1)What is the Capital Allocation Line (CAL)? How do indifference curves inform positioning along the CAL? Explain the risk aversion metric employed in utility modeling? What is the (approximate) range? 2)What is the difference between systematic and unsystematic risk? Which one can be diversified away? Which one is priced? What is the efficient frontier? Link the Sharpe Ratio, the Efficient Frontier, and the CAL to the focus of portfolio theory.

QUESTION

1)What is the Capital Allocation Line (CAL)? How do indifference curves inform positioning along the CAL? Explain the risk aversion metric employed in utility modeling? What is the (approximate) range?

2)What is the difference between systematic and unsystematic risk? Which one can be diversified away? Which one is priced? What is the efficient frontier? Link the Sharpe Ratio, the Efficient Frontier, and the CAL to the focus of portfolio theory.

3)Explain the components of the single index model, linking diversifiable and systematic risk to your answer. What is the Security Characteristic Line and what information does it convey?

4)In a sentence, what is the essence of CAPM (what is the intent of its simplistic elegance)? With respect to CAPM and employing The Economist Group’s “Tales from the FAR Side”, what five simple ideas can CAPM be reduced to?

5)Link the economic cycle to Stephen Ross’ arbitrage pricing theory (APT) framework, explaining where the economy is positioned and where the portfolio should be positioned with respect to APT betas, respectively. Explain the foundational elements of the Fama-French (FF) Three Factor Model, linking it to the Morningstar Box framework.

6)What does the Efficient Market Hypothesis (EMH) portend? What five anomalies appear difficult to reconcile with the EMH?

7)Explain behavioral finance in the context of heuristics, biases, and anomalies. What is a market bubble, how do bubbles confirm or disaffirm the EMH, and who wrote Manias, Panics and Crashes? Finally, what are the five or six stages outlined in MP&Cs?

8)Explain “liquidity” as a priced market factor? When is liquidity particularly valuable? What is the Equity Risk Premium Puzzle?

9)What is the link between interest rates and bond prices? What is the difference between Yield-to-Maturity, Realized-Yield-to-Maturity, and Yield-to-Call? Explain how default is measured – and then depicted to investors – on the Street?

10)When constructing a yield curve, what is the role of zero-coupon bonds? What is a yield curve? What is the difference between a spot rate, a short rate, and a forward rate? How is a one-year forward rate five years out easily calculated?

11)What is duration? What is modified duration? What is effective duration? What is convexity? What do duration and convexity measure? If the benchmark duration is 5, what duration are you targeting in rising rate environment? Why?

12)What is operating leverage? What is financial leverage? What is the industry life cycle, linking how it may relate to valuation discussions? What is sector rotation, linking it to where you would want to position yourself in today’s marketplace? Why?

13)Link equity valuation to discounted cash flow models from your Intro to Finance. In theory, is it similar, different? Link the Price/Earnings Ratio to Growth Opportunities, using today’s S&P500 Index as an example. How are FCFF and FCFE defined? What does “consistency” refer to in valuation theory?

14)Explain how the Dupont Decomposition can inform one’s comparative analysis of two companies? Is ROE, ROA, or ROIC the best measure to decompose? Why?

15)Draw a long call, short call, long put, short put, labeling the two axes. What is the difference between a theoretical option value and an actual payoff? What does the put-call parity relationship represent? Provide an example of combining options into a strategy that is long volatility.

16) What are the six determinants of call option values? Which one can be effectively discerned implicitly for trading? Explain how. What is the VIX and how is it calculated?

17)Explain what links the spot and futures “financial” prices? Explain what links the spot and futures “commodity” prices? What is contango? What is backwardation?

ANSWER

An Overview of Investment Concepts and Financial Theory

The Capital Allocation Line (CAL) is a graphical representation of the risk-return trade-off in an investment portfolio. It shows the different combinations of risk (measured by standard deviation) and expected return that can be achieved by adjusting the allocation between a risk-free asset (such as Treasury bills) and a risky portfolio of assets.

Indifference curves inform positioning along the CAL by reflecting an investor’s preferences for risk and return. These curves represent different levels of satisfaction or utility for an investor. Higher curves indicate higher levels of utility. By combining the CAL with an investor’s indifference curves, it is possible to determine the optimal allocation that maximizes the investor’s utility, given their risk preferences.

The risk aversion metric employed in utility modeling quantifies an investor’s willingness to take on risk. It is typically measured by the coefficient of risk aversion (denoted as γ), which represents the degree to which an investor values a decrease in wealth compared to an increase in wealth. A higher value of γ indicates higher risk aversion. The range of the risk aversion coefficient is typically positive, with values ranging from 0 to infinity. Systematic risk refers to the risk inherent in the overall market or a particular segment of the market. It cannot be diversified away because it affects the entire market or a specific group of assets (Chen, 2023). Unsystematic risk, on the other hand, is specific to individual assets or companies and can be diversified away by holding a well-diversified portfolio.

Systematic risk is priced in the market through expected returns, as investors demand compensation for bearing this risk. Unsystematic risk, being diversifiable, is not priced since it can be eliminated through diversification.

The efficient frontier is a concept in portfolio theory that represents the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. It shows the optimal combinations of assets that maximize return or minimize risk. The Sharpe Ratio measures the risk-adjusted return of a portfolio and is directly linked to the efficient frontier. The CAL connects the risk-free asset with the efficient frontier, allowing investors to choose their desired level of risk by adjusting their allocation between the risk-free asset and the risky portfolio.

