portfolio and describe the role that the market portfolio plays in the
formation of the capital market line (CML).

Portfolio M (i.e. market portfolio) lies at the point of tangency is a completely diversified
portfolio that includes all risky assets in proportion to their market value. All investors
want to invest in Portfolio M and borrow or lend to be somewhere on the CML.

The Capital Market Line represents the relationship between the risk free asset and the
standard deviation of the market portfolio. The line begins with the risk free asset and
then increases with increasing levels of risk (as defined by standard deviation). All
investors hold a combination of the risk free asset and the risky portfolio. Those who want
additional returns may borrow and lend at the risk free rate. The relationship is shown in
the graph illustrated below:

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DERIVATION OF CAPITAL MARKET LINE ASSUMING LENDING OR BORROWING

AT THE RISK FREE RATE

E(Rport)
CML
Borrowing

Lending

RFR

E(Oport)

• Points to the right of M require borrowing at the risk-free rate

• Returns increase in a linear manner along the RFR-M line
• All portfolios on the CML invest in either the RFR or risky portfolio
• All portfolios on the CML are perfectly positively correlated (same two assets with
differing percentages)
• Portfolio M includes all risky assets and represents the desired portfolio
• The risk in the CML is represented by the standard deviation of returns in the market
portfolio

Total risk is comprised of systematic (undiversifiable risk) and unsystematic or

diversifiable risk. By adding more securities to a portfolio, much of the unsystematic or
diversifiable risk can be eliminated (shown below). While it is not possible to eliminate
the systematic risk through diversification, it is possible to reduce this risk through
international diversification (discussed later).

NUMBER OF STOCKS IN A PORTFOLIO AND THE STANDARD DEVIATION OF

PORTFOLIO RETURN

Standard Deviation of Return

Unsystematic
(diversifiable)
Total Risk
Risk
Standard Deviation of
the Market Portfolio
Systematic Risk (systematic risk)

Number of stocks in the portfolio

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The table shown above has the following important attributes:

• A completely diversified portfolio has a correlation with the market portfolio of 1.0
• After unsystematic risk is eliminated, then only systematic risk is left
• About 90 percent of the maximum benefit of diversification occurs with portfolios of
12-18 stocks
• Adding stocks to a portfolio reduces overall standard deviation of portfolio but does
not eliminate variability
• It is possible to lower systematic risk by investing globally rather than in the U.S. only
• It is possible to reduce systematic-risk through global diversification. Global
diversification reduces the portfolio systematic risk as a result of combining the
relatively low correlation among different countries

Separation Theorem:
The separation theorem frequently appears on AIMR exams. The separation theorem
refers to the independence of the investment decision from the financing decision. For
example, when the investor initially decides to invest in the market portfolio, M this is
the investment decision. However, subsequent to the risk preference, if the investor
decides to borrow or lend based on risk preferences, this is a separate financing
decision.

DERIVATION OF CAPITAL MARKET LINE ASSUMING LENDING OR BORROWING

AT THE RISK FREE RATE

E(R port )
CML

RFR

E(O port)

• This graph represents the CML and the separation theorem

• CML leads investors to invest in same risky portfolio M, but different points on CML
depend on the financing decision (separation theorem)
• Portfolio M represents the investment decision
• Points A or B represent a financing decision
• Point A represents a risk-averse investor who lends some assets at the RFR (buys risk
free assets) and invests the balance in risky assets (M)
• Point B represents an investor who prefers more risk. This investor borrows funds (at
RFR) and invests everything in portfolio M

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• The relevant risk when adding a security to a portfolio is its average covariance with all
other assets in the portfolio

Capital Market Line

Risk Measure for the CML
• The relevant risk measure for risky assets is their covariance with the M portfolio
(systematic risk)
• The relevant risk when adding a security to a portfolio is its average covariance
with all other assets in the portfolio
• Portfolio M is the only relevant portfolio

Define and distinguish between systematic and unsystematic risk.

