Investment and Portfolio Management, Study notes of Investment Management and Portfolio Theory

Download Investment and Portfolio Management and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! I. UNIT TITLE/CHAPTER TITLE: CHAPTER V II. LESSON TITLE : THEORY FOR INVESTMENT PORTFOLIO FORMATION III. LESSON OVERVIEW The lesson introduce the modern theory of investment as follows: Markowitz portfolio theory, the capital asset pricing model and arbitrage pricing theory. The student will learn its component and concept; formulas on how it will be computed; and analyzed the results. IV. LESSON CONTENT THE MARKOWITZ PORTFOLIO THEORY In 1952, an American economist named Harry Markowitz wrote his dissertation on “Portfolio Selection”, a paper that contained theories which transformed the landscape of portfolio management—a paper was published in the Journal of Finance in the same year and would earn him the Nobel Prize in Economics nearly four decades later. Instead of focusing on the risk of each individual asset, Markowitz demonstrated that a diversified portfolio is less volatile than the total sum of its individual parts. While each asset itself might be quite volatile, the volatility of the entire portfolio can actually be quite low. Markowitz created a formula that allows an investor to mathematically trade off risk tolerance and reward expectations, resulting in the ideal portfolio. This theory was based on the two main concepts: 1. Every investor’s goal is to maximize return for any level of risk 2. Risk can be reduced by diversifying a portfolio through individual, unrelated securities. CAPITAL ASSET PRICING MODEL (CAPM) The basic theory that links return and relevant risk for all assets is the capital asset pricing model COMPONENT OF RISK The risk of an investment consists of two components as follows: 1. Diversifiable risk (unsystematic risk) – results from uncontrollable or random events that are firm-specific, such as labor strikes, lawsuits and regulatory actions. 2. Nondiversifiable risk (systematic risk) – the inescapable portion of an investment’s risk. It is attributed to more general forces such as war, inflation, political events that affect all investments and therefore are not unique to a given vehicle. Total risk = Nondiversifiable risk + Diversifiable risk The two key components of of this theory is Beta – which is a measure of risk, and the capital asset pricing model (CAPM) which uses beta to estimate return. Beta indicates how the price of a security responds to market forces. The more responsive the price of a security is to changes in the market, the higher that security’s beta. Beta is found by relating the historical returns for a security to the market return. Market Return is the average return for all stocks. Analysts commonly use the average return on all stocks in the Standard & Poors’ 500-stock Composite index or some other broad stock index to measure market return. Beta can easily obtain them actively trade securities from a variety of published and online sources Important points to remember about Beta 1. Beta measures the nondiversifiable ( or market) risk if a security. 2. The beta for overall market is equal to 1.00. That also implies that the beta of the “average” stock. 3. Stocks may have positive or negative betas. Nearly all are positive. 4. Stocks with betas greater than 1.00 are more responsive to changes in the market return and therefore are more risky in the market. Stocks with betas less than 1.00 are less risky in the market. 5. Because of its greater risk, the higher a stock’s beta, the greater its level of expected return. Equation Required return on investment j = Risk-free rate + [ Beta for investment j x ( Expected market return – risk free rate) rj = RF + [bj x ( rm – RF)] Where: rj = the required return on investment j, given its risk as measured by beta RF = the risk-free rate of return; the return that can be earned on a risk-free investment bj = beta coefficient or index of nondiversifiable risk of investment j rm = the expected market return ; the average return on all securities (typically measured by the average return on all securities in the Standard & Poor’s 500- Stock Composite Index or some other broad stock market index) The CAPM can be dived into two parts: 1 the risk free rate of return R f and (2) the risk premium, bj x (rm-Rf). The risk premium is the return investors demand beyond the risk free rate to compensate for the investment’s nondiversifiable risk as measured by beta.