FNCE30001 Investments Exam Review

Comprehensive practice flashcards covering Lectures 1 through 11 of the FNCE30001 Investments course, focusing on fixed-income, portfolio theory, asset pricing models, and behavioural finance.

According to the Expectations Hypothesis, what determines the relationship between forward rates and expected future market rates?

It assumes investors are risk-neutral and there is no default risk, meaning forward rates equal expected future market rates ($f_{tT} = E[\tilde{r}_{tT}]$).

What characterizes an 'Inverted' yield curve, and what does it typically signal?

An inverted yield curve occurs when long rates are less than short rates, typically serving as a recession signal or indicating that future rates are expected to fall.

What are the naming conventions for a bond based on the relationship between its YTM and its coupon rate?

If YTM < coupon rate, it is a Premium bond ($P_0 > \text{Par}$). If YTM > coupon rate, it is a Discount bond ($P_0 < \text{Par}$). If YTM = coupon rate, it is a Par bond ($P_0 = \text{Par}$).

What is the Macaulay Duration of a zero-coupon bond?

The duration is equal to its maturity ($D = \text{maturity}$).

How does a bond's Duration change over time around coupon payment dates?

Duration decreases linearly between coupon dates and jumps up on the coupon payment date because the price ($P$) in the denominator drops after the coupon is paid.

What is the primary goal of an immunisation strategy in bond portfolio management?

To ensure a bond portfolio hits a target return even if yields change by matching the portfolio duration to the investment horizon, so that capital gains/losses offset reinvestment rate changes.

When should an investor use the Arithmetic mean versus the Geometric mean for stock returns?

The Arithmetic mean is used to estimate the expected future return for one period. The Geometric mean is used to summarize the actual compound return over a long period for a single stock.

What does the 'A' parameter represent?

For risk-averse investors, A > 0, meaning higher risk decreases utility.

What is the difference between Systematic risk and Idiosyncratic risk?

Systematic risk is market-wide and cannot be eliminated (undiversifiable), while Idiosyncratic risk is firm-specific and can be diversified away in a large portfolio.

State the Portfolio Separation Theorem (Tobin, 1958).

Portfolio construction consists of two independent steps: 1. Determine the optimal risky (tangency) portfolio, which is the same for all investors. 2. Determine the complete portfolio based on individual risk aversion.

What are the Beta values for the market portfolio and a risk-free asset in the CAPM?

The market portfolio has a Beta of 1 ($\beta_M = 1$) and the risk-free asset has a Beta of 0 ($\beta_{rf} = 0$).

Define Alpha ($\alpha$) in the context of the Security Market Line (SML).

Alpha is the deviation from the SML. A positive alpha indicates an underpriced asset, while a negative alpha indicates an overpriced asset.

What is Roll's Critique (1977) regarding the CAPM?

The CAPM is untestable because the true market portfolio (all traded assets) is unobservable, making any test a joint test of the CAPM and the adequacy of the market proxy used.

What three factors are included in the Fama-French 3-Factor Model?

Market risk premium, SMB (Small Minus Big) which represents the size factor, and HML (High Minus Low) which represents the book-to-market value factor.

How does the Arbitrage Pricing Theory (APT) differ from the CAPM regarding the foundation of the model?

The CAPM is based on the concept of equilibrium and requires homogeneous expectations, whereas the APT is based on the no-arbitrage condition and requires far fewer assumptions.

Compare Time-Weighted Return (TWR) and Dollar-Weighted Return (DWR).

TWR is the geometric mean of sub-period returns where each period has equal weight. DWR is the IRR of a cash flow sequence, making it appropriate for funds with active inflows/outflows.

When evaluating performance, which measures are appropriate for a standalone risky portfolio versus an asset being added to an already-diversified portfolio?

Sharpe Ratio and $M^2$ are for standalone portfolios (total risk matters). Treynor Ratio, Alpha, and Information Ratio are for assets added to diversified portfolios (systematic risk matters).

What is the formula for the trigger price ($P_{call}$) for a margin call when buying on margin?

$$P_{call} = \frac{\text{Loan}}{\text{Shares} \times (1 - \text{Maintenance Margin})}$$

Describe the three forms of Market Efficiency in the taxonomy of price efficiency.

Weak form: Prices reflect all past prices. Semi-strong form: Prices reflect all public information. Strong form: Prices reflect all public and private information.

According to Prospect Theory, how do investors behave in the gain domain versus the loss domain?

The value function is concave in the gain domain (risk-averse) and convex in the loss domain (risk-seeking). The function is steeper for losses, indicating the pain of a loss is greater than the joy of a gain.

What is the Disposition Effect?

The tendency where investors hold losing stocks too long and sell winning stocks too early, resulting from loss aversion and behaving oppositely to what is optimal if momentum exists.