Total risk is measured as the standard deviation of security returns. As the number of
securities increase, the portfolio manager can eliminate unsystematic risk (or
diversifiable risk) and focus on the systematic or undiversifiable risk.

The systematic risk is the risk that is inherent in the market that cannot be diversified
away. Examples of systematic risk or market risk include macro economic factors that
affect everything (such as the growth in US GNP, inflation, etc.).

Unique, diversifiable or unsystematic risk is the risk that can be diversified away. This
risk is offset by the unique variability of the other assets in the portfolio.

Diversification efforts tend to focus on the risk reduction of unsystematic risk. As the
exhibits (shown earlier) demonstrate, much of this risk can be reduced or eliminated
with 18 or more diverse securities (randomly selected). While unsystematic risk can be
reduced, the systematic risk generally cannot. Attempts to introduce international
securities or even securities in differing asset classes (such as adding bonds with stocks
or vice versa) are attempts to reduce the systematic risk of a portfolio.

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GRAPH OF SECURITY MARKET LINE

E(R1)
SML

Rm

RFR

σM2
CovM

• Because all investors want to be on the CML, an asset’s covariance with the market
portfolio of risky assets emerges as the appropriate risk measure
• SML uses the covariance of an individual security with the market

Key Formula

• E(Ri) = RFR + RM – RFR (Cov i,M)

σ2
• E(Ri) = RFR + (Cov i,M) (RM – RFR)
σ2m
β= (Covi,M)
σ2 m

The term above is important for Level I and II candidates. AIMR occasionally
provides candidates with the covariance and variance of returns on the market,
rather than the beta term. Consequently, it may be necessary to derive the
security’s beta, by dividing its covariance with the market by the market variance.
This is not a complicated computation, but a formula that is easily forgotten. It
may come in handy.

The expression below is a key relationship. Many exam questions will come from
this equation. Candidates should remember that the risk free rate is often
synonymous with the Treasury bill rate (short term). The beta is usually provided
(though not always—see note above) and the return on the market is usually
provided as the expected return on the S&P 500 (or other large index of returns).

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Key Formula
E(Ri) = RFR + β i (RM – RFR)

GRAPH OF SML WITH NORMALIZED SYSTEMATIC RISK

E(R 1)
SML

Rm

Negative
Beta
RFR

Beta(Cov im/σM
2)
0 1.0

• The relevant risk measure represents the covariance of any asset (i) with the market
portfolio (Cov i,M)
• β is the standardized measure of systematic risk because it relates the covariance
between a security and the market to the variance of the market portfolio
• Market portfolio has a β = 1 (by definition)
• If β > 1 ⇒ asset is more volatile than market
• If β < 1 ⇒ asset is less volatile than market

Discuss the security market line (SML) and how it differs from the CML.

CAPM refers to the capital asset pricing model. The CAPM uses the SML or security
market line to compare the relationship between risk and return. Unlike the CML
which uses standard deviation as a risk measure on the X axis, the SML uses the
market Beta, or the relationship between a security and the marketplace. The use of
beta enables an investor to compare the relationship between a single security and the
market return, rather than a single security with each and every security (as Markowitz
did). Consequently, the risk added to a market portfolio (or a fully diversified set of
securities) should be reflected in the security’s beta. The expected return for a security
in a fully diversified portfolio should be equal:

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Key Formula
E(Ri) = Rf + β I (Rm - Rf)

Calculate, using the SML, the value of a security and evaluate whether the security is
undervalued, overvalued, or properly valued.

Using the exhibit below, the CAPM will be computed and compared to the analyst-
estimated rate of return. Analysts estimate the rate of return based on company and
industry growth rates.

