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Equity Portfolio Management 410 Master Syllabus Revised October 2007 Prepared by Ryan Garvey, Ph.D. Course Description Equity Portfolio Management is an elective for both Finance and Investment Management majors at Duquesne University. The course introduces students to the theory behind constructing an optimal investment portfolio and the implications this theory has for asset pricing. A second theme of the course is to examine the theory behind why market prices are thought to be fairly priced or “efficient” versus the opposing view (behavioral finance) that questions investor rationality and, therefore, efficient market prices. Equity Portfolio Management serves as the introductory course to the Investment Center at Duquesne University. Students become proficient in using Bloomberg, Compustat, Morningstar/Ibbotson and other financial databases in order to apply the theoretical material presented in this course. The Hewlett Packard 12C Financial Calculator (or equivalent) is required for this course. Prerequisite: Business Finance 331 and Theory of Finance 330. Note: this course was phased out of the Investment Management curriculum with the introduction of Fund Management. Learning Goals After completing the course, students will understand: the interpretation, composition, and calculation process involved in commonly used market indexes. the mechanics, risk, and calculations involved in both margin and short trading. the concept of risk aversion and utility. the process of allocating funds between a risky asset and a risk free asset and how leverage could be used in this process. systematic and firm-specific risk, and how to reduce the amount of firm-specific risk in a portfolio by combining securities with differing patterns of returns. how to quantify the risk-reduction process by being able to calculate and interpret covariance and correlation coefficients. the development and the theory of the capital asset pricing model (CAPM) and how to construct and use the security market line. 8cdbfd12-b170-4d67-b4c0-56656f5c12b1.doc the concept of market efficiency and how to make rational investment decisions based upon the existence of market efficiency. the key errors made by individuals in processing information and the biases uncovered by psychologists. Objectives The Investment Setting (Introductory Material) a) distinguish among the composition and characteristics of the three predominant weighting schemes used in constructing stock market series; b) discuss the source and direction of bias exhibited by each of three predominant weighting schemes used in constructing stock market series; c) compute a price weighted, a market weighted, and an unweighted index series for three stocks; d) compare and contrast major structural features of domestic and global stock indexes; e) describe the process of buying a stock on margin; f) compute the rate of return on a margin transaction; g) define maintenance margin; h) determine the stock price at which the investor would receive a margin call; i) explain the concept of required rate of return and discuss the components of an investor’s required rate of return; j) differentiate between the real risk-free rate of return and the nominal risk-free rate of return and, compute both return measures; k) explain the risk premium; Portfolio Theory a) define risk aversion and cite evidence that suggests that individuals are generally risk averse; b) explain the capital allocation line. c) list the assumptions about individuals’ investment behavior of the Markowitz Portfolio Theory; d) compute expected return for an individual investment and for a portfolio; e) compute the variance and standard deviation for an individual investment; f) compute the covariance of rates of return, and show how it is related to the correlation coefficient; g) compute and interpret the standard deviation of return for a risky asset, the covariance and correlation coefficient between the returns for two assets, and the variance or standard deviation of a two-asset portfolio; h) 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; i) demonstrate the change in the risk–return tradeoff of a two-asset portfolio as the correlation between the two assets changes in specified ways; j) describe the efficient frontier and explain the implications for incremental returns as an investor assumes more risk; k) demonstrate the concept of the efficient frontier, and show, using utility 2 8cdbfd12-b170-4d67-b4c0-56656f5c12b1.doc analysis, how a risk-averse investor selects the optimal portfolio. l) Explain indifference curves m) define optimal portfolio and show how each investor may have a different optimal portfolio. Asset Pricing Theory a) list the assumptions of the capital market theory; b) discuss the assumptions of the capital market theory, explain how the presence of a risk-free asset changes the portfolio possibilities relative to the Markowitz efficient frontier, describe the market portfolio and the role it plays in the formation of the capital market line (CML), and distinguish between systematic and unsystematic risk; c) 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; explain and illustrate the standard deviation of return as a function of the number of stocks in the portfolio; d) identify the market portfolio, and describe the role of the market portfolio in the formation of the capital market line (CML); e) define systematic and unsystematic risk and explain why an investor should not expect to receive additional return for assuming unsystematic risk; f) describe the capital asset pricing model, diagram the security market line (SML), and define beta; g) discuss the security market line (SML) and how it differs from the CML, calculate the beta of a risky