FINANCE EXAM 1 ULTIMATE CHEATSHEET

Performance Measures & Optimization 4. MARKET EFFICIENCY

1. KEY RETURN CALCULATIONS
• Sharpe Ratio: (r_p - r_f)/σ_p EMH Forms
Basic Returns
• Max Sharpe Ratio Portfolio: Weak-form: Prices reflect all market data
• Expected Return: E(R) = Σ[p(s) × r(s)]
w₁ = [E(R₁)σ₂² - E(R₂)×Cov(R₁,R₂)]/D Semi-strong: Prices reflect all public info
• Holding Period Return: HPR = (P₁ - P₀ + D₁)/P₀ Strong-form: Prices reflect all info (public &
where D = [E(R₁)σ₂² + E(R₂)σ₁² - (E(R₁)+E(R₂))×Cov]
• Price Appreciation + Carry: E(R) = [E(P₁)-P₀]/P₀ + private)
E(D₁)/P₀ and R₁ = r₁ - r_f (excess returns)
Market Anomalies
• Gross Return: 1 + HPR Utility Function Momentum Effect: Recent winners continue to
Risk Measures • U = E(r_P) - (1/2)Aσ_p² win
• Optimal Complete Portfolio: Size Effect: Small firms outperform (SMB)
• Variance: σ² = Σ[p(s) × (r(s) - E(r))²]
Value Effect: High B/M firms outperform (HML)
• Standard Deviation: σ = √σ² y* = [E(r_risky) - r_f]/(Aσ_risky²)
January Effect: Better performance in January
• Covariance: Cov(A,B) = Σ[p(i) × (rₐᵢ - E(rₐ)) × (rᵦᵢ - 3. CAPM & FACTOR MODELS
E(rᵦ))] 5. SECURITIES TRADING
CAPM Equations Margin Trading
• Correlation: ρ = Cov(A,B)/(σₐ × σᵦ)
• CAPM: E(r_i) = r_f + β_i[E(r_M) - r_f] • Initial Margin: % of purchase price required upfront
Time Value of Money
• Beta: β_i = Cov(r_i,r_M)/σ_M² • Maintenance Margin: Minimum equity %
• Future Value: FV = PV × (1 + r/n)^(n×t)
• Alpha: α = Actual Return - CAPM Expected Return • Margin Call: When equity falls below maintenance
• Present Value: PV = FV/(1 + r)^t
• Security Market Line (SML): • Return on Margin = (Asset Return × Value)/Equity
• EAR = (1 + APR/n)^n - 1
E(R_i) = R_f + β_i[E(R_M) - R_f] Short Selling
• APR = n × [(1 + EAR)^(1/n) - 1]
Index Models • Profit = Initial Sale - Repurchase - Dividends - Fees
Inflation & Real Returns
• Single Index: R_i = α_i + β_i×R_m + ε_i Short sellers must post margin & may face margin calls
• Real Return: r_real = (1+r_nominal)/(1+r_inflation) -
1 • Asset Risk: σ_i² = β_i²σ_m² + σ²(ε_i) 6. INVESTMENT COMPANIES
1st term: systematic risk | 2nd term: idiosyncratic risk
• Approximation: r_nominal ≈ r_real + r_inflation
• Covariance: Cov(r_i,r_j) = β_i×β_j×σ_m²
Investment Company Types
• After-Tax Equiv Yield: Tax-Free Yield/(1-Tax Rate) Unit Investment Trusts: Fixed portfolio
• R-Squared: R² = (β_i²σ_m²)/σ_i²
Closed-End Funds: Fixed shares, market price
2. PORTFOLIO THEORY Multi-factor Models Open-End Funds: Variable shares, NAV price
Portfolio Calculations • Fama-French 3-Factor: ETFs: Exchange-traded, index tracking
• Portfolio Weight: w_i = x_i/Σx_j E(R_i) - R_f = β_i,M(R_M - R_f) + β_i,SMB(SMB) +
Mutual Fund Pricing
• Portfolio Return: r_p = Σw_i × r_i β_i,HML(HML) • NAV = (Assets - Liabilities)/Shares Outstanding
SMB = Small Minus Big (size premium) • Front-End Load: Reduces initial investment
• Portfolio Risk (2 assets): HML = High Minus Low (value premium)
σ_p² = w_A²σ_A² + w_B²σ_B² + • Back-End Load: Fee when selling shares
2w_A×w_B×Cov(r_A,r_B) • Expense Ratio: Annual expenses as % of assets
σ_p² = w_A²σ_A² + w_B²σ_B² +
2w_A×w_B×σ_A×σ_B×ρ_AB
Diversification & Efficient Frontier
• Equally Weighted Risk:
σ_p² = (1/N)σ_avg² + [(N-1)/N]Cov_avg
As N↑, portfolio risk approaches systematic risk (Cov_avg)
• Min Variance Portfolio:
w_A = (σ_B² - ρσ_A×σ_B)/(σ_A² + σ_B² -
2ρσ_A×σ_B)
 FINANCE EXAM 1 ULTIMATE CHEATSHEET (PAGE 2)
CAPM & Factor Models
