...Review on Modern Portfolio theory Historical development and current state of theory: Modern Portfolio theory is developed by Markowitz (1952, 1959). Portfolio problem has been formulated as an option of the variance and mean of an asset portfolio. If investors concern on the return distributions for a single period, the mean and variance portfolio theory need to be developed to find the optimum portfolio. Then the investors need to find out the mean and the variance of return for each asset in the portfolio for that single period. Markowitz also has proved the fundamental theorem of mean variance theory, which are holding variance constant, maximize the expected return, as well as holding constant the expected return minimize variance. Based on these principles and individual risk return preferences, investors could choose their preferred portfolio and form the optimum efficient frontier. Issues in estimating the key inputs for portfolio theory There are two different models are used, which are index models and covariance estimates. The single-index model was developed and popularized by Sharpe (1967). However, multi-index model was developed to better explain the theory. Multi-index models can be used to provide inputs for a portfolio optimization technique; it also can be used to understand the sensitivity of the portfolio to various economic influences. If we make additional assumption that Capital Asset Pricing Model (CAPM) holds and ignore insight of Fama...
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...fundamentals of the modern portfolio theory In the first paragraph we show the crucial differences between the modern portfolio theory and pre-Markowitz one, summarize the mathematical framework of the MPT and critically evaluate the core assumptions building the MPT. This paragraph is devoted to the second stage of the portfolio selection process assuming that all input parameters of the model are true. 2.1 Definition of the modern portfolio theory Harry Markowitz is highly regarded as a pioneer in theoretical justification of investor’s behavior and development of optimization model for portfolio selection process. In 1990, Markowitz shared a Nobel Prize for his contributions to financial economics and corporate...
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...Can We Measure Portfolio Performance? by Steen Koekebakker and Valeri Zakamouline Introduction The risky assets available to investors are numerous: mutual funds, hedge funds, structured products, equity-linked notes to name a few. The characteristics of each asset class can be summarized in the different return distributions. Even within a single asset class the return distributions of assets are not alike. We assume that the return distributions of all risky assets are known and would like to choose the best asset to invest to, meaning that the risky assets are mutually exclusive investment alternatives. How to do this? The standard approach in financial theory and practice is to employ some portfolio performance measure to rank the various risky investments. Each portfolio performance measure calculates a score for each asset using its probability distribution of returns. The best asset to invest to is the asset with the highest score. The Sharpe ratio is a commonly used measure of portfolio performance. But because it is based on mean-variance theory, this measure can only be used in some restrictive cases, for example, when return distributions are normal. When return distributions are non-normal, the Sharpe ration can lead to misleading conclusions and unsatisfactory paradoxes, see Bernardo and Ledoit (2000) and Hodges (1998). There have been proposed numerous universal performance measures that, in one way or the other, are alternatives to the Sharpe...
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...decide to use Mean-Variance preferences method to calculate the utility we can get from investing four stocks: DBS, SPH, GE, SIA. We know the equation: Ur= μ-γ2 Varri=μ- γ2σi2 We can decide weight of four stocks by maximizing the utility of the portfolio. (N=4, T=232) So we suppose: 1. The best portfolio is the one that satisfy owner most, which means have the maxi utility. 2. The owner is afraid of risk, and the risk aversion is measured by γ, γ=3 3. The portfolio will be hold for one year. From equation: Rate=R1-R2R1 We can get return rates of four stocks in different periods since Jan-96 (See sheet 1), and the mean return rates μ for the four stocks are: DBS=0.10814638, SPH=0.0733264, GE=0.12002196, SIA=0.06982988 And we can get the Covariance Matrix: 0.105279399 0.041817263 0.05022109 0.0565126810.041817263 0.062596535 0.025656805 0.0373403140.05022109 0.025656805 0.109059667 0.0386166250.056512681 0.037340314 0.038616625 0.065556537 A= 21.372. B= 1.72756669. C= 0.18175538, D= 0.90015379 And we get σ σDBS=0.32446787, σSPH=0.250193,σGE=0.33024183, σSIA=0.25604011 From the equation: σportfolio2=wi2σi2+wiwjσi,j (i≠j) We can get the σ with different weights (See sheet) Since efficient frontier is equal to the minimum-variance frontier for expected returns larger than the expected return of the global minimum-variance portfolio We also know the equation wμp=a+bμp Expected portfolio return: μp1=μTw(μp) ...
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...Modern portfolio theory From Wikipedia, the free encyclopedia "Portfolio analysis" redirects here. For theorems about the mean-variance efficient frontier, see Mutual fund separation theorem. For non-mean-variance portfolio analysis, see Marginal conditional stochastic dominance. Modern portfolio theory (MPT) is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory,[1] in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways.[2] For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated.[3] More technically, MPT models...
