CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Investment Planning

1. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning Session 6Modern Portfolio Theory & Application, Capital Market Line (CML), Security Market Line (SML) & Asset Allocation

2. Session Details

3. Markowitz Portfolio Theory Assumptions made: • Investors are risk-averse. • Decisions are made based on expected risk and return only. • Investors have homogeneous expectations regarding return and risk for opportunities in the market. • Investors have a common one-period time horizon. • Investors have free access to all information. • There are no transaction costs. • The capital market is perfectlycompetitive.

4. Efficient Frontier E(Ri) D C B A Si

5. Optimal Portfolio U4 U3 U2 U1 E(Ri) X Si

6. Capital Asset Pricing Model (CAPM) The CAPM has: • MACRO component explains risk and return in a portfolio context (uses standard deviation) • MICRO component explains individual stock returns (uses beta) • The micro component is the one used to value stocks:

7. Capital Asset Pricing Model (CAPM) • The CAPM determines the total return required for the amount of risk being taken (as measured by beta). • The difference between the return of the market and risk-free rate is the “market risk premium” (Rm – Rf).

8. The Capital Market Line (uses SD) Return % B Z Y A rf X Risk: Portfolio Standard Deviation ( )

9. Security Market Line (uses beta) SML E(Ri) M RF i 0 1.0 b

10. CAPM Example Assume the risk-free rate is 5%, and the expected return is 13%.

11. SML & Equilibrium Expected Return 20 Y W 15 X 10 Z 5 Beta 2 0 1.5 0.5 1 -0.5 -1

12. SML & Inflation NewSML E(Ri) RFR* OriginalSML RFR Beta

13. SML & Risk Aversion NewSML E(Ri) OriginalSML RFR

14. Arbitrage Pricing Theory (APT) Multi-Factor Model Four factors used are unexpected changes in: • Inflation • GDP changes • Risk premiums • Interest rates (yield curves)

15. Risk Tolerance Measurement • Loss aversion • Risk aversion • Liquidity available • Life cycle phase • Value at risk – Monte Carlo simulation

16. Asset Allocation Strategies • Strategic allocation • Tactical allocation • Dynamic allocation • Core/Satellite allocation • Public allocation recommendations by investment firms

17. Question 1 Which of the following illustrate the important factors in the construction of a portfolio under the principles of modern portfolio theory? • investors want to maximize utility • correlation between pairs of securities • beta as a measure of total portfolio risk • investors indifferent to efficient portfolios • I and II only • II and III only • I, II, and III only • I, II, and IV only

18. Question 2 The construction of an investment portfolio according to the principles of modern portfolio theory includes which of the following risk/return concepts? • The intercept of the capital market line is the risk-free rate of return. • The intercept of the security market line is the risk-free rate of return. • Low correlations between securities lowers the portfolio standard deviation. • The beta coefficients for a portfolio are more stable over time than those for an individual security. • I and II only • I, II, and III only • II, III, and IV only • I, II, III, and IV

19. Question 3 The capital asset pricing model (CAPM) accounts for which one of the following risks associated with a stock? • financial risk • systematic risk • total risk • unsystematic risk

20. Question 4 Arbitrage pricing theory (APT) takes into account unexpected changes in all of the following except • interest rates. • GDP. • inflation. • market risk premium. • standard deviation.

21. Question 5 According to the Markowitz model, which one of the following portfolios is considered inefficient when compared to the other three portfolios? • 12% expected return, 10% standard deviation • 18% expected return, 16% standard deviation • 22% expected return, 14% standard deviation • 28% expected return, 18% standard deviation

22. Question 6 According to the Markowitz model, which of the following portfolios is not attainable on the efficient frontier? • 12% return, 15% standard deviation • 14% return, 16% standard deviation • 16% return, 20% standard deviation • 18% return, 25% standard deviation

23. Question 7 Nicholas owns the Cosmic Fund, and wants to invest in another mutual fund. The Cosmic Fund has a standard deviation of 12, and a beta of .80. He has narrowed his choices down to three funds. Since he will only own two funds, he wants to choose the fund that offers him the greatest ability to reduce the risk of his portfolio. To help Nicholas with his decision you have gathered the following information: Which fund should you recommend to Nicholas, and why? • Jupiter Fund, because its correlation coefficient with the Cosmic Fund is the lowest • Pluto Fund, because it has the lowest beta • Mars Fund, because it has the highest 5-year annualized return • Pluto Fund, because the correlation coefficient with the Cosmic Fund is the highest • Jupiter Fund, because it matches a low volatility fund (Cosmic) with a high volatility fund (Jupiter)

24. Question 8 Hector has been investing for years, and has approximately three-quarters of his portfolio invested in stock index and bond index funds, which he rebalances periodically. He has the remainder of his portfolio invested in oil and health care stocks, which he believes provide above-average price appreciation potential over the next few years. His style of asset allocation would be best described as • strategic. • tactical. • dynamic. • core/satellite.

25. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning Session 6End of Slides