PRICE, DIVIDEND, AND RATE OF RETURN ESTIMATES

Current Price Expected Price Expected Dividend Esimated Future Rate

Stock (P 1) (Pe + 1) (De + 1) of Return (Percent)
A 25 27 0.50 10.0
B 40 42 0.50 6.2
C 33 39 1.00 21.2
D 64 65 1.10 3.3
E 50 54 - 8.0

COMPARISON OF REQUIRED RATE OF RETURN TO ESTIMATED RATE OF RETURN

Expected Return Estimated Esimated Return

Stock Beta E(R1) Return Minus E(R 1) Evaluation
A 0.70 10.2 10.0 -0.2 Properly valued
B 1.00 12.0 6.2 -5.8 Overvalued
C 1.15 12.9 21.2 8.3 Undervalued
D 1.40 14.4 3.3 -11.1 Overvalued
E -0.30 4.2 8.0 3.8 Undervalued

• Assume: RFR = .06; RM = .12 (12%)

• Market risk premium = (RM – RFR) =
• Risk Premium = (.12 - .06) =.06 (6%)
• E(Ri) = RFR + β i (RM – RFR)
• E(RA) = .06 + .70(.12-.06) = 10.2%
• E(RB) = .06 + 1.0(.12-.06) = 12%
• E(RC) = .06 + 1.15 (.12-.06) = 12.9%
• E(RD) = .06 + 1.4(.12-.06) = 14.4%
• E(RE) = .06 + (-.3)(.12-.06) = 4.2%
• Security A is properly valued
• Securities B & D are overvalued—Required return > estimated return
• Securities C & E are undervalued—
• Required return < estimated return

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Overvalued and undervalued securities are those securities that do not lie on the SML line.
By definition, securities that are efficiently priced should fall directly on the (calculated)
SML line. If a security is above the line it is deemed undervalued since it is providing more
expected return than what is demanded for that risk level. Securities falling below the SML
line are, on the other hand, providing less return than the market demands. Securities that
fall below the SML are considered overvalued. In the former case, the security price will
be bid up, such that the expected return declines and the security falls back to the SML
line. In the situation where the security is overvalued, the security price declines until the
expected return rises.

PLOT OF ESTIMATED RETURNS ON SML GRAPH

Return Undervalued
E(R 1)
0.22 C SML

0.18
Properly
0.14 Valued
Rm
0.1
Overvalued
E B
0.06
A D
0.02

-0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40

Risk Beta

All assets and all portfolios should plot on the SML.

• Stock “A” has an estimated rate of return equal to its systematic risk or required rate of
return.
• Stocks C and E are expected to provide rates of return above the required rates of
return.
• Stocks B and D are expected to provide rates of return below the required rates of
return.
• Investor should buy C and E (undervalued).
• Investor should sell B and D (overvalued)

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Describe the relationship between the SML and the capital asset pricing model (CAPM)
and explain how these two concepts are used to determine the required and expected rates
of return for risky assets

The SML represents the required rate of return, given the systematic risk provided by the
security. However, if the expected rate of return exceeds this amount, then the security
provides an investment opportunity for the investor. The difference between the expected
and required return is called the alpha (α) or excess rate of return. The alpha can be
positive when the stock is undervalued, or negative when the stock is overvalued. The
alpha becomes zero when the stock falls directly on the SML (properly valued).

Explain how the systematic risk of an asset is derived using the characteristic line

The systematic risk for an individual asset is derived from a regression model known as the
characteristic line of the asset to the market portfolio.

Key Formula
E(Ri,t ) = α i + β i (RM,t + ε)
Where:

Ri,t = rate of return for asset i during period t

RM,t = rate of return for the market portfolio during time period t
α i = the constant term, or intercept, of the regression, that equals Ri - β i RM,t
β i = the systematic risk (beta) of asset i that equals Cov i,M/σ2M
ε = the random error term

The characteristic line represents the regression line based on historical relationships. As a
practical matter, many companies calculate betas based on weekly or monthly returns.
Beta values may vary depending on the size of the firm, time interval used (weekly or
monthly) as well as the market proxy. Most investigators tend to use the S&P 500
Composite Index as a proxy for the market portfolio. However, the computation of beta,
use of market proxy and evidence using the CAPM has come under considerable criticism.
These criticisms typically form a critical element of discussion in Level II CFA exam
readings.

