Financial Investment and

Portfolio Management
Group II

THEORY FOR INVESTMENT

PORTFOLIO FORMATION

MARKOWITZ PORTFOLIO
THEORY
Henry Markowitz author of the
modern
portfolio
theory
who
introduced the analysis of the
portfolios of investments in his
article Portfolio Selection published
in the Journal of Finance in 1952.
The new approach presented in this
article included portfolio formation
by considering the expected rate of
return and risk of individual stocks
and crucially, their interrelationship
as measured by correlation.

MODERN PORTFOLIO THEORY

A theory on how risk-averse investors can
construct portfolios to optimize or maximize
expected return based on a given level of
market risk, emphasizing that risk is an
inherent part of higher reward.

INDIFFERENCE CURVES
The method that should be
used in selecting the most
desirable portfolio.
Represent
an
investors
preferences for risk and
return. These curves should
be
drawn,
putting
the
investment return on the
vertical axis and the risk on
the horizontal axis.

FEATURES OF INDIFFERENCE
CURVES
All portfolios that lie on a given
indifference curve are equally desirable
to the investor. An implication of this
future: indifference curves cannot
intersect.
An investor has an infinitive number of
indifference curves. Every investor can
represent several indifference curves.

TWO IMPORTANT
FUNDAMENTAL ASSUMPTIONS
Assumption of nonsatiation
The investors are assumed to prefer higher
levels of return to lower levels of return,
because the higher levels of return allow the
investor to spend more on consumption at the
end of the investment period. Thus, given two
portfolios with the same standard deviation, the
investor will choose the higher expected return.

Assumption of risk aversion

Investors are risk averse. It means
that the investor when given the
choice, will choose the investment
or investment portfolio with the
smaller risk.

EFFICIENT SET THEOREM

States that an investor will choose his / her optimal
portfolio from the set of the portfolios that :
1. Offer maximum expected return for varying level of
risk
2. Offer minimum risk for varying levels of expected
return

EFFICIENT SET OF PORTFOLIO

Involves the portfolios that the investor will find
optimal ones. These portfolios are lying on the
northwest boundary of the feasible set and is called
EFFICIENT FRONTIER.
The Efficient Frontier can be described by the curve
in the risk-return space with the highest expected
rates of return for each level of risk.

FEASIBLE SET
It is the opportunity set, from which the efficient
set of portfolio can be identified. The feasibility
set represents all portfolios that could be
formed from the number of securities and lie
either or, or within the boundary of the feasible
set.

RISK OF THE PORTFOLIO

The most often used measure for the risk of investment is
standard deviation, which shows the volatility of the
securities actual return from their expected return.
The relationship between the assets can be estimated
using a covariance and coefficient of correlation. As
covariance can range from - to + infinity, it is more
useful for identification of the direction of relationship
(positive or negative), coefficients of correlation always
lies between -1 & +1 and is the convenient measure of
intensity and direction of the relationship between the
assets.

RISK OF THE PORTFOLIO

-Expected Rate of Return

/ -the portion of the portfolios
initial value investment
/ - Expected rate of security

RISK OF THE PORTFOLIO

p=[+]+2[

SAMPLE PROBLEM
PORTFOLIO

RATE IF
RETURN

STANDARD
DEVIATION

WEIGHT

18%

12%

60%

25%

20%

40%

CORRELATION

CAPITAL ASSET PRICING

MODEL (CAPM)
Developed by W. F. Sharpe
Based on the idea of risk aversion
Whatever the rate of return on an investment, it
should be achieved with the lowest possible
level of risk
A high-level of risk should be accompanied by a
corresponding high-level of return

CAPM FORMULA

Ke = Rf + (Rm Rf)
where;
Ke is the cost of equity
Rf is the rate of free risk investment
is the coefficient beta
Rm is the rate of the general market

DEFINITION OF TERMS
Systematic

risk

also known as SYSTEMIC RISK

[INVESTMENT] is a probability of loss common to all businesses and
investment opportunities, and inherent in all dealings in a market. Also
called MARKET RISK, it cannot be circumvented or eliminated by
portfolio diversification but may be reduced by hedging. In stock
market, systemic risk is measured by BETA-COEFFICIENT.

