Advanced Investment Analysis Flashcards

What is the 'Sharpe ratio' and what does it measure?

Answer: A measure of risk-adjusted return calculated by dividing the portfolio's excess return (above the risk-free rate) by its standard deviation

The Sharpe ratio measures how much excess return (above the risk-free rate) an investment generates per unit of total risk (standard deviation). A higher Sharpe ratio indicates better risk-adjusted performance — more return for each unit of risk taken.

What is 'alpha' in the context of investment performance?

Answer: The excess return of a portfolio above its benchmark, adjusted for risk, indicating the value added (or destroyed) by active management

Alpha measures the excess return of a portfolio relative to its expected return given its level of market risk (beta). Positive alpha indicates the manager has added value beyond what market exposure alone would explain; negative alpha indicates underperformance.

What is the 'information ratio' used to assess in investment management?

Answer: The consistency and magnitude of a manager's outperformance relative to a benchmark, calculated as active return divided by tracking error

The information ratio measures the active return (portfolio return minus benchmark return) divided by tracking error (standard deviation of active returns). A higher information ratio indicates more consistent outperformance relative to the risk taken in deviating from the benchmark.

What is 'tracking error' in portfolio management?

Answer: The standard deviation of the difference between a portfolio's returns and its benchmark returns, measuring how closely the portfolio follows the benchmark

Tracking error measures the volatility of the difference between the portfolio's returns and the benchmark's returns. Low tracking error (e.g., in index funds) means the portfolio closely mirrors the benchmark; high tracking error indicates significant deviation from the benchmark.

What is 'fundamental analysis' in the context of equity valuation?

Answer: The analysis of a company's financial statements, business model, competitive position, and economic factors to determine its intrinsic value

Fundamental analysis examines a company's financial statements (income statement, balance sheet, cash flow), management quality, competitive advantages, and macroeconomic factors to estimate the intrinsic value of its shares and determine whether they are over- or undervalued.

What is the 'dividend discount model' (DDM)?

Answer: A model that values a share by discounting all expected future dividends back to their present value

The DDM values a company's shares by summing the present value of all expected future dividend payments, discounted at the required rate of return. In its simplest form (Gordon Growth Model), value = D1 / (r - g), where D1 is next year's dividend, r is the required return, and g is the constant growth rate.