Modern Portfolio Theory

MBA

Modern Portfolio Theory

Corporate Finance II

Final Paper

Table of Contents

1. Title Page pg. 1

2. Table of Contents pg. 2

3. Introduction/ Executive Summary pg. 3

4. Modern Portfolio Theory pg. 3

5. Portfolio Management pg. 4

6. Controlling the Risk pg. 5

7. Diversification pg. 6

8. CAPM pg. 7

9. Beta: Advantages and Disadvantages pg. 8

10. Options pg. 10

11. Hedging pg. 11

12. Net Present Value (NPV) pg. 12

13. Technical Indicators: pg. 14

14. Efficiency Frontier pg. 15

14. Conclusion pg. 16

15. Bibliography pg. 18

16. Bonus Assignment- Investing Websites pg. 19

Modern Portfolio Theory

Introduction/ Executive Summary

On a general level, investment managers and academic economists have long been aware of the necessity of taking returns and risk into account: "all your eggs should not be placed in the same basket". This is where the idea of holding a portfolio of shares comes from. Modern portfolio theory (MPT), or portfolio theory, was introduced by Harry Markowitz with his paper "Portfolio Selection" which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Portfolio theory explores how risk adverse investors construct portfolios in order to optimize expected returns for a given level of market risk. The theory quantifies the benefits of diversification. Out of a universe of risky assets, an efficient frontier of optimal portfolios can be constructed. Each portfolio on the efficient frontier offers the maximum possible expected return for a given level of risk. An example of this can be seen below.

Modern Portfolio Theory (MPT)

The Modern Portfolio Theory, MPT, founded by Harry Markowitz, in the 1952 Journal of Finance, is a revolutionary theory that changed the finance profession. Thirty-eight years after Markowitz's published the MPT, he and his colleagues, Merton Miller and William Sharpe, were honored with a Nobel Prize for what has now turned out to be a broad theory for portfolio selection. The modern portfolio theory gives direction of how to minimize risk at a given return or maximize return at a given return. A portfolio is a bundle of assets with different levels of return and risk. Each of the assets is combined with relative weights. Portfolio theory studies how the characteristics (e.g. risk and return) of asset combination differ from those of its constituent assets. The term diversification is common when referring to investment portfolios and is also a relatively standard strategy for investment circles. Risk in finance is very uncertain even when all possible precautions have been examined, they best one can do is use these precautionary tools to asses the risk involved; although there are always different possible outcomes.

Finance basically deals with risk and expected return. A portfolio is one of the important factors of finance. Certain amounts of money invested in different assets like stocks or securities make up a portfolio of investments. The portfolio is all about how can we reduce the risk and make better return through diversification. A diversified portfolio would be composed of a mixture of both risk free and risky assets; that way the investor is spreading his/her risk. Examples of risk free assets are the bonds issued by government and some financial institutions, like Treasury bills. On the other hand, the investments which are considered to be more risky assets are stocks. Returns of the risky assets depend on economical situation. There are three main classifications of economical situations which can cause a fluctuation with the returns of risky assets; recession, normal and boom situations. Risk free assets always give the same return in all three situations of economy. Alternatively, risky assets give different rate of return in different economic situations. So in different types of situation we will get different types of return depending on which type of investment it is and what the economic situation is at the time (www.xpresstrade.com).

Portfolio Management:

By selecting securities that have little relationship with each other, an investor is able to reduce relevant risk. Ideally, one would combine their securities in a way that will reduce relevant risk, such as diversification, to optimally manage their portfolio. The decision to invest excess cash in marketable securities involves not only the amount to invest but also the type of securities to invest. To some extent, the two decisions are interdependent. Both should be based on an evaluation of expected net cash flows and the uncertainty associated with these cash flows. In future cash flow patterns are known with reasonable certainty and the yield curve is upward sloping in the sense of long-term securities yielding more than shorter-term ones, a company may wish to arrange its portfolio so that securities will mature approximately when the funds will be needed. Such a cash-flow pattern gives the firm a great deal of flexibility in maximizing the average return on the entire portfolio, for it is unlikely that significant amounts of securities will have to be sold unexpectedly.

Controlling the risk

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