International Financial Markets: Fundamentals of Portfolio Theory - Assignment Example

International Financial Markets (2200 words, without the reference list) Introduction: Large ventures are generally organized as corporations. Conglomerates have three key features. First, they are officially distinct from their employers and pay their individual taxes. Second, conglomerates offer limited liability, which indicates that the stockholders who possess the company cannot be held accountable for the firm’s obligations. Third, the employers of a conglomerate are not typically the managers. The overall job of the financial manager can be divided into the venture, or capital budgeting decision and the financing decision. In other words, the company has to decide what real assets to purchase and how to increase the required cash. The financial manager plays on a global stage and must comprehend how global financial markets function and how to assess overseas investments (Brealey and Myers, 2003, p.10). This study will address the theoretical justification as well as practical application of portfolio theory and capital asset pricing model with respect to an investor or fund manager. Portfolio theory: In order to identify with risk-return trade-off, we view risks of the asset returns of individuals. Risks in individual asset returns have 2 parts - systematic risks and non-systematic risk. Systematic risks are non-diversifiable whereas the non-systematic risks are diversifiable. To eliminate the non-systematic risks, one can form portfolios. Instead of single individual assets, the investors opt for portfolio diversification. The investors’ main concern is about the systematic risks. The return on assets pays off for systematic risks (Jiang, 2003, p. 3). Portfolio diversification, correlation, efficient frontier set and market portfolio: A little diversification can present a considerable lessening in variability. Suppose one computes and evaluates the standard deviations of arbitrarily selected one-stock or two-stock portfolios. A high percentage of the investments would be in the stocks of small corporations and separately very risky. However, diversification can slash the unpredictability of returns by about fifty percent. Diversification works since prices of various stocks do not move perfectly together (Brealey and Myers, 2003, p.166). In the above figure, diversification decreases the risk rapidly in the initial stage. After that it is gradually decreasing the risk. Given the nonexistence of arbitrage opportunities there is an exceptional, positive stochastic discount factor, m such that for any payoff X. The problem of the investor is to select a portfolio. Let the payoff of his portfolio be ˆX, so its price or value is . He will consume . Thus, his problem is: Max {ˆX} Where, W=wealth, L=labor or business income. The first order conditions are given as: The optimal portfolio places marginal utility relative to the discount factor. The optimal portfolio itself is given by: The initial wealth constraint is satisfied by the Lagrange multiplier, λ. The investor will invest less in high priced stock and invest more in the low priced stock. Risk aversion, or curvature of the utility function, resolves how much the investor is eager to substitute his investment across his portfolio (Cochrane, 2007, p. 5). Investing in some assets may bring in good or bad returns. The intrinsic diversification of an individual’s portfolio will alter. One of the examples was the dotcom boom. At that time, stock market investors became extremely overweight in tech shares because of that sector’s achievement. However, the investors who invested a major part of their shares in this sector lost a lump sum amount of money when the shares collided in 2000-2003 (Portfolio Diversification, 2009). We consider that there are two assets. The returns are given by ˜r1, ˜r2. The mean returns are given by ^r1 and ^r2. The variances and the co variances matrix are given by: ˜r1 ˜r2. ˜r1 ˜r2. σ12 σ12 σ21 σ22 Covariance of an asset is the variance of itself: A portfolio of these two assets is typified by the value invested in each asset. Let V1 and V2 be the amount of money invested in 1st and 2nd asset respectively. The total value of the portfolio is We will consider a portfolio in which is the weight on asset 1 and W2 = V2/V is the weight on asset 2. The portfolio return is a weighted average of the returns of the individual: The locus of all border portfolios in the mean-volatility plane is regarded as portfolio frontier. The section above the portfolio frontier consists of “efficient” frontier portfolios. When σ1 = 0, the asset 1 becomes risk –free. . . . . . . . When more assets are incorporated, the portfolio frontier enhances. It shifts toward upper-left. It specifies higher mean returns and lesser risk. The inclusion of the new assets will not make the investor worse-off (Jiang, 