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Crash Course for
Portfolio Management
CFA

Level-I Exam

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Neev Knowledge Management Pristine
Portfolio Management and Wealth Planning






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Neev Knowledge Management Pristine
Portfolio Management
Investment Policy
Statement
Introduction to Portfolio Management Introduction to Asset Pricing Models
Importance:
imposes investment
discipline & provides
guidance for investment
advisors
Investment objectives:
Return objectives
Capacity to take risk
Willingness to take risk
Constraints:
Liquidity needs
Investment time horizon
Tax concerns
Legal & regulatory factors
Unique needs
Preferences
The difference between
ability and willingness to take
on risks.
Strategic Asset Allocation
Risk Budgeting
Tactical Asset Allocation
Security Analysis
Drift
Performance Review
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Neev Knowledge Management Pristine
Risk and returns
Portfolio Management
Investment Policy
Statement
Introduction to Portfolio Management Introduction to Asset Pricing Models
E(Rp) = w
A
E(R
A
) + w
B
E(R
B
)



Var (A) =

Var(R
p
)=w
2
A

2
(R
A
)+ w
2
B

2
(R
B
)+2w
A
*w
B
*(R
A
)*(R
B
)*(R
A
,R
B
)

P
=
B) Cov(A, w) - 2w(1 w) - (1 w
2
B
2 2
A
2
+ + o o
N
N
t
2
1
__
2
R - R

=
|
.
|

\
|
= o
Q.
2
return of stock P=100.0

2
return of stock Q=225.0
Cov(P, Q) =53.2
Current Holding $1 Mn in P.
New Holding: $1 million in Q and $3 million in stock P. What percentage of portfolio
risk (
P
) is reduced?
Ans.

P
=
w= 0.75

P
2
= 100*(0.75)
2
+ 225*(0.25)2+2*0.25*0.75*53.2

P
= 9.5 old = 100 = 10
Reduction = 5%
B) Cov(A, w) - 2w(1 w) - (1 w
2
B
2 2
A
2
+ + o o
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Neev Knowledge Management Pristine
Assumptions of Capital Market theory
All investors use mean variance framework and select
only those securities which lie on the efficient frontier
Unlimited lending & borrowing possible at the risk free
rate
All investors are rational & have identical expectations
There is one period horizon
All assets are infinitely divisible
There are no taxes or transaction costs
There is no inflation
Interest rates will remain constant throughout the
holding period
Capital markets are in equilibrium
Optimal portfolio for each investor is the point where
her indifference curve is tangent to the efficient frontier.

Systematic Risk:
Non diversifiable
Investors get compensation for taking systematic
risk
Non-Systematic Risk:
Company specific risk
Investors are not compensated for taking non-
systematic risk
M
2
Uses total risk
Produces the same portfolio ranking as that of Sharpe ratio





Jensens Alpha
Uses systematic risk (|)
Measures the percentage return over that of a portfolio with
the same beta.
p
p f
R - R
Ratio Sharpe
o
=
p
f p
R - R
Ratio Treynor
|
=
) ( ) (
2
f m
p
m
f p
R R R R M =
o
o
)] ( [
f m f p p
R R R R + = | o
Portfolio Management
Investment Policy
Statement
Introduction to Portfolio Management Introduction to Asset Pricing Models
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Capital Market Line

E(R
i
)
Systematic Risk (
i
)

RFR

mkt
=1

E(R
mkt
)

Security Market Line

Market portfolio with =1

SML: E(R
i
) = R
f
+ *(R
mkt
- R
f
)
E(Rp)
Risk (
p
)

I
2
I
1
I
2 I
1
Efficient
frontier

Efficient
frontier

RFR
X
Y
CML: E (R
p
) = RFR + w
M
[E(R
M
) RFR]

m
i m i
m
m i m i
m
m i
i
R R Cov
o
o
o
o o
o
|
,
2
,
2
) , (
= = =
Portfolio Management
Investment Policy
Statement
Introduction to Portfolio Management Introduction to Asset Pricing Models
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Question 1
Which of the following statements about CML and SML are least likely true?
A. The CML graphs the risk premiums of efficient portfolios and the SML graphs mainly
the Individual asset risk premium that are a part of a diversified portfolio
B. The risk premium on an efficiently diversified portfolio as a function of the portfolio
standard deviation is represented by the CML.
C. The SML is valid only for individual assets



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Answer 1
C.
The SML can be plotted not only for individual assets but also efficient portfolios
comprising of only the market and risk free assets.

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Question 2
Which of the following is most likely correct about a minimum variance portfolio?
A. A minimum variance portfolio has a standard deviation which is lower than the
standard deviation of each of the individual component assets.
B. With an increase in the correlation coefficient between two asset classes, the
standard deviation of the portfolio reduces.
C. The minimum variance of a perfectly correlated portfolio between the stocks and
bonds is lower than the standard deviation of the bond.