asset, and calculate and interpret, based on the SML, the expected return for an asset; h) determine whether the asset is undervalued, overvalued, or properly valued; and outline the appropriate trading strategy; h) calculate and interpret using the SML, the expected return on a security, and evaluate whether the security is undervalued, overvalued, or properly valued; i) evaluate the effect on the SML of relaxing each of the following assumptions: 1) differential borrowing and lending rates, 2) transactions costs, 3) heterogeneous expectations and planning periods, and 4) taxes; j) explain how the systematic risk of an asset is estimated using the characteristic line; k) discuss the stability of individual asset betas and portfolio betas over time; l) discuss beta estimation problems and why published beta estimates may differ m)describe the concept of benchmark error and its implications for testing the capital asset pricing model (CAPM). Market Efficiency a) define an efficient capital market, discuss arguments supporting the concept of efficient capital markets, describe and contrast the forms of the efficient market hypothesis (EMH): weak, semistrong, and strong, and describe the tests used to examine the weak form, the semistrong form, and the strong form of the EMH; b) identify six market anomalies and explain their implications for the semistrong form of the EMH, and explain the overall conclusions about each form of the EMH; c) explain the implications of stock market efficiency for technical analysis and fundamental 3 8cdbfd12-b170-4d67-b4c0-56656f5c12b1.doc analysis, discuss the implications of efficient markets for the portfolio management process and the role of the portfolio manager, and explain the rationale for investing in index funds. Behavioral Finance a) identify and evaluate “fundamental” and “noise trader” risk that may be present in implementing a trade designed to profit from a mispricing of an asset; b) discuss the costs of implementing a trade designed to profit from a mispricing of an asset; c) explain what conditions are sufficient to limit arbitrage and allow deviations from fundamental value to persist. d) identify the key assumptions that have evolved in the field of finance, and discuss the limitations of these assumptions; e) formulate the problem of overestimating the precision and importance of information. f) discuss the effect of overconfidence on investors’ trading; g) describe how overconfidence may affect risk-taking behavior. h) explain how the fear of regret and seeking of pride affects investors’ holding periods of winning and losing investments; i) discuss the disposition effect in relation to investor wealth and investor reaction to company- specific versus general economic news; j) justify how the concept of “reference point” may affect an investor’s trading behavior. k) compare and contrast the “house money,” “snake bite,” “trying to break even,” and “endowment” effects on investor decision-making behaviors; l) explain how various events in the past may affect an investor’s future risk taking; m) discuss how the avoidance of cognitive dissonance may affect an investors’ decision-making process. n)explain how mental accounting may 1) result in investor decisions that are contrary to the strategy of wealth maximization and 2) affect the diversification of an investor’s portfolio. o) explain how mental accounting may lead both individual and institutional investors to misperceive risk; p) discuss how the concept of correlation is generally not implemented when investors affected by mental accounting build portfolios; q) explain how mental accounting can result in naive diversification as compared to the efficient diversification that results from implementing MPT. r) discuss how the concept of representativeness may cause investors to incorrectly extrapolate a company’s past business operations or stock price performance into the future; s) identify and discuss the characteristics of a portfolio constructed by an investor affected by the concept of familiarity; t) discuss the investment decision problems of investors affected by the concept of familiarity. Topic Outline The recommended time that should be allocated to each part of the course is as follows: Introductory Material (20%) 4 8cdbfd12-b170-4d67-b4c0-56656f5c12b1.doc Portfolio Theory (40%) Asset Pricing Theory (10%) Market Efficiency (15%) Behavioral Finance (15%) Instructors should follow the learning objectives in the order that they are presented on the master syllabus. Instructors must cover up to at least the Behavioral Finance Section. Recommended Teaching Procedure The theoretical material covered in this course can be conceptually difficult for many students to comprehend. Therefore, it is recommended that instructors apply the theoretical material through the use of a series of course projects. The Investment Center at Duquesne University provides a wealth of resources (e.g., Bloomberg, Compustat, Morningstar/Ibbotson, Reuters, etc.) in order for instructors to develop course projects that correspond to the theoretical material covered in this course. Evaluation Exam 1 – 20% of the final grade Exam 2 – 20% of the final grade Final Exam – 25% of the final grade Assignments (Suggested - Investment Center Competency Project, Portfolio Project, Market Efficiency and or Behavioral Finance Reading Assignments) – 30% of the final grade Class participation – 5% of the final grade *The plus/minus grading system is used in this course. Textbooks and References Required Textbook: Investments, Bodie, Kane, and Marcus, 7th edition. Learning Outcomes Assessment Instructors are encouraged to measure student learning through the use of exams and projects. Please see attached examples. 5 8cdbfd12-b170-4d67-b4c0-56656f5c12b1.doc