Chapter 1

1. What is portfolio management?

Portfolio management is the art of selecting the best investment
mix in the right proportion and continuously shifting them in the
portfolio to increase the return on the investment and maximize
the wealth of the investors. Here, portfolio refers to a range of
financial products such as stocks, bonds, mutual funds and so
forth that are held by the investors.

2. Why do we need a portfolio diversification?

Portfolio diversification helps investors avoid disastrous
investment outcomes.
Portfolio diversification can also help investors reduce risk. The
overall risk of this portfolio is going to be less than the risk of
holding a single stock. This is called a diversification benefit.

3. Does portfolio diversification always protect your investor

wealth?
No, Portfolio diversification does not offer proper protection of
risk especially during the financial crisis where all the assets
might lose their values.
 4. Describe types of investors and distinctive characteristics
and needs of each.

Investors Time Risk Income Needs Liquidity Needs

Horizon Tolerance

Individuals Vary Vary Vary Vary

DB pensions Long High Depends on age Low

Banks Short Low Pay interest High

Endowments Long High Spending level Low

Insurance Long-life Low Low High

Short-P&C

Mutual funds Vary Vary Vary High

5. Describe the steps in the portfolio management process.

Planning:
• To interpret the clients 'needs
• To come up with IPS (investment policy statement)
Execution:
• To allocate the clients’ money into different asset classes
• To identify the specific securities that need to be purchased
• To buy those securities to construct the portfolio
Feedback:
• To monitor and rebalance the portfolio to match with
benchmark portfolio identified

6. Define the pooled investment

The definition of the pooled investment as the way of putting
sums of money from many investors into a large fund spread
across many investment and managed by professional.
7. What is a top-analysis and bottom-up security analysis?
As a top-down analysis, a portfolio manager will examine
current economic conditions and forecasts of such
macroeconomic variables as GDP growth, inflation,… to
identify the most attractive asset classes and to invest in.

Bottom-up securities analysis, security analysts use model

valuations for securities to identify those that appear
undervalued and invest in them.

8. Describe mutual funds and compare them with other pooled

investment products.
Mutual fund is single portfolio that contain investment funds
from multiple investors. Each investor owns shares representing
ownership of a portion of the overall portfolio.

Investment project Minimum investment

Mutual funds Small amount of money

Exchange traded funds Small amount of money

Separately Managed Accounts Medium amount of money

Hedge funds Large amount of money

Private Equity Funds Large amount of money

Venture capital funds Large amount of money
 Chapter 2

9. Calculate and interpret major return measures and describe

their appropriate uses.

Holding period return (HPR)

• It is simply the percentage increase in the value of an investment
over a given time period:
𝑒𝑛𝑑−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒
• Holding period return = –1
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒
Average returns

It is simply the average of a series of periodic returns.

𝑅 +𝑅 +𝑅 +⋯+ 𝑅𝑛
Arithmetic mean returns = 1 2 3
𝑛
Geometric mean return
• It is a compound annual rate. Generally, for time series data or
to evaluate the performance or the annualized return over time.
• Geometric mean return =
𝑛
√(1 + 𝑅1 ) ∗ (1 + 𝑅2 ) ∗ (1 + 𝑅3 ) ∗ … (1 + 𝑅𝑛 ) – 1
Money-weighted rate of return (IRR)
It is the internal rate of return on a portpolio based on all of its
cash inflows and outflows. IRR is the interest rate at which the
cash outflow equal to the cash inflow.
Annualized return
Annualized returns are returns over a period scaled down to a
12-month period. This scaling process allows investors to
objectively compare the returns of any assets over any period.
The formula for annualize return:
𝟑𝟔𝟓
Annualized return = (𝟏 + 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒓𝒆𝒕𝒖𝒓𝒏) 𝒅𝒂𝒚𝒔 𝒉𝒆𝒍𝒅 -1
10.Calculate and interpret the mean, variance, and covariance
(or correlation) of asset returns based on historical data.
Mean:

Variance:
The variance is a measure of the volatility of the asset returns. The
returns fluctuate significantly over the period of time. That means
the risk related to the asset is high.

where:
µ: the mean of expected value of the population’s distribution
𝑥̅ : the mean of the observations
x: the return for each period.
N: the total number periods.
Covariance:
Covariance is a measure of how two variables move together over
time.
- Positive covariance means that the variables tend to move
together.
- Negative covariance means that the two variables tends to move
in opposite directions.
- A covariance of zero means there is no linear relationship
between two variables.

Correlation
• Correlation is a standardized measure of the linear relationship
between two variables with values ranging between -1 and +1.
Correlation 1 means that there is perfect positive correlation
between two variables, they move up and down together.
• A correlation of 0 means that there is no correlation between
two variables.
• A correlation of -1 means that there is perfect negative
correlation between two variables.
A formula that connects correlation and covariance

Cov(𝑅𝑖 , 𝑅𝑗 )
𝜌(𝑅𝑖 , 𝑅𝑗 ) =
𝜎(𝑅𝑖 )𝜎(𝑅𝑗 )

11. Calculate and interpret portfolio standard deviation and

return of two assets.
We have a formula for calculating portfolio expected return:
E(𝑅𝑝 ) = 𝑊1 𝑅1 + 𝑊2 𝑅2
We also have a formula for calculating risk of portfolio:
𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = √𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜌𝜎1 𝜎2

12. Draw a graph and explain the portfolio benefit

13. What is the risk aversion? Give an example
Risk aversion refers to the behaviour of an investor who, when
faced with a range of different investments with the same expected
return, tend to choose the least risky option.
Notice: Risk tolerance which refers to individuals’ ability and
willingness to take risk.
=> High risk aversion is the same as low risk tolerance.
Example:

14. Describe risk profiles

• A rational investor is usually a risk averse one.
• A risk neutral investor is simply the one who does not care
about risk. A risk neutral investor will consider both investment
opportunities X and Y the same despite their different risk level.
• A risk-seeking investor actually prefers more risk to less, given
equal expected returns, the investor will choose the riskier
investment opportunities.

