3. Discuss why international diversification reduces portfolio risk. Specifically, why would you expect low correlation in the rates of return for domestic and foreign securities? International diversification reduces portfolio risk because of the low correlation of returns among the securities from different countries. This is due to differing international trade patterns, economic growth, fiscal policies, and monetary policies among countries.
7. Some investors believe that international investing introduces additional risks. Discuss these risks and how they can affect your return. Give an example.
The additional risks that some investors believe international investing introduces include foreign exchange risk and country risk. For example, the domestic return on Canada bonds of 10.36% exceeded the U.S. return of 9.78%. The exchange rate effect of -2.19% lowered the Canadian dollar return after conversion to U.S. dollars to 8.17%. (Exhibit 3.2).
4. Discuss some disadvantages of technical analysis.
The disadvantages of technical analysis are: (1) past price patterns may not be repeated in the future; (2) the intense competition of those using the trading rules will render the technique useless; (3) the trading rules require a great deal of subjective judgment; and (4) the values that signal action are constantly changing.
13. Explain the reasoning behind a support level and a resistance level. A support level is a price range where considerable demand is expected, while a resistance level is a price range where a large supply is expected. Support and resistance levels exist due to the behavior of a number of investors who are closely monitoring the market and will trade quickly at attractive price levels. Specifically, a support level occurs after a stock has increased in price followed by a brief period of profit-taking at which time some investors who did not get in on the first round decide to take the opportunity to get in. A resistance level occurs after a stock has declined and when it experiences a recovery, some investors who missed selling at a price peak take the opportunity to sell. A price break through a resistance level on strong volume would be considered very bullish. This is because as the price rises to the target price set by investors, the supply increases usually causing the price increase to reverse. Thus, a price breakthrough on strong volume would be bullish because it would mean the excess supply is gone.
1. Why have passive portfolio management strategies increased in use over time? Passive portfolio management strategies have grown in popularity because investors are recognizing that the stock market is fairly efficient and that the costs of an actively managed portfolio are substantial.
2. What is meant by an indexing portfolio strategy and what is the justification for this strategy? How might it differ from another passive portfolio?
Numerous studies have shown that the majority of portfolio managers have been unable to match the risk-return performance of stock or bond indexes. Following an indexing portfolio strategy, the portfolio manager builds a portfolio that matches the performance of an index, thereby reducing the costs of research and trading. In an indexing strategy, the portfolio manager’s evaluation is based upon how closely the portfolio tracks the index or “tracking error,” rather than a risk-return performance evaluation.
5. Discuss three strategies active managers can use to add value to their portfolios. Managers attempt to add value to their portfolio by: (1) timing their investments in the various markets in light of market forecasts and estimated risk premiums; (2) shifting funds between various equity sectors, industries, or investment styles in order to catch the next “hot” concept; and (3) stockpicking of individual issues (buy low, sell high).
10. CFA Examination Level I
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