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 Portfolio Management

Explain the similarities and differences between arbitrage pricing theory (APT) and
CAPM

Arbitrage pricing theory (APT) is a broader based theory compared to the CAPM, which
states that all of the systematic factors may not be represented in the single market factor
represented by the CAPM. The APT model requires fewer assumptions and considers
multiple factors to help explain the risk of an asset. APT suggests that there may be several
systematic factors (such as oil prices, market risk aversion, etc.) that vary from period to
period. While the APT theory may be conceptually appealing, it lacks practical application
since it does not specify the relevant systematic factors. Consequently, portfolio managers
are left with a difficult choice. They can continue to use the CAPM with its limitations
and assumptions or select a more intuitively appealing theory that does not specify the
relevant factors to include in pricing a security. While the APT continues to be tested for
relevant market factors, most investors will continue to rely on either the CAPM or a
variation of the CML using standard deviation as a risk proxy.

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 Portfolio Management

Problems: An Introduction to Asset Pricing Models

1. Phan Ngo purchased a security with a standard deviation of 0.19. A short-term

Treasury bill offers an expected rate of return of 6.5%. Assume the market has an
expected return of 15.00% and an expected standard deviation of 0.11. What is the
expected rate of return for this security assuming it has a correlation with the market of
0.452?

A. 11.79%
B. 9.093%
C. 16.68%
D. 13.14%

2. Barry Bondman from MyExistence Capital Ind. Purchased a security that has a beta of
–0.38. Based on Barry’s insight, he believes that his security will provide a return of
5.60%. Given an expected risk-free rate of 5%, an expected return on the S&P at 12%
and expected inflation at 3.2%, select the correct evaluation below.

A. The security is properly valued

B. The security falls above the SML
C. The security falls below the SML
D. The security falls directly on the SML

3. John Heller from Fast Bank Securities Corp. purchased a security that has a beta of
1.12. Based on John’s insight, be believes that his security will provide a return of
6.97%. Given an expected risk free rate of 5%, an expected return on the S&P 500 of
16% and expected inflation rate at 1.90%, select the correct evaluation below.

A. The security falls below the SML

B. The security is overvalued
C. The security provides the same estimated rate of return demanded by the CAPM
D. The security provides more estimated return than demanded by the CAPM

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 Portfolio Management

4. Chris Galen owns Security X which has a standard deviation of 0.49 and wants to
purchase another security. Assuming that Chris owned a fully diversified portfolio,
which of the following securities should she add to her portfolio?

Security S T U V
Correlation 0.80 0.80 -0.68 0.08
Covariance 0.044 0.036 -0.014 0.008
Standard 0.20 0.16 0.17 0.34
Deviation

A. Investment S
B. Investment T
C. Investment U
D. Investment V

5. Bill Silverman has a portfolio with the following characteristics. Determine the beta
for his portfolio.

Security ABC XYZ Treasury Bill S&P Index

Fund
Weight 0.40 0.31 0.25 0.04
ß -0.10 1.70

A. 0.418
B. 0.668
C. 0.527
D. 0.125

6. In regard to the equation E(R) = RF + ß(RM – RF), which of the following statements is
(are) incorrect?
A. The Beta represents systematic risk
B. The market portfolio will, by definition, always have a ß of 1.0
C. A parallel shift in the yield curve will cause ß to increase
D. Total risk includes diversifiable (unsystematic) risk and non-diversifiable
(systematic) risk

7. Which of the following statement regarding the Security Market Line and Capital
Market Line is (are) false?

A. The efficient frontier represents the investment opportunity set that has the highest
reward-to-volatility ratio (i.e. return-to-standard deviation)
B. All portfolios on the CML invest in either the risk-free asset or risky portfolio
C. The CAPM refers to both the SML and CML
D. SML uses the covariance of an individual security with the market

© Shulman Review 244 Study Session #18

 Portfolio Management

8. Which of the following statements regarding portfolio diversification is untrue?

A. Adding many stocks (over 100) to a portfolio reduces overall standard deviation of
the portfolio and can eliminate variability
B. World systematic risk levels may be lower than any single country due to the lower
correlation among the different countries
C. Unique, diversifiable or unsystematic risk can be offset by the unique variability of
the other assets in the portfolio
D. Examples of systematic risk include macroeconomic factors (such as growth in
GDP and inflation)