7. WORKED EXAMPLES
Market Portfolio & Efficiency
Example 1: Discrete Returns Beta & Systematic Risk
Condition Probability Return Security Market Line (SML)
Recession 20% -10% Risk Decomposition
Alpha as Abnormal Return
Normal 50% 8%
Single-Index Model Applications
Boom 30% 15%
Multi-Factor Extensions
• E(R) = 0.2×(-10%) + 0.5×8% + 0.3×15% = 6.5% Market Efficiency
• Var = 0.2×(-10%-6.5%)² + 0.5×(8%-6.5%)² + EMH Forms (Weak, Semi-Strong, Strong)
0.3×(15%-6.5%)² = 0.00773 Implications for Active Management
• σ = √0.00773 = 8.79% Documented Anomalies
Behavioral Explanations
Example 2: Index Model Testing Methodologies
R_i = α_i + β_i×R_m + ε_i
9. CRITICAL FORMULA SUMMARY
Given: E(R_m) = 8%, R_f = 3%, α_i = 2%, β_i = 1.2, σ_m
= 15%, σ_εi = 10% 1. Portfolio Return: r_p = Σw_i × r_i
E(R_i) = 2% + 1.2 × 8% = 11.6% 2. Two-Asset Portfolio Risk:
σ_i² = 1.2² × 0.15² + 0.1² = 0.0424 σ_p² = w_A²σ_A² + w_B²σ_B² +
σ_i = √0.0424 = 20.6% 2w_A×w_B×σ_A×σ_B×ρ_AB
Example 3: Margin Trading 3. CAPM: E(r_i) = r_f + β_i[E(r_M) - r_f]
4. Beta: β_i = Cov(r_i,r_M)/σ_M²
Buy 200 shares @ $40 with 50% margin:
• Total cost: $8,000 5. Sharpe Ratio: (r_p - r_f)/σ_p
• Initial margin (50%): $4,000 6. Index Model: R_i = α_i + β_i×R_m + ε_i
• Amount borrowed: $4,000 7. Min Variance Weight:
w_A = (σ_B² - ρσ_A×σ_B)/(σ_A² + σ_B² -
If price rises to $50 (1 year, 7% interest): 2ρσ_A×σ_B)
• Share value: $10,000
• Loan value: $4,280 8. Real Return: r_real =
• Equity: $5,720 (1+r_nominal)/(1+r_inflation) - 1
• ROI: 43% 9. Expected Return: E(R) = Σ[p(s) × r(s)]
10. Variance: σ² = Σ[p(s) × (r(s) - E(r))²]
If price falls to $30:
• Share value: $6,000 10. EXAM STRATEGY TIPS
• Equity: $1,720 (29% of position)
• Required equity (25%): $1,500 Problem-Solving Approach
• ROI: -57%
1. Identify question type (portfolio, CAPM, etc.)
Example 4: Portfolio Optimization 2. Write down the formula needed
Stock A: E(r) = 12%, σ = 20% 3. Organize given information
Stock B: E(r) = 8%, σ = 12% 4. Solve step-by-step
Correlation = 0.3, r_f = 3% 5. Verify units and reasonableness
Min Variance Portfolio: Common Mistakes to Avoid
w_A = (σ_B² - ρσ_A×σ_B)/(σ_A² + σ_B² - 2ρσ_A×σ_B) Confusing σ vs σ² (std dev vs variance)
w_A = (0.144 - 0.3×0.2×0.12)/(0.04 + 0.0144 - Forgetting to annualize returns/rates
2×0.3×0.2×0.12)
w_A = (0.0144 - 0.0072)/(0.0544 - 0.0144) = 0.18 Mixing up real vs. nominal returns
w_B = 1 - 0.18 = 0.82 Ignoring correlation in portfolios
Confusing weight types ($ vs %)
E(r_p) = 0.18×12% + 0.82×8% = 8.72% Using inconsistent time periods
σ_p² = 0.18²×0.2² + 0.82²×0.12² +
2×0.18×0.82×0.3×0.2×0.12
Misinterpreting Sharpe & other ratios
σ_p = 13.45% Memory Aids
CAPM: "Risk Free + Beta × Risk Premium"
Optimal CAL Portfolio: Portfolio Risk: "Weighted Vars + 2× Weighted Covariance"
Sharpe_A = (12%-3%)/20% = 0.45
Sharpe: "Excess Return per unit of Risk"
Sharpe_B = (8%-3%)/12% = 0.42
Alpha: "Actual Return - CAPM Expected Return"
Sharpe_p = (8.72%-3%)/13.45% = 0.43 Asset Risk: "Systematic Risk + Idiosyncratic Risk"

8. KEY CONCEPTS TO KNOW

Investment Fundamentals
Risk-Return Tradeoff
Time Value of Money
Compounding & Future Value
Real vs. Nominal Returns
Risk Measures (Std Dev, VAR)
Historical Statistics as Estimators
Portfolio Theory
Diversification Benefits
Efficient Frontier
Capital Allocation Line (CAL)
Capital Market Line (CML)
Risk-Free Asset Mixing
Mean-Variance Optimization
Minimum Variance Portfolio
Maximum Sharpe Ratio Portfolio