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FIN4514 Exam 1 Review Be able to distinguish between security analysis and portfolio management Security analysis Involves estimating the merits of individual investments A three step process The analyst considers prospects for the economy given the stage of the business cycle The analyst determines which industries are likely to fare well in the forecasted economic conditions The analyst chooses particular companies within the favored industries Referred to as EIC analysis Portfolio management investments Deals with the construction and maintenance of a collection of Literature supports the efficient markets paradigm On a well developed securities exchange asset prices accurately reflect the tradeoff between relative risk and potential returns of a security Efforts to identify undervalued securities are fruitless Free lunches are difficult to find A properly constructed portfolio achieves a given level of expected return with the least possible risk Portfolio managers have a duty to create the best possible collection of investments for each customer s unique needs and circumstances Understand the purpose of portfolio management Portfolio management primarily involves reducing risk rather than increasing return Know what EIC analysis refers to See Security Analysis Be prepared to identify the six steps of portfolio management 1 Learn the basic principles of finance 2 Set portfolio objectives 3 Formulate an investment strategy 4 Have a game plan for portfolio revision 5 Evaluate the performance 6 Protect the portfolio when appropriate Understand the implications of the efficient markets paradigm Be able to distinguish between risk and uncertainty Uncertainty involves a doubtful outcome What birthday gift you will receive Whether a particular horse will win at the track Risk involves the chance of loss Whether a particular horse will win at the track if you made a bet Know how to distinguish between the different types of risk including total risk systematic undiversifiable risk and unsystematic diversifiable risk Total risk Undiversifiable Systematic risk refers to the overall variability of the returns of financial assets arises from systematic factors that affect all securities of a particular type Must be borne by virtue of being in the market arises from company specific events can be removed by proper portfolio diversification Diversifiable Unsystematic risk Understand the concept of diminishing marginal utility Rational people prefer more money to less Money provides utility The relationship between more money and added utility is not linear see slide 23 of Chapter 2 for graph Be able to compute various types of returns including the holding period return the arithmetic mean return and the geometric mean return See Formulas Be prepared to use the basic correlation and covariance formulas o AB COV A B A B COV A B AB A B See Formulas Understand the basics of linear regression including the importance of R squared and standard error as well as how to use the standard error to calculate a confidence interval Linear regression is a mathematical technique used to predict the value of one variable from a series of values of other variables e g predict the return of an individual stock using a stock market index o Linear regression finds the equation of a line through the points that gives the best possible fit statistics R squared and the standard error are used to assess the accuracy of calculated R squared is a measure of how good a fit we get with the regression line R squared is the square of the correlation coefficient between the security If every data point lies exactly on the line R squared is 100 returns and the market returns It measures the portion of a security s variability that is due to the market variability Standard error s n divided by the square root of the number of observations The standard error is equal to the standard deviation The standard error enables us to determine the likelihood that the coefficient is statistically different from zero About 68 percent of the elements of the distribution lie within one standard error of the mean About 95 percent lie within 1 96 standard errors About 99 percent lie within 3 00 standard errors The standard error also enables us to compute the confidence interval or the range in which the observations are expected to fall with a specified probability x 96 1 96 1 SE SE x x E g 95 Confidence Interval o See Formulas See Formulas See Formulas Be prepared to compute the weights of the minimum variance portfolio Know how to calculate the expected return variance standard deviation and beta of a portfolio o This includes not only a portfolio limited to risky assets but also one including a risk free asset Understand how to compute portfolio statistics with the single index model Be ready to calculate the risk from each security as well as the interaction component of total risk for a two security portfolio See Formulas Understand the concept of dominance over another Dominance is a situation in which investors universally prefer one alternative All rational investors will clearly prefer one alternative A portfolio dominates all others if o For its level of expected return there is no other portfolio with less risk o For its level of risk there is no other portfolio with a higher expected return Know how to compute the portfolio weights necessary to achieve a desired level of return See Formulas Be familiar with capital market theory including the efficient frontier the capital market line the security market line and the CAPM Efficient Frontier o see slide 25 of Chapter 6 o Construct a risk return plot of all possible portfolios o Those portfolios that are not dominated constitute the efficient frontier o These portfolios are efficient because they feature the lowest risk for their return level or the highest return for their risk level When a risk free investment is available the shape of the efficient frontier changes The efficient frontier with a risk free rate o Extends from the risk free rate to point B o The line is tangent to the risky securities efficient frontier o Follows the curve from point B to point C The tangent line passing from the risk free rate through point B is the capital o When the security universe includes all possible investments point B is the market line CML market portfolio o It contains every risky asset in the proportion of its market value to the aggregate market value of all assets o It is the

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