The single index model is a method used to estimate the expected return of a stock based on its sensitivity to the overall market, represented by a market index. It decomposes the stock’s risk into two components: diversifiable risk (unsystematic risk) and systematic risk. Diversifiable risk can be eliminated through diversification, while systematic risk cannot.

The Security Characteristic Line (SCL) is a graphical representation of the single index model. It plots the excess return of a stock against the excess return of the market index. The slope of the SCL represents the stock’s beta, which measures its sensitivity to market movements. The SCL provides information on how the stock’s returns are related to the overall market and helps in understanding its systematic risk exposure.

The essence of the Capital Asset Pricing Model (CAPM) is to determine the expected return of an asset based on its beta, which measures its sensitivity to systematic risk. The intent of CAPM’s simplistic elegance is to provide a straightforward model that relates an asset’s expected return to its risk.

The five simple ideas that CAPM can be reduced to, as depicted in “Tales from the FAR Side” by The Economist Group, are:

 Investors are risk-averse and seek to maximize their utility.

The risk of an investment is divided into systematic risk (beta) and idiosyncratic risk (alpha).

The expected return of an asset is determined by its beta and the risk-free rate.

The market portfolio represents the average of all investors’ portfolios.

The CAPM equation (expected return = risk-free rate + beta * market risk premium) provides a way to estimate the expected return of an asset.

Stephen Ross’ arbitrage pricing theory (APT) framework links the economic cycle to the positioning of a portfolio based on APT betas. APT suggests that the returns of an asset can be explained by multiple factors, such as changes in interest rates, inflation, GDP growth, and other macroeconomic variables. These factors are related to the economic cycle. During different phases of the economic cycle (e.g., expansion, contraction), the sensitivities of assets to these factors may vary. By adjusting the portfolio’s exposure to different APT betas based on the economic cycle, an investor can position their portfolio to potentially benefit from expected market movements.

The Fama-French Three Factor Model is a well-known asset pricing model that extends the CAPM by adding two additional factors: size and value. It suggests that the size and relative valuation of companies (as measured by their market capitalization and book-to-market ratio) can explain differences in stock returns. The Morningstar Box framework is a way to classify mutual funds based on their investment style and exposure to different market segments. It provides a systematic way to analyze and compare mutual funds based on their characteristics.

The Efficient Market Hypothesis (EMH) posits that financial markets are efficient and that all available information is reflected in asset prices. It suggests that it is not possible to consistently achieve above-average returns by exploiting market inefficiencies because prices quickly adjust to new information.

Five anomalies that appear difficult to reconcile with the EMH are:

The momentum effect: Stocks that have performed well in the past tend to continue performing well in the future.

 The value effect: Value stocks (those with low price-to-book ratios) have historically outperformed growth stocks.

The small-cap effect: Small-cap stocks have generated higher returns than large-cap stocks.

The size effect: Stocks of companies with smaller market capitalizations have outperformed stocks of larger companies.

The low-volatility effect: Stocks with lower volatility have shown higher risk-adjusted returns.

Behavioral finance studies how psychological factors and biases affect financial decision-making. Heuristics are mental shortcuts or rules of thumb that individuals use to simplify complex decision-making processes (Ayaa et al., 2022). Biases are systematic errors in judgment that can lead to suboptimal decisions. Anomalies are observed patterns in financial markets that contradict traditional economic theories.

A market bubble occurs when asset prices significantly exceed their intrinsic value due to irrational exuberance and speculative buying. Bubbles can be seen as disaffirming the EMH because they suggest that market prices can deviate from fundamental values. “Manias, Panics, and Crashes” is a book written by Charles P. Kindleberger that explores historical episodes of financial crises and their causes.

The five or six stages outlined in “Manias, Panics, and Crashes” are:

Displacement: A new event or innovation creates excitement and fuels speculation.

Boom: Prices start to rise rapidly, attracting more investors.

Euphoria: Market participants become excessively optimistic and speculative.

Distress: Doubts and concerns about the sustainability of high prices emerge.

Panic: A sudden, widespread fear leads to a rapid sell-off and price collapse.

Revulsion (optional sixth stage): Negative sentiment persists, and market participants become skeptical and avoid investments.

Liquidity as a priced market factor refers to the degree of ease with which an asset can be bought or sold without causing significant price changes (Hayes, 2023). It is valuable to investors because illiquid assets may have higher transaction costs and can be harder to sell, potentially leading to unfavorable prices.

Liquidity is particularly valuable during times of market stress or uncertainty when investors may need to quickly access funds or adjust their portfolios. In such situations, liquid assets can be sold more easily and at prices closer to their fair value.

The Equity Risk Premium Puzzle refers to the empirical observation that historical equity returns have been higher than what can be explained by traditional models, such as the CAPM. It suggests that investors have been consistently rewarded with higher returns for holding equities compared to what would be expected based on their level of risk. The puzzle arises from the challenge of determining the precise reasons for this excess return and reconciling it with existing theories of asset pricing.

References

Ayaa, M. M., Peprah, W. K., Mensah, M. O., Owusu-Sekyere, A., & Daniel, B. (2022). Influence of Heuristic Techniques and Biases in Investment Decision-Making: A Conceptual Analysis and Directions for Future Research. International Journal of Academic Research in Business & Social Sciences, 12(5). https://doi.org/10.6007/ijarbss/v12-i5/13339 

Chen, J. (2023). Systematic Risk: Definition and Examples. Investopedia. https://www.investopedia.com/terms/s/systematicrisk.asp 

Hayes, A. (2023). Understanding Liquidity and How to Measure It. Investopedia. https://www.investopedia.com/terms/l/liquidity.asp