9. Which of the following statements does not apply to the separation theorem?

A. The financing decision refers to the tangent point between the CML and an
investor’s utility curve
B. The financing decision refers to a single point along the CML
C. Investors desiring less risk will lend money at the risk free rate
D. An investor that is 100% in risky assets will be at Point M on the CML

10. All of the following terms may represent the systematic risk of an individual asset,
derived from a regression model of an asset with the market portfolio (characteristic
line), except?

A. αI
B. ε
C. Cov i,M/σ2M
D. µi

11. Which of the following represent a distinguishing difference between the Arbitrage
pricing theory (APT) and the CAPM?
I APT requires more assumptions than CAPM
II CAPM uses multiple factors in describing the risk of an asset
III APT has widespread practical application
IV CAPM uses a single systematic factor

A. I only
B. II and III only
C. IV only
D. III and IV only

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 Portfolio Management

12. Of the stocks shown below, which ones would be considered overvalued? For
purposes of these computations, assume a Risk Free Rate of 5% and a Market Return
of 13%

A. AA Only
B. BB & DD
C. CC & EE
D. BB & CC

Estimated
Stock βi Return
AA 0.5 9.00%
BB 1.2 6.20%
CC 0.15 21.20%
DD 0.8 3.30%
EE -0.4 8.00%

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 Portfolio Management

Answers: An Introduction to Asset Pricing Models

1. D. This is a difficult question that requires an analyst to be able to manipulate the

different components of the CAPM. First, candidates need to recognize that there are
3 parts to the puzzle missing before the computation for the expected return can be
made. First, Beta is missing from the provided information. Beta can be computed
from the data using the covariance and the respective standard deviations of each
security, but the covariance has not yet been provided. Moreover, the Beta is
comprised of the covariance divided by the variance of the market—not the standard
deviation! Thus, before answering this question, the candidate needs to convert the
standard deviation of the market to a variance, compute the covariance and then
calculate the security beta. This first computation is simple. The variance of the
market equals the market standard deviation of .110 squared or .012. Next the
covariance needs to be computed. The covariance = correlation multiplied by the
respective standard deviations of the different securities. Since the correlation has been
provided, the covariance needs to be derived from the formula Cov iM = riM * s i * s M.
In this situation, riM = .452, s i = .19 and s M = .110. Thus Cov iM = .452 * .190 * .110
or .009. Once Beta is calculated, the CAPM can then be applied. The Beta =
(Cov iM/s 2M). Since Cov iM = .009 and s 2M = .012, the ß = .781.

The required rate of return = RF + ß(RM –RF). RF = 0.065 and RM = 0.150. Since,
Cov iM = 0.009 and the s 2M = 0.012, ß must equal (0.009)/(0.012) or 0.781. Again, it’s
important to remember that the variance of the market is equal to (.110)2 or .012.
Since ß = .781 the equation can now be completed. RF + ß(RM –RF) = 0.065 + .781*
(0.15 - 0.065) = 13.14%.

Expected
2
RF ß RM CoviM s M si sM riM Return

0.065 ? 0.150 ? ? 0.190 0.110 0.452 ?

0.012
0.009
0.781
0.1314

TestNet Update:: According to TestNet, our online exam database, only 56% of all of
our test takers answered this question correctly. This is a difficult question, but certainly
“fair game” for the Level I exam. In our database, this is an “infinite series question” in
which the numbers and corresponding answers change each time.

2. B. This security is undervalued or above the SML. This implies that the security is
providing greater return than demanded by the SML. The required rate of return for
security j = RF + ß(RM –RF), where RF = 0.05, ß= -0.38 and RM = 0.12.

