Portfolio Investment Theory - Essay Example

At portfolio balance theory national and foreign assets are imperfect substitutes; market participants are holding both types of assets at equilibrium. Macroeconomic shocks are affecting expected returns of national and foreign assets and changes relative asset demands. Assets markets are balanced with a change in exchange rate. Current and capital accounts surpluses/deficits are among the most important macroeconomic shocks affecting relative asset demand. In portfolio balance theory a sterilized sale of foreign currency denominated bonds by Central bank creates an excess supply for foreign currency denominated bonds and an excess demand for domestic currency denominated bonds.

For market to come to the equilibrium price of the domestic bonds must rise and price of foreign bonds must fall. That means that domestic interest rate must fall and foreign interest rate must rise. Domestic currency must appreciate in order to equalize real returns on both assets. (Kereya, I. 2002) Rational investors would tend to choose more value over less, and usually prefer to limit and minimize their risk. There are many optimal portfolios offered by dealers and brokers on the forex market that an investor can utilize to support his goals.

Over time a balanced portfolio, by diversification, helps to increase investors' chances of success. These portfolios are formed by bringing together groups of assets in different proportions, and then setting out to ascertain the resultant amount of risk and returns associated with each group of assets. A balanced Portfolio investment approach assumes imperfection in assets that are denominated in foreign and domestic currencies. Investors in the foreign exchange market should be able to diversify their investments between domestic and foreign assets, based on the amount of risk and the returns expected.

Sterilized intervention in forex alters the relative supply of foreign and domestic funds available, and investors tend to rebalance their portfolios, since exchange rates can be affected due to fluctuations in the relative supply of foreign and domestic assets. A balanced Portfolio investment Strategy also aims to achieve the right combination of growth, risk and income for investors that want a management approach that is conservative, and which includes bonds, stocks, and cash.

Another channel of sterilized intervention impact in the foreign exchange market is the noise trading approach. Noise traders are traders that utilize statistical or technical analysis in order to forecast the future price of a given asset. unlike traders who consider the fundamental value assets before and buying or selling the assets, These traders try to identify a price trend and also consider the behavioral pattern of fellow traders, using these as a source of information. This though, can lead to a rise to the tendency towards herding.

It is also possible to use sterilized foreign exchange intervention to disrupt short-run trends and this might affect the decisions made