十八 Portfolio Management Capital Market Theory Basic Concepts.docx
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十八 Portfolio Management Capital Market Theory Basic Concepts.docx
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十八PortfolioManagementCapitalMarketTheoryBasicConcepts
十八PortfolioManagement:
CapitalMarketTheory:
BasicConcepts
1.A:
TheInvestmentSetting
a:
Explaintheconceptofrequiredrateofreturnanddiscussthethreecomponentsofaninvestor'srequiredrateofreturn.
Determinantsoftherequiredrateofreturn.Thenominalrateofreturninvestorsrequiretotakeinvestmentsvariesovertimeandisafunctionofthe:
∙Therealriskfreerateofinterest.Therealriskfreerateofinterestisdeterminedbythesupplyanddemandforfundsintheeconomy.
∙Theinflationpremiumisanadjustmenttotherealriskfreeratetocompensateinvestorsforexpectedchangesinthepriceindexesandmoneymarketconditionsbeingtightenedoreasedduetoinflationaryexpectations.
∙Theriskpremiumiswhatinvestorsdemandfortheuncertaintyassociatedwithaninvestment.Thefundamentalviewofriskisthatitiscausedbyfactorssuchas:
businessrisk,financialrisk,liquidityrisk,exchangeraterisk,andcountryrisk.
b:
Describetherealrisk-freerateandcomputenominalandrealrisk-freeratesofreturn.
Therealrisk-freerateofinterest.Therealrisk-freerateofinterestisthepricechargedfortheexchangebetweencurrentgoodsandfuturegoodsbyinvestorsintheeconomy.Thispriceisinfluencedbyasubjectiveandanobjectivefactor.Thesetwofactorsare:
1.Consumerpreferencesforcurrentconsumption(timepreference).
2.thesetofinvestmentopportunitiesavailableintheeconomy(investmentopportunities).
Theinflationpremiumisanadjustmenttotherealrisk-freeratetocompensateinvestorsforexpectedchangesinthepriceindexesandmoneymarketconditionsbeingtightenedoreasedduetoinflationaryexpectations.Thisadjustmentisnotasimplesummationoftherealriskfreerateofreturnandinflationexpectations,ratherthecorrectadjustmentis:
nominalriskfreerate=(1+realriskfreerate)(1+inflationrate)–1
Ontheexamitmightbehandytoknow:
1.Thenominalriskfreerateisapproximatedby:
Realriskfreerate+Inflationrate.
2.Therealriskfreerate=[(1+nominalriskfreerate)/(1+inflationrate)]–1
c:
Explaintheriskpremiumandtheassociatedfundamentalsourcesofuncertainty.
Theriskpremiumiswhatinvestorsdemandfortheuncertaintyassociatedwithaninvestment.Thefundamentalviewofriskisthatitiscausedbyfactorssuchas:
businessrisk,financialrisk,liquidityrisk,exchangeraterisk,andcountryrisk.Thenominalrequiredrate=(1+realrate)(1+expectedinflationrate)(1+riskpremium).Theriskpremiumaddressesthefollowingtypesofriskexposure:
∙Businessriskistheuncertaintyofincomeflowscausedbythenatureofafirm’sbusiness.Causedbythenatureofthefirmitself.
∙Financialriskistheuncertaintyintroducedbythemethodbywhichthefirmfinancesitsinvestments.Causedbyhowthefirmfinanceditself.
∙Liquidityriskistheuncertaintyintroducedbythesecondarymarketforaninvestment.Causedbythemechanicsofthemarket.
∙Exchangerateriskistheuncertaintyofreturnsinvestorsfacewhentheyacquiresecuritiesincurrenciesotherthantheirown.
∙Countryrisk(politicalrisk)istheuncertaintyofreturnscausedbythepossibilityofamajorchangeinthepoliticaloreconomicenvironmentofacountry.Causedbythefirm’senvironment.
d:
Discussthesecuritymarketlineandillustratetherelationshipbetweenriskandreturn.
Theplottedrelationshipbetweenexpectedreturnandthelevelofsystematicriskiscalledthesecuritymarketline(SML).TheequationoftheSMLisER=Rf+(RM-Rf)Beta.Whateveryourviewofrisk,theriskierthesecurity,thegreatertheexpectedrateofreturnaninvestorwilldemandtobuyandholdthesecurity.
∙MovementalongtheSMLdemonstratesachangeintheriskcharacteristicsoftheindividualinvestment.
∙ChangesintheslopeoftheSMLdemonstrateachangeintheattitudesofinvestorstowardrisk.
∙ParallelshiftsintheSMLdemonstratechangingmarketconditions,suchaschanginginflationexpectationsortighteningofthemoneysupply(achangeintherealriskfreerate).
e:
Explainwhytheslopeofthesecuritymarketlinechangesovertime.
Achangeintheslopeofthesecuritymarketlineindicatesthatinvestorshavechangedtheirriskpremiumperunitofmarketrisk.Ifthereisanincreaseinthemarketriskpremium,theSMLwillrotatecounterclockwiseabouttheriskfreerate.Ifthereisadecreaseinthemarketriskpremium,theSMLwillrotateclockwiseabouttheriskfreerate.