© Shulman Review 247 Study Session #18

 Portfolio Management

Consequently, the E(Rj) = 5% - 0.38 * (12% - 5%) = 2.34%). The required rate of
return as determined by CAPM is 2.34%. Since the analyst’s estimated return is 5.6%,
the security is providing a return of 3.26% greater than the return demanded by the
CAPM. This implies that the security is undervalued or above the line. Candidates
should note that the expected inflation rate mentioned in this question is extraneous
information.

Expected Estimated Overvalued

Estimated Return Excess or
βi Return E (Ri ) Return Undervalued
-0.38 5.60% 2.34% 3.26% Undervalued

TestNet Update:: According to TestNet, our online exam database, only 63% of all of our
test takers answered this question correctly. This is a very popular question at Level I.
Candidates should absolutely review this question many times to ensure consistency and
accuracy with computations and interpretation. In our database, this is an “infinite series
question” in which the numbers and corresponding answers change each time.

3. A. This security is overvalued or below the SML. This implies that the security is
providing less return than demanded by the SML. The required rate of return for this
security is based on the formula E(Rj) = RF + ß(RM –RF) where, RF = 0.05, ß = 1.12
and RM = 0.16. Thus E(Rj) = 5% + 1.12 * (16% - 5%) = 17.32%. The required rate
of return as determined by CAPM is 17.32%. Since the estimated return is 6.97%, the
security is providing a return of 10.35% less than the required return demanded by the
CAPM. This implies that the security is a poor value (i.e. providing less return than
what is demanded for a security of this risk level) and is considered overvalued. An
overvalued security would be positioned below the SML.

Expected Estimated Overvalued

Estimated Return Excess or
βi Return E (Ri ) Return Undervalued
1.12 6.97% 17.32% -10.35% Overvalued

© Shulman Review 248 Study Session #18

 Portfolio Management

PLOT OF ESTIMATED RETURNS ON SML GRAPH

Return
E(R1 )
22.0% SML

18.0%

17.3%
Rm
Overvalued
10.0%
6.0%

2.0%

-0.80 -0.60 -0.40 -0.20 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00 2.20 2.40
1.12 Risk Beta

TestNet Update:: According to TestNet, our online exam database, only 43% of all of our
test takers answered this question correctly. This is a very popular question at Level I.
Candidates should absolutely review this question many times to ensure consistency and
accuracy with computations and interpretation. In our database, this is an “infinite series
question” in which the numbers and corresponding answers change each time.

4. C. The best security is “U”. The correlation coefficient = -0.68 and the covariance =
-0.014. Investors should select the asset combination that reduces risk to the portfolio.
This would include the asset with the lowest correlation.

TestNet Update:: According to TestNet, our online exam database, approximately 82%
of all of our test takers answered this question correctly. This is a very popular question at
Level I. In our database, this is an “infinite series question” in which the numbers and
corresponding answers change each time.

5. C. This question assumes that the candidate will be able to complete the table before
making the necessary computations. The Treasury bill has a ß = 0.00 since it has no
covariance, and the S&P Index fund has a ß = 1.0 since it moves with the market
(technically it is the market). After completing the missing data in the table, the beta of
the portfolio can be determined by multiplying each security’s ß by its weight in the
portfolio.

Security ABC XYZ Treasury S&P Total

Bill Index
Fund
Weight 0.40 0.31 0.25 0.04 1.00
ß -0.1 1.7 0 1
Weighted ß -0.04 0.527 0 0.04 0.527

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 Portfolio Management

The final computation equals each weighted average added together:

ABC = 0.40 * -0.10 +
XYZ = 0.31 * 1.70 +
Tbill = 0.25 * 0.00 +
S&P = 0.04 * 1.00 = 0.527

TestNet Update:: According to TestNet, our online exam database, approximately 78%
of all of our test takers answered this question correctly. This is a very popular question at
Level I. In our database, this is an “infinite series question” in which the numbers and
corresponding answers change each time.