15. What does utility theory refer to? Calculate the utility of an
investment.
The world “Utility” means the ability to satisfy a particular need
or the usefulness of something. Therefore, in finance, Utility theory
or utility function is an important concept that measures an
inventors’ preferences over an asset in terms of risk and return.
The utility of formula
1
Utility of an investment = E(r) – *A* 𝛿 2
2

where:
E(r) is the expected return of an investment
A is a measure of risk aversion.
𝛿 2 is a measure of risk of the investment.
Notice: when using this formula is that you must do all calculations
in decimals. So if the data given is in percent, you must convert it
into decimal beforehand.

16. Draw a graph and describe an indifference curve? Dose an

investor seems to be happier with higher utility?

17. Describe types of indifference curves

18. Describe and interpret the minimum-variance and efficient

frontiers of risky assets and the global minimum-variance
portfolio.
19. Discuss the selection of an optimal portfolio, given an
investor’s utility (or risk aversion ) and the capital allocation line.

20. Explain systematic and non-systematic risk, including why

an investor should not expect to receive additional return for
bearing non-systematic risk.
Systematic risk refers to the risk of a breakdown of an entire
system rather than simply the failure of individual parts.
For example, there is a global economic slowdown. There is a
reduction in consumer demand. It affects all firms. Therefore,
systematic risk cannot be diversified away because of almost
stocks’ price decreasing.
Unsystematic risk is unique to a specific company or industry.
For example, the death of Steve Job affected the price of Apple’
stock.
However, this risk can be diversified away.
For example, instead of only investing in Apple, you could invest
in a portfolio of stocks.
21. Calculate and interpret beta

22. Explain the capital asset pricing model (CAMP), including

the required assumptions and the security market line (SML)
CAPM is the most important models in finance. It allows us to
compute the expected returns of assets are based on systematic
risk.

CAMP is the most important models in finance and they are

several applications:
• The expected return can be estimated using the CAPM formula.

• To estimate the price of an asset, the future cash flows can be

discounted at the CAPM rate.

• The CAPM rate is also used in the capital budgeting process in

corporate finance.
Security market line
The security market line is a graphical representation of the capital
asset pricing model (CAPM) and applies to all securities, whether
they are efficient or not.
23. Comparing the CML (Capital Market Line) and the SML
- Notice that with CML/ we considered the total risk/ whereas
with the SML, we are considering only systematic risk.
- The CML applies to efficient portfolios. SML however applies
to any securities whether it is efficiently priced or not.

24. Summarize the four measures (Sharpe ratio, M-squared,

Treynor Measure and Jensen’s alpha)

The Sharpe ratio

It is the excess return of a portfolio over the risk-free rate divided
by the risk of the portfolio.
𝑅𝑝 −𝑅𝑓
Sharpe Ratio =
𝜎𝑝
Limit:
- It uses total risk /rather than systematic risk or beta.
- This ratio which is not informative enough itself

Treynor
Treynor is the excess return of the portfolio over the risk-free rate
divided by the systemic risk.
𝑅𝑝 −𝑅𝑓
Treynor =
𝛽𝑝
This Treynor deals with the limit of Sharpe ratio. It uses the
systematic risk. However, it is not informative enough itself.
M squared
𝛿
𝑀2 = (𝑅𝑝 - 𝑅𝑓 ) 𝑀 - (𝑅𝑝 - 𝑅𝑓 )
𝛿𝑃
- M squared gives similar rakings to the Sharpe ratio. Both M
squared and Sharpe ratio use total risk.
- The benefit of this measure over the Sharpe ratio is that it get a
number which has meaning.

Jensen’s alpha
Jensen’s alpha is simply the return on a portfolio minus the return
predicted by CAMP.
 Chapter 3

25. Describe the reasons for a written investment policy

statements (IPS)
• To be clear about a client’s investment objectives, we create
investment policy statement (IPS).
• Investment policy statement (IPS) defines a plan for investment
success, given the client’s situation and requirements.
• Notice that, the IPS should be reviewed on a regular basis.

26. Distinguish between the willingness and the ability (capacity)

to take risk in analysing an investor’s financial risk tolerance.
• The overall risk tolerance depends on the willingness and
ability to take risk.
• Ability to take risk is based on financial factors such as wealth,
time horizon, expected income…
• The willingness to take risk is related to a client’s psychology,
such as personality type and level of financial knowledge.
For example, the client has bad experience (lost a lot of money)
from his previous investment that will impact his psychology to
some extent which will impact his willingness to take risk.
27. What is strategic asset allocation? What is the tactical asset
allocation?
• Strategic asset allocation is a set of percentage allocation to
various asset classes that is designed to meet the investor’s
objectives.
• The strategic asset allocation is developed by combining the
objectives and constraints in the IPS with the performance
expectations of the various asset classes.
• Tactical asset allocation refers to an allocation that deviates
from the baseline (strategic) allocation in order to profit from a
forecast of shorter-term opportunities in specific asset classes.

28. Describe passive and active investing? Describe the core

satellite approach.
• Investing in a fund that is based on the S&P500 that is called
passive investing. Investors are not trying to figure out which
stocks are undervalue or overvalue.
• Active investing means that investors are actively looking for
stocks that are undervalues.
• The core satellite approach what means is investors divide their
portfolio into two parts. The core part and a satellite.
• The core part: where investors put most of this money in some
sort of index fund so they are taking only systematic risk.
• a part of the portfolio or the satellite is invested in stock that
they believe are undervalued that part is called active investing.