Unsystematic risk

also known as UNSYSTEMIC RISK

[SECURITY] is an investment risk that is not common to all securities
or the securities market, but instead is associated with the securities
of a particular issuer. Unlike a systemic risk, unsystemic risk can be
avoided by portfolio diversification.

DEFINITION OF TERMS
Cost of Equity

is the common stockholders required

rate of return.

Risk Premium

[INVESTING] (1) is the difference between

a risk-free return (such as fro government bonds) and the total
return from a risky investment (such as equity stock). (2)
Additional return or rate of interest (above the market interest
rate) an investor requires for investing in a proposition or
venture. Also called price of risk.

Beta

is the way of measuring risk using VOLATILITY

compared to a commonly used system (e.g. General Stock
Market)

THE ESSENCE OF THE CAPM: THE MORE

SYSTEMATIC RISK THE INVESTOR CARRY, THE
GREATER IS HIS / HER EXPECTED RETURN.
The CAPM being theoretical model is based on some important
assumptions:
All investors look only one-period expectations about the future;
Investors are price takers and they cant influence the market
individually;
There is risk free rate at which an investors may either lend (invest)
or borrow money.
Investors are risk-averse.
Taxes and transaction costs are irrelevant.
Information is freely and instantly available to all investors.

SECURITY MARKET LINE

(SML)
Demonstrates the relationship between the expected
return and Beta. Each security can be described by its
specific security market line, they differ because their
Betas are different and reflect different levels of market
risk for these securities.

COEFFICIENT BETA ()
Each security has its individual systematic
undiversified risk, measured using
coefficient Beta. It indicates how the price
of security / return on security depends
upon the market forces. The Beta of the
portfolio is simply a weighted average of
the Betas of its component securities,
where the proportions invested in the
securities are the respective weights.

ARBITRAGE
It is the earnings of riskless profit by taking advantage
of differential pricing for the same assets or security.

ARBITRAGE PRICING THEORY

(APT)
APT was proposed by Stephen S. Rose and
presented in his article The arbitrage theory of
Capital Asset Pricing, published in Journal of
Economic Theory in 1976.
States that the expected rate of return of
security is the linear function from the complex
economic factors common to all securities.

FOUR FACTORS ECONOMIC

VARIABLES

Inflation
Industrial Production
Risk Premiums
Slope of the Term Structure in
Interest Rates

POSSIBLE MACROECONOMIC
FACTORS WHICH COULD BE
INCLUDED IN USING APT MODEL:

GDP Growth
An Interest Rate
An Exchange Rate
A Default spread on Corporate
Bonds

MARKET EFFICIENCY THEORY

The concept of market efficiency was proposed by
Eugene Fama in 1965, when his article Random
Walks in Stock Prices was published in Financial
Analyst Journal.

Market Efficiency means that the price which

investor is paying for financial asset (stock, bond, other
security) fully reflects fair or true information about the
intrinsic value of this specific asset or fairly describe
the value of the company the issuer of this security.
The key term in the concept of the market efficiency is
the information available for investors trading in the
market.

CAPITAL MARKET IS EFFICIENT:

If the prices of securities which are traded in the market, react to
the changes of situation immediately, fully and credibly reflect all
the important information about the securitys future income and
risk related with generating this income.

Three Forms of Market Efficiency

Weak form of efficiency the stock prices are
assumed to reflect any information that may be
contained in the past history of the stock prices.
Semi-strong form of efficiency all publicly available
information is presumed to be reflected in stocks
prices.
Strong form of the efficiency asserts that stock
prices fully reflect all information, including private or
inside information, as well as that which is publicly
available.