6. C. A parallel shift in the yield curve will not necessarily make the ß increase or
decrease. CAPM refers to the capital asset pricing model. The CAPM uses the SML or
security market line to compare the relationship between risk and return. Unlike the
CML which uses standard deviation as a risk measure on the X axis, the SML uses the
market Beta, or the relationship between a security and the marketplace. The use of
beta enables an investor to compare the relationship between a single security and the
market return, rather than a single security with each and every security (as Markowitz
did). Consequently, the risk added to a market portfolio (or a fully diversified set of
securities) should be reflected in the security’s beta. Total risk is measured as the
standard deviation of security returns. As the number of securities in a portfolio
increase, the portfolio manager can eliminate unsystematic risk (or diversifiable risk)
and focus on the systematic or undiversifiable risk. The market portfolio, by definition,
always has a ß = 1.

TestNet Update:: According to TestNet, our online exam database, approximately 65%
of all of our test takers answered this question correctly.

7. C. The capital market line (CML) assumes that an asset’s covariance with the market
portfolio of risky assets is the relevant risk measure. The capital asset pricing model
(CAPM) is a model that estimates what the expected or required rates of returns should
be on risky assets. CAPM includes the utilization of the security market line (SML)
that represents the relationship between risk and expected rate of return for an asset.

TestNet Update:: According to TestNet, our online exam database, exactly one-half or
50% of all of our test takers answered this question incorrectly. This is a very important
topic at Level I that could make the difference. Candidates need to know the difference
between the CML and SML for all three levels of the AIMR examination.

8. A. Adding stocks to a portfolio reduces the overall standard deviation of a portfolio

but does not eliminate the variability. The reduction in risk accrues to the diversifiable
portion of risk (unsystematic), but the systematic still remains. It is possible to reduce
the systematic risk of a domestic portfolio through global diversification. This happens
as a result of combining low or even negative correlations among the different
countries.

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 Portfolio Management

9. B. Separation theorem refers to the independence of the investment decision from the
financing decision. The financing decision occurs wherever the investor’s utility curve
becomes tangent to the CML. For example, when the investor initially decides to
invest in the market portfolio, M this is the investment decision. However, subsequent
to the risk preference, if the investor decides to borrow or lend based on risk
preferences, this is a separate financing decision.

TestNet Update:: According to TestNet, our online exam database, only 28% of all test
takers answered this question correctly. Questions regarding the Separation Theorem
periodically appear at Level I. However, even if this question does not appear at Level I, it
continues to stay important at Levels II and III. Again, this question demonstrates how
seemingly, short simple questions can create problems for a test taker. Some topics rely on
long, confusing questions or complex formulae. In Portfolio Management, candidates need
to know formulae but also need to be familiar with terminology and applications. This
topic is not heavily covered at Level I, but has plenty of material that can potentially pose
a significant problem. This question provides one such example.

10. D. There is no term with µ. The characteristic line represents E(Ri,t) = α i + β i (RM,t +
ε)

Where:

Ri,t = rate of return for asset i during period t

RM,t = rate of return for the market portfolio during time period t
α i = the constant term, or intercept, of the regression, that equals Ri - β i RM,t
β i = the systematic risk (beta) of asset i that equals Cov i,M/σ2M
ε = the random error term

TestNet Update:: According to TestNet, our online exam database, only 46% of all test
takers answered this question correctly. This question took a familiar Greek symbol and
placed it into a spot where it did not belong. Consequently, 54% of all test takers in our
sample fell into this trap. Don’t let this happen to you on exam day! Simply because a
symbol looks familiar does not mean that it necessarily applies to the exam question.
AIMR might not set the same trap for you at Level I, but candidates need to be prepared.
Many questions will provide too much data or irrelevant data. With a thorough
background of this subject matter or extensive preparations, candidates should be able to
approach the exam with confidence that they can distinguish between information which is
important and information which is extraneous. This question provides one such example.

11. C. Arbitrage pricing theory (APT) is a broader based theory compared to the CAPM,
which states that all of the systematic factors may not be represented in the single
market factor represented by the CAPM. The APT model requires fewer assumptions
and considers multiple factors to help explain the risk of an asset. APT suggests that
there may be several systematic factors (such as oil prices, market risk aversion, etc.)