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...------------------------------------------------- MAF707 Portfolio investments and Financial Planning ------------------------------------------------- Group Assignment Group 77: Weizhe Shi_900443906 Ran Li_210037023 Yichao FU_900387184 Contents Question 1 3 Analysis of securities and the market index 3 Summary 3 Question 2 7 Question 3 8 Question 4. 9 Standard Consumption of CAPM 9 Expectation errors relied on ex-post data 12 Reference List 14 Question 1 Analysis of securities and the market index Summary Firstly we calculated the monthly return of each securities which depend on the data of adjust close price every month. The formula is the latter month’s adjust close price minus the previous monthly adjust close price then divide the latter month’s adjust close price. On the basis of the results, we moved forward the steps that calculate the mean, median, skewnes, kurtosis, variance and correlation coefficients. Those data have been calculated and presented in excels. Definition and Formula 1. Mean The mean value is the average value of monthly return from Jun 2003 to Dec 2010. The formula is: μ=i=1NXiN where N is the number of the month we count of the return and Xi is the total value of the monthly return. 2. Median The median is the value of the middle item of a set of items that has been sorted into ascending or descending order. In an odd-numbered sample of n items, which means the total value of...
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...Efficient portfolio & Stock market efficiency Prepared by: Ahmed Mohamed Ahmed Zaki Nofal Submitted to: Dr.Tarek el Domiaty Modern portfolio theory Modern portfolio theory (MPT) is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize[1] for the theory, in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated More technically, MPT models an asset's return as a normally distributed function (or more generally as an elliptically distributed random...
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...Introduction Focusing on asset returns governed by a factor structure, the APT is a one-period model, created in 1976 by Stephen Ross, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The APT, however, does not preclude arbitrage over dynamic portfolios. Consequently, applying the model to evaluate managed portfolios contradicts the no-arbitrage spirit of the model. An empirical test of the APT entails a procedure to identify features Of the underlying factor structure rather than merely a collection of mean-variance efficient factor portfolios that satisfies the linear relation. An asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables. The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage...
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...Group Assignment Application of Portfolio Theory Semester 2, 2013 Total Marks: 40 Percentage Weighting: 20 % Investment Guidelines You are required to construct an Equity Investment Portfolio with the following specifications: Market: Australia Portfolio Size: $1 Million Portfolio Composition: 4 assets; must be shares of companies listed on the ASX Asset Allocation: Direct Investment in equities Time Horizon: 5 years commencing January 1st, 2008 to January 1st 2013 Transaction Fees, taxes and charges: Ignore Portfolio Policy Objectives: Maximise total return (capital gains plus reinvested income) Portfolio Liquidity: $10 000 in cash or near-cash required per year Portfolio Benchmark: S&P ASX200 Portfolio Management Style: Passive, Buy and Hold Asset Weights: Equal weighting Market proxy: S&P ASX200 Risk free proxy: 90 day Bank Accepted Bill rate (BAB) 1. Portfolio Construction * Manually collect price data for your 4 assets from the investment horizon - 5 years commencing January 1st, 2008 to January 1st 2013. * The price data should be Monthly. Depending on your choice of company you could find the price data from: Yahoo finance; the ASX; or the company’s own website * Download the price data for the sample period required. [Note: You must leave all formulas in your answer, the excel functions allowed are “AVERAGE”,“SUM” and “SQRT” only]. Other excel data...
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... Discuss potential explanations for the Security Market Line has been flatter than the Capital Asset Pricing Model (CAPM) would predict. The Capital Asset Pricing Model is based on asset portfolio theory and capital market theory. It emphasizes on the study of the relation between the expected return of asset and risky asset in the securities market. As one of prediction models based on the balance of risky asset expected return, CAPM elaborates on the formation of market equilibrium in the case of investors through Markowitz’ theory to investment management. (Pennacchi, 2008) It shows that a sample liner relation about expected return of asset and expected risks. In the model, beta is a significant parameter, since it measures the expected risks of assets. The Capital Asset Pricing Model has been widely adopted by investors, however, it has some limitation. The relation between beta and average return is too flat is confirmed in time-series tests. It is described by the the Security Market Line. Black, Jensen and Scholes (1972) concentrated their attention on the security market line. If the portfolio is efficient, which means there is a positive relation between beta and expected return. The study of Fama and MacBeth (1973) mainly focus on predicting the future returns of the portfolio based on the last estimate of the risk variables. However, the evidence of their studies showed that the relation between beta and average return is too flat is confirmed in time-series tests...
