Level_I.session18

Portfolio Management
The candidate should be able to demonstrate a working knowledge of the key elements of the portfolio management process, including the investment setting, investment policy, and asset allocation.
Study Session 18
Portfolio Management
Reading Assignments
Investment Analysis and Portfolio Management, 7th edition, Frank K. Reilly and Keith C. B rown (South-Western, 2003)
76. “The Investment Setting,” Ch. 1, pp. 16–29
77. “The Asset Allocation Decision,” Ch. 2
78. “An Introduction to Portfolio Management,” Ch. 7
79. “An Introduction to Asset Pricing Models,” Ch. 8, pp. 237−256
Note: Candidates are responsible for the problems listed following the learning outcome statements for readings 78 and 79. Solutions to the problems can be found in the Solutions Manual for the Reilly and Brown text. The Solutions Manual is listed on the textbook order form in this Study Guide.
Learning Outcomes
76. “The Investment Setting”
The candidate should be able to
a)explain the concept of required rate of return and discuss the components of an
investor’s required rate of return;
b)differentiate between the real risk-free rate of return and the nominal risk-free rate
of return and, compute both return measures;
c)explain the risk premium, the associated fundamental sources of risk, and why these
sources are complementary to systematic risk;
d)define the security market line, and discuss the factors that cause movements along,
changes in the slope of, and shifts of the security market line.
Corrections/Clarifications
•In the first chapter, for example on page 21, there are references to “HPY”, which means Holding Period Yield, i.e. the percentage return of an investment, expressed as ((Ending Value of Investment/Beginning Value of Investment)-1)
77.“The Asset Allocation Decision”
Note: Although this reading addresses the taxation of individual investors from the
viewpoint of a U.S. investor, candidates are not expected to know the U.S. tax code. This reading is intended to illustrate the importance of taxation to investors, particularly
individual investors.
The candidate should be able to
a)describe the steps in the portfolio management process and explain the reasons for a
policy statement;
b)explain why investment objectives should be expressed in terms of both risk and
return and list the factors that may affect an investor’s risk tolerance;
c)describe the return objectives of capital preservation, capital appreciation, current
income, and total return and describe the investment constraints of liquidity, time
horizon, tax concerns, legal and regulatory factors, and unique needs and
preferences;
d)describe the importance of asset allocation, in terms of the percentage of a
portfolio’s return that can be explained by the target asset allocation and list reasons
for the differences in the average asset allocation among citizens of different
countries.
78. “An Introduction to Portfolio Management”
The candidate should be able to
a)define risk aversion and cite evidence that suggests that individuals are generally
risk averse;
b)list the assumptions about individuals’ investment behavior of the Markowitz
Portfolio Theory;
c)compute expected return for an individual investment and for a portfolio;
d)compute the variance and standard deviation for an individual investment;
e)compute the covariance of rates of return, and show how it is related to the
correlation coefficient;
f)list the components of the portfolio standard deviation formula, and explain which
component is most important to consider when adding an investment to a portfolio;
g)describe the efficient frontier and explain the implications for incremental returns as
an investor assumes more risk;
h)define optimal portfolio and show how each investor may have a different optimal
portfolio.
Problems: 3, 4, 5
Corrections/Clarifications
•On page 213, in footnote 4, insert an “=” after R i.
•On page 218, in Exhibit 7.9, all subscripts in the Coca-Cola section should be i. Also on page 218, the first two equations following Exhibit 7.9 are calculating σ2. The first should be subscripted “i” and the second “j.” Finally, in the last equation on page 218, insert an “=”
before the (.108) term.
•On page 219, in equation 7.6, under the last summation sign it should read j=1. Also on page 219, the “Standard Deviation of a Portfolio” sub-header in green text should be next to the second paragraph, rather than at the top left corner of the page.
•On page 220, in the next to last equation, under the last summation sign it should read j=1. •On page 221, in the calculation of standard deviation for case b, in the second line, insert a plus sign between the first two terms.
•On page 227, the last line of the first complete paragraph the weights are reversed. It should read: “In this case, it is W1 = 0.588 and W2 = 0.412.”
79. “An Introduction to Asset Pricing Models”
The candidate should be able to
a)list the assumptions of the capital market theory;
b)explain what happens to the expected return, the standard deviation of returns, and
possible risk-return combinations when a risk-free asset is combined with a
portfolio of risky assets;
c)identify the market portfolio, and describe the role of the market portfolio in the
formation of the capital market line (CML);
d)define systematic and unsystematic risk and explain why an investor should not
expect to receive additional return for assuming unsystematic risk;
e)describe the capital asset pricing model, diagram the security market line (SML),
and define beta;
f)calculate and interpret using the SML, the expected return on a security, and
evaluate whether the security is undervalued, overvalued, or properly valued;
g)explain how the systematic risk of an asset is estimated using the characteristic line.
Problems: 2, 15
Corrections/Clarifications
•On page 240, in the last equation, the last subscript should be “i.”。