Major Asset Classes

Equity

Highest risk, highest return

Eg. Australian company stocks, managed funds, foreign stocks & specialty stocks

Cash

Low risk, low return

Short term debt instruments

Eg. 90-day treasury notes & bank accepted bills

Fixed Interest

Relatively low risk, relatively low return (higher than cash)

Long term debts

Eg. Government bonds & corporate debentures

Property

High risk, high return

Real estate

Eg. Property trusts & residential property investment

Asset Allocation

The choice of asset class within a portfolio is asset allocation – division of investment capital between the different asset classes

It determines the overall risk & expected return of a portfolio

Three Types of Revenue

Equal-Weighted Return

Value-Weighted Return

Price-Weighted Return

Normal Distribution

Zero skewness & zero excess kurtosis

Can be completely specified by mean & variance

Useful Assumption:

Allows mean to be used to estimate expected returns & variances

Useful for making statistical inferences

A lot of investment analysis’s require the assumption of a normal distribution

Week 2 – Portfolio Theory

Indifference Curves/Utility Curves

Utility Curve: combination of expected profit (return) & risk (measured by ) that yield the same level of expected utility (satisfaction) to the decision maker

Importance: they are important as they identify the portfolio of risky assets an investor prefers

Portfolio Variance – Large Number of Assets

Not that & number of covariance terms = [n – n]

As there are a large number of asset, w = 1/n

Variance of each asset can be approximated by average variance

* When n becomes larger & larger

Variance & covariance terms: n x n = n

Variance terms: n (diagonal cells)

Covariance terms: n – n (off-diagonal cells)

Unique covariance terms: (matrix is symmetric)

Week 3 – Asset Pricing Models

Efficient Frontier

CAPM Assumptions

Investors are risk averse & maximise their utility

Investors have unlimited access to borrowing/lending at risk-free rate

Investors face a one-period investment horizon

Investors are infinitely divisible

No transaction costs or taxes

No inflation or changes in interest rate

Capital markets are in equilibrium

Problem Testing CAPM

Requiring that an ex-ante model be tested using ex-post information

Estimating expected return for the market portfolio, individual risky assets or portfolio of risky assets, & the risk-free asset

Observed breaches of CAPM assumptions

Inclusion of surviving companies & the exclusion of failing ones

CAPM vs. APT

CAPM: shows that equilibrium rates of expected return on risky assets are a function of their covariance with the market (systematic risk in relation to broad-based market portfolio)

APT: shoes that expected return on any risky asset is a linear combination of various factors (diversification & arbitrage)

Multi-factor model doesn’t define factors

Weeks 4 & 5 – Behavioural Finance & Market Anomalies

Efficient Market Hypothesis (EMH)

Security prices immediately & fully reflect all available & relevant information

Reaction to new information is instantaneous & unbiased

EMH & Technical Analysis

Information dissemination process is slow

This view contradict the EMH

EMH suggests rapid dissemination process & therefore, prices reflect all information

Thus, there would be no value to technical analysis

EMH & Fundamental Analysis

At one point in time, there is a basic intrinsic value for individual securities & if this intrinsic value is substantially different from the prevailing market value, the investor should make the appropriate investment decision

EMH – prices already fully reflect all available information

FA will be of little value

Even with an excellent valuation model, if you solely rely on past data, you cannot expect to do better than a buy-&-hold policy

Market Efficiency

A large number of competing profit-maximising participants analyse & value securities, each