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...risk/return relationship and interact: information about how markets work influences investment decisions, which influences the market in its turn. The amount matters (mean and variance) and the relation with other factors (covariance) matters. , x = return distribution (magnitude), p = price, E = expectation (which captures and combines the probability that different outcomes can/will happen) and m = SDF and captures the relation with other factors and the reward required to bear the risk inherent in x (it indicates how much (marginal) utility the outcome has, which captures the role of when we like the payoff more, the conditions matter; it captures the premium needed for this specific risk). The SDF can be derived from the utility function, this gives: . The problem with this is determining marginal utility. In many cases, the SDF is a linear function of a factor (CAPM): That factor f captures when returns in situation A may be more pleasant than the same returns in situation B. Portfolio theory (Risk & return: theory – empirics) Uses assumption A1 and A2, and more: Investors: A3. Agents maximize utility, and do so for 1 period. (Rationality: agents are capable to find the very best solution for their problem, and are willing to do so). A4. Utility is a function of expected return and variance (and nothing else). Market conditions: A5. No distortion from costs, transaction fees, inflation or taxes. If trading has costs, the optimum shifts (another allocation...
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...University Graduate School of Business, Stanford, California, USA INTRODUCTION* Following tradition, I deal here with the Capital Asset Pricing Model, a subject with which I have been associated for over 25 years, and which the Royal Swedish Academy of Sciences has cited in honoring me with the award of the Prize in Economic Sciences in Memory of Alfred Nobel. I first present the Capital Asset Pricing Model (hence, CAPM), incorpo1 rating not only my own contributions but also the outstanding work of Lintner (1965, 1969) and the contributions of Mossin (1966) and others. My goal is to do so succinctly yet in a manner designed to emphasize the economic content of the theory. Following this, I modify the model to reflect an extreme case of an institutional arrangement that can preclude investors from choosing fully optimal portfolios. In particular, I assume that investors are unable to take negative positions in assets. For this version of the model I draw heavily from papers by Glenn (1976), Levy (1978), Merton (1987) and Markowitz (1987, 1990). Finally, I discuss the stock index futures contract - a major financial innovation of worldwide importance that postdates the development of the CAPM. Such contracts can increase the efficiency of capital markets in many ways. In particular, they can bring actual markets closer to the idealized world assumed by the Capital Asset Pricing Model. THE CAPITAL ASSET PRICING MODEL The initial version of the CAPM, developed over 25 years ago, was extremely...
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...financial analyst. From different theories we can determine the value of assets into three steps i.e., Expected Cash Flow, number of periods and the expected rate of returns. Investors have several questions before investing his money in any stock or in any other commodity that is what should be the accuracy of prices of selling or buying the stocks, what could be the risk, what are the factors should be considered that ignores uncertainty and the expected returns of the stock. The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) both are well known pricing model determines the risk factor for analyzing the appropriate returns for the investors in their own unique ways. CAPM model uses the whole market environment as one factor but on the other hand APT uses five different economics factor which is more detailed in describing risk which accelerates for these factors. The adoption of CAPM is in practice but other hand its various criticisms are documented on it as well and academics are working on the new approaches of it such as APT and others is discussed in later paragraphs. In this assignment I will discuss the assumptions of CAPM and APT model and their pros and cons and the limitations of CAPM over APT models. CAPM and its Shortcomings Hary Markowitz (1952) and Tobin (1958) first introduced the idea of asset pricing model. Markowitz (1952) observed that “when two risky assets are combined, their deviations from the mean are not additive, provided the...
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...------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- Efficient Portfolio Construction ------------------------------------------------- Prepared For: Pallabi Siddique Assistant Professor Department of Finance University of Dhaka ------------------------------------------------- Prepared By: Yasir bin yousuf Roll-16-036 Sec-B Department of Finance University of Dhaka ------------------------------------------------- Date of submission: ------------------------------------------------- November 24, 2012 ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ------------------------------------------------- ...
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...the LTP, the Partners Investment Committee introduced a new type of assets, real assets, into the original LTP during the past years. Both of the assets’ performance turned to be excellent during 2004. As a result, the Investment Committee was considering expanding the real-asset segment of the LTP. Michael Manning, the deputy treasurer of Partners Healthcare System, was asked to recommend the size and the composition for the real-asset portfolio contributed to the $2.4 billion long-term pool (LTP) in the Partners. Facts and Analysis Due to the fact that different Partners Healthcare hospitals might have different acceptable risk levels for their investment portfolio then the most reasonable solution would be to invest both in risk-free STP and risky LTP. By choosing different mixes each hospital could achieve their acceptable risk level. Since the STP has a nearly fixed rate of return considered to be risk free for each hospital’s own portfolio, the variation from LTP would ultimately determine the risk and return level of individual portfolio. Using long-term historical data, Manning and his staff calculated average annual returns, volatilities, and correlations...
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