∙Expectedrateofreturn=nominalriskfreerate+(expectedmarketreturn–nominalriskfreerate)(beta)
∙(Expectedmarketreturn–nominalriskfreerate)iscalledthemarketriskpremium
∙[(Expectedmarketreturn–nominalriskfreerate)(beta)]iscalledthestock’sriskpremium
1.B:
TheAssetAllocationDecision(IncludingAppendix)
a:
Identifythevariousphasesofwealthaccumulationanddescribetheinvestmentobjectivesinvestorsusuallypursueineachphase(ie,theinvestorlifecycle).
Theaccumulationphaserepresentsyourearlytomiddleworkingyears.Hereyoumustsatisfyyourimmediateneedsandplanforlongtermgoals.Youhavealongtimehorizonandgrowingearningscapacity.Intheaccumulationphaseyoucantakehighriskinhopesofobtainingaboveaveragenominalreturns.
Theconsolidationphasebeginsatthemidpointofyourworkinglife.Hereyoustillhaveafairlylongtimehorizonandyourearningswillexceedyourneeds.Intheconsolidationphaseyoushouldstartlookingforlessrisky(moderaterisk)investmentstoprotecttheassetsyouhavealreadyaccumulated.
Thespendingphasebeginswithyourretirement.Yourearningsyearshaveconcludedandyourtimehorizonshortens.Inthespendingphaseyouseekprotectionforyourassets.Youarelookingforlowriskinvestments.Youmust,however,stilltakesomerisktoprotectyourselfagainstinflation.
Thegiftingphaserunsconcurrentlywithandissimilartotheinvestorsspendingphase.Thisphasecoverstheinvestor’sestateplanningandtaxminimizationactivitiessinceexcessassetscanbegivenawaytominimizetaxes.
b:
Discusstheinputstothepolicystatement,includingtheprocessofidentifyingthegoals,constraints,andobjectivesofindividualinvestors.
Apolicystatementforcestheinvestortounderstandtheirownneedsandconstraintsandtoarticulatethemwithintheconstructofrealisticgoals.Thepolicystatementhelpstheinvestorunderstandtherisksandcostsofinvesting.Thepolicystatementwillalsoguidetheactionsoftheportfoliomanager.
Performancecannotbejudgedwithoutanobjectivestandard.Thepolicystatementshouldstatetheperformancestandardsbywhichtheportfolio’sperformancewillbejudgedandspecifythespecificbenchmarkwhichrepresentstheinvestor’sriskpreferences.Theportfolioshouldbemeasuredagainstthestatedbenchmarkandnottheportfolio’srawoverallperformance.
Thepurposeofthepolicystatementistoimposeinvestmentdisciplineontheclientandtheportfoliomanager.
∙Liquidityneeds.Liquidityintheinvestmentsenseistheabilitytoquicklyconvertinvestmentsintocashatapriceclosetotheirfairmarketvalue.Liquidityfromtheinvestor’sviewisthepotentialneedforreadycash.Thismaynecessitatesellingoffassetsatunfavorableterms.
∙Timehorizon.Thisisthetimebetweenmakinganinvestmentandneedingthefunds.Thereisarelationshipbetweenaninvestor’stimehorizon,liquidityneeds,andtheabilitytohandlerisk.Investorswithshortertimehorizonsgenerallyfavorlessriskyinvestmentsbecauselossesarehardertoovercomeduringashorttimeframe.
∙Taxconcerns.Theinvestmentplanmaybecomplicatedbythetaxcode.
∙Legalandregulatoryfactors.Regulatoryconstraintsmayhampertheinvestmentstrategiesofindividualsandinstitutions.
∙Uniqueneedsandpreferences.Investorsmayhavemanyspecialneedsorplacespecialrestrictionsoninvestmentstrategiesforpersonalorsociallyconsciousreasons.
Theinvestmentobjectivesmustbestatedintermsofbothriskandreturn.
∙Risktoleranceisafunctionoftheinvestor’spsychologicalmakeupandtheinvestor’spersonalfactors(age,familysituation,andexistingwealth).
∙Returnobjectivesmaybestatedinabsoluteterms(dollaramounts)orpercentages.Returnconsiderationsalsocovercapitalpreservation,capitalappreciation,currentincomeneeds,andtotalreturns.
c:
Discusstheimportanceofassetallocationindeterminingoverallinvestmentperformance.
Empiricalstudieshaveshownthat85%to95%ofaportfolio’stotalreturnscomesfromtheassetallocationpolicydecision(thatissettingtheallowableassetclassesandthenormalinvestmentweightingsoftheseclasses).Eventhoughtheothertwoinvestmentdecisions(timingandindividualsecurityselection)addvaluetotheportfolio,therealfoundationofreturnscomesfromtheoriginalassetallocationpolicydecisions.
d:
Comparetheinvestmentobjectives,constraints,andpoliciesofinstitutionalinvestors,suchaspensionfunds,endowmentfunds,insurancecompanies,andbanks.
Mutualfundspoolmoneysfrommanyinvestors.Eachmutualfundhasitsownstatedinvestmentobjectivesandstrategies.Investorschoosebetweenfundsbasedontheseobjectivesandstrategies.
Pensionfundsreceivefundsandinvestthemforfuturedistributiontothepensionbeneficiaries.Therearetwobasictypesofpensions:
Definedcontributionplans:
Theemployerdepositsafixedcontributionintheemployee’snamewiththefundmanager.Theemployeedirectshowthefundswillbeinvested.Definedbenefitplans:
Theemployerpromisestheemployeeaspecificinc
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