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Chapter 13 Performance Evaluation and Risk Management.docx

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FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 13 PERFORMANCE EVALUATION AND RISK MANAGEMENT PERFORMANCE EVALUATION  Performance evaluation: the assessment of how well a money manager achieves a balance between high returns and acceptable risks  Raw return (R )P states the total percentage return on an investment with no adjustment for risk or comparison to any benchmark  Four best known measures to evaluate investment performance 1. Sharpe ratio: measures investment performance as the ratio of portfolio risk premium over portfolio return standard deviation; reward-to-risk ratio that focus on total risk  Measures whether or not a portfolio produces extra return over the risk-free rate  Return standard deviation is a measure of the total risk (as opposed to systematic risk) for a security or a diversified portfolio SHARPE RATIO = (R – RP) / f p 2. Treynor ratio: measures investment performance as the ratio of portfolio risk premium over portfolio beta; reward-to-risk ratio that focus on systematic risk  In an active, competitive market, a strong argument can be made that all assets (and portfolios of those assets) should have the same Treynor ratio TREYNOR RATIO = (R – R p / βf p 3. Jenson’s alpha: measures investment performance as the raw portfolio return less the return predicted by the Capital Asset Pricing Model  The excess return above (positive) or below (negative) the security market line and can be interpreted as a measure of how much the portfolio “beat the market” α P R –PE(R ) P R –P{R + fE(R ) M R ] xfβ } p 2 4. M Measure: compares the performance of managed portfolio with the same risk level hypothetical portfolio which gives excess return of a hypothetical portfolio over the market portfolio  Create a hypothetical portfolio by combining a percentage of portfolio p with a risk-free asset (T-bill) such that the hypothetical portfolio will have the same standard deviation as the market portfolio M = R – R
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