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Answer 2
A. Minimum Variance Portfolio is defined as the portfolio that has lowest standard
deviation of all portfolios with a given expected return
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Question 3
A well diversified portfolio is least likely to be which of the following:
A. A portfolio comprising of stocks with a high percentage of unsystematic risk and less
of systematic risk
B. A portfolio comprising of stocks with a low correlation coefficient
C. A portfolio comprising of stocks with high beta values


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Answer 3
C.
A portfolio that consists of stocks all with high betas would be more reactive to changes
in the market but nothing can be said about the firm specific risk from the value of beta.
Therefore such a portfolio may or may not be well diversified. From the given options C
is most likely not to be well diversified.

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Question 4
Which of the following about portfolio theory is least likely correct?
A. A high standardised covariance of a stock means the stock has a high contribution to
the portfolio variance.
B. The sharpe ratio of the portfolio increases when an investor is able to borrow at a
higher rate and invest at the risk free rate.
C. The sharpe ratio grows with the length of the holding period at the rate of square root
of time.


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Answer 4
B.
The sharpe ratio reduces when the investor is able to borrow at a higher rate than the
risk free rate but invests at the risk free rate. There is a kink in the CAL when such a
scenario arises.


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Question 5
A 26 year old investor wants to discuss his investment plan with his portfolio
management advisor. The investor wants to satisfy his long term investment needs.
Which of the following parameters should not be of concern for the client?
A. Capital preservation
B. Tax concerns
C. Legal and regulatory factors


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Answer 5
A.
Capital preservation is a concern when the funds are needed in the near future. Since
the investor wants to plan for long term, capital preservation is not a concern.

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Question 6
Mr X purchases 100 shares of a company that has an expected return of 24%. If the
expected market return is 14% and the risk free rate is 8%. Find the beta of the stock.
A. 2.67
B. 0.7
C. 1.25


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Answer 6
A.
Using the CAPM equation: E(R)= Rf+ *(Rm-Rf),
24 = 8 + * ( 14 - 8)
we get =2.67


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Question 7
An investor has an investment budget of $420,000. He borrows $200,000 at 7% to
invest in a risky asset with expected return of 12%. The portfolio comprises of
investment in the risky asset and T- bills only. The risk free interest rate is 7%. What is
the portfolio return?
A. 14.38%
B. 9.38%
C. 12%


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Answer 7
A.
Percentage investment in risky asset is 620000/420000 = 1.48. Using the expected
returns formula E(rc)= Rf+ y*(Rp- Rf), E(Rc)= 7+ 1.48 * (12-7) = 14.38%.



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Question 8
The following information regarding two stocks is available
Expected returns Standard deviation
Stock A 12% 5%
Stock B 22% 13.8%
The risk free rate is 5%
Which of the following about the stocks is true?
A. Stock A is better than Stock B since it rewards the investors better for the risk
involved
B. Stock B has a higher return than Stock A. Hence it is a better investment than A
C. Stock A and B reward the investor equally after adjusting for risk


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Answer 8
A.
Stock A has a higher sharpe ratio than B .Hence it is a better investment option.

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Question 9
An insurance company offers a 1 year insurance policy on a residential property valued
at $100000. The probability of a loss to the insurer is 0.4% and that of no loss is
99.6%. The risk free interest rate is 5%. What is the minimum profit that the insurance
company would make should it invest in T bills?
A. $13
B. $20
C. $34


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Answer 9
B.
The insurance company should charge minimum premium of 0.04*100000=400 which
when invested at the risk free rate gives $420. Therefore profit to the company is $20.


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Question 10
An analyst prepares the following report about 2 stock returns for different scenarios:

Good market Normal market Bad market
Probability 34% 29% 37%

Stock returns
Stock A 12% 17% 5%
Stock B 22% 25% -20%

If the portfolio comprises of these two stocks weighted in the ratio of 3:2, find the
expected return on this portfolio.
A. 9.45%
B. 10.02%
C. 21.56%

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Answer 10
A.
Individual stock expected return is R= 0.34*R1+0.29*R2+0.37*R3. Portfolio expected
return is E(Rp)= 3/5*Ra + 2/5*Rb
R1 = 3/5*12 + 2/5*22 = 16%
R2 = 3/5*17 + 2/5*25 = 20.2%
R3 = 3/5*5 + 2/5* (-20) = -5%

Total return = 0.34* 16%+0.29* 20.2%+0.37* -5%
= 9.44%



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Question 11
The portfolio standard deviation is calculated using the formula p = w1*1 - w2*2.
Which of the following about the portfolio is least correct?
A. The portfolio is perfectly hedged
B. The expected returns on this portfolio is always higher than the expected returns on a
portfolio that has a standard deviation that equals w1*1 + w2*2
C. This portfolio will have a standard deviation of 0 despite the standard deviation of 2
being very high.


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Answer 11
B.
The expected return is not dependent on the standard deviation but the weights of w1
and w2. Therefore for a given set of weights the expected return would be the same for
both the portfolios.


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Question 12
Which of the following investment objective is least likely to be a concern for a 65 year
old?
A. Investment in fixed income securities
B. Current income
C. Tax deferred investment


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Answer 12
C.
The need for tax deferred investments decrease for older retirees.


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