© Shulman Review 251 Study Session #18

 Portfolio Management

that vary from period to period. While the APT theory may be conceptually appealing,
it lacks practical application since it does not specify the relevant systematic factors.

TestNet Update:: According to TestNet, our online exam database, only 39% of all test
takers answered this question correctly. Questions regarding the Arbitrage Pricing Theory
and Capital Asset Pricing Model frequently appear at Level I. However, even if this
question does not appear at Level I, it continues to stay important at Levels II and III.
Again, this question demonstrates how seemingly, short simple questions can create
problems for a test taker. This is a straightforward, unambiguous question. Level I
candidates should know the differences between these two important theories. Perhaps of
equal importance, exam candidates need to know the underlying assumptions and
applications regarding these theories and use this information at Level I to build to more
advanced levels in the next couple of years.

12. B. There are two stocks that are overvalued—BB & DD. The way to assess the value
of each stock requires the expected return formula: E(Ri) = RF + ß(RM –RF) with the
assumed data given previously (RF = 5% and the RM = 13%). Consequently, the
computation for each expected return is shown below. When the estimated return
exceeds the expected return there is a positive excess return and the security is
undervalued. It would be a good purchase. On the other hand, when the estimated
return is less than the expected return (i.e. the analysts expect the security to provide
less return than what is demanded by the inherent risk of the security) the security
would be overvalued and should be sold. According to the computations below,
securities BB & DD are overvalued (i.e. should be sold), securities CC & EE are
undervalued (i.e. should be purchased) and security AA is properly valued (provides
the return demanded by the market).

Expected Estimated Overvalued

Estimated Return Excess or
Stock βi Return E (Ri ) Return Undervalued
AA 0.5 9.00% 9.00% 0.00% Properly Val.
BB 1.2 6.20% 14.60% -8.40% Overvalued
CC 0.15 21.20% 6.20% 15.00% Undervalued
DD 0.8 8.50% 11.40% -2.90% Overvalued
EE -0.4 8.00% 1.80% 6.20% Undervalued

© Shulman Review 252 Study Session #18

 Key Formulae for Portfolio Management :

Nominal risk-free rate = Pure time value of money + Inflation rate

NRFR = (1 +RRFR) * (1 + expected rate of inflation

RRFR = [(1 + Nominal Risk Free Rate)] – 1

(1 + Rate of Inflation)

RRR = time value of money + inflation rate + risk premium

HPR = Ending value of investment

Beginning value of investment

HPY = HPR – 1

Annual HPR = HPR1/n

Annual HPY = Annual HPR - 1

Coefficient of Variation (CV) = Standard Deviation of Returns

Expected Rate of Return

Risk premium= RPj = E(Rj ) – NRFR

Equivalent Taxable Yield = Municipal Yield

1-Marginal tax Rate

Bonds: Dollar return =Foreign currency return * Currency

gain/(loss)

1 + R$ = [ 1 + B(1) – B (0) + C] (1 + g)
B(0)
 Portfolio Management

Stocks: Dollar return = Foreign currency return * Currency gain

(loss)

1 + R$ = [ 1 + P(1) – P (0) + Div] (1 + g)

P(0)
n
Variance (σ 2 ) = ∑ [ Ri − E ( Ri )] 2 Pi
i =1

n
Standard deviation (σ) = ∑[Ri =1
i − E ( Ri )] 2 Pi

Covik = E{[Ri - E(Ri )][Rj - E(Rj)]}

σ I σ j r ij = Covij

r ik = Covik
σi σk

E(Rp ) = E(Rj)(Wj)+ E(Rk)(Wk)

Standard Deviation of Portfolio = (wj2σ j2 + wk2σ k2 + 2wjwkCovjk).5

E(Ri) = RFR + RM – RFR (Covi,M)

σ2

E(Ri) = RFR + (Covi,M) (RM – RFR)

σ 2m

β = (Covi,M)
σ 2m

E(Ri) = RFR + β i (RM – RFR)

Ri,t) = α i + β i (RM,t + ε )

© Shulman Review 139 Study Session #18