2003, p. 17-22). Combining the returns from several states helps to level the return from an individual’s investments. Diversifying the portfolio into overseas market is one of the means to avoid risk. Here is a real life example which helped an individual to minimize his risk of investment. Most of his money was invested into a Japanese stock. He perceived that Japan was not exposed to Western borrowings. However, his perception was wrong. Japan proved to be exposed to Western borrowing owing to its dependence on overseas exports. Thus, it can be observed that investing major share of one’s earnings in only one stock may lead to immense loss. Hence, diversification of portfolio is required (Why investing in overseas market will diversify your portfolio? 2009). Capital market line (CML) and the relevance with the investor: CML is the tangent line drawn from the risk-free point to the viable area for risky assets. This line illustrates the association between Rp^ and σp for efficient portfolios. The tangency point M symbolizes the market portfolio. The rational investors (having the minimum variance) should possess their risky assets in the ratios proportional to their weights within the market portfolio. Rational investors anticipate advanced returns for riskier assets and the CML elucidates this graphically. In the above figure, at the point L, an investor can take less risk to hold risk free asset. At R, he can borrow to raise his leverage. And at point M, an investor invests all his wealth into the risky assets. Equation of the CML is given by: Where, r^ ,σ and rf are the mean and standard deviation of the rate of return and rate of risk-free return respectively of an efficient portfolio. Slope of the CML is given by: This implies how much the anticipated rate of return must augment if the standard deviation rises by one unit (Capital Asset Pricing Model and Factor Models, n.d.). Advantages and disadvantages of portfolio theory: The advantages of worldwide portfolio diversification vary across nations from the viewpoint of a local investor. Most of the advantages are acquired from investing outside the area of the domestic nation. The gains from worldwide portfolio diversification seem to be largest for nations with high nation risk (Driessen and Laeven, n.d.). One or few poorly performing stocks do not considerably decrease the overall portfolio performance. However, an outstandingly performing stock does not drastically develop the performance of the portfolio, and thus large potential gains are lost. Performance is highly associated with the broad market. The level of performance is not seen to be well in a down market (Introduction to Portfolio Diversification, n.d.). Capital Asset Pricing Model (CAPM): About CAPM: CAPM forecasts that the surplus return on any stock (portfolio) adjusted for the risk on that stock should be identical. The assumptions of CAPM are as follows: - All agents have uniform anticipations. They maximize anticipated return in relation to the standard deviation. They can borrow or lend limitless amounts at the risk-free rate. The market is in equilibrium at throughout the time period. The CAPM is used to understand the association between the risk and the expected return.   Beta: Let M be the market portfolio M, then the anticipated return r^m of any asset i assures Here, σiM is the degree of association between the return of risky asset, i and the return of market portfolio, M. When β i = 0, r^i = rf , a risky asset (with σi > 0) that is not correlated with the market portfolio will have an anticipated rate of return. This will be equal to the risk free rate. There is no predictable excess return over rf even the investor accepts some risk in holding a risky asset with zero beta. When β i = 1, r^i = rM . A risky asset which is completely correlated with the market portfolio has the same anticipated rate of return as that of the market portfolio. When β i > 1, then expected surplus rate of return is greater than that of market portfolio. This asset is known to be aggressive. When β i < 1, the asset is said to be protective. In case, r^i < rf. then, it implies that a negative beta of a risky asset will tend to reduce the variability of the portfolio (Capital Asset Pricing Model and Factor Models, n.d.). Security market line (SML): The investors take higher risk in order to get higher return from the market. The difference between the market return and the rate of interest is known as the market risk premium which is expressed as (rm- rf). In a competitive framework, the expected risk premium varies directly with the β which is a measure of risk. Hence all the investments should be undertaken on SML. The entire investment portfolio must be plotted along the slope of the SML. The x- axis contains β and y- axis indicates the expected return (Brealey and Myers, 1993, p. 195).  Expected Return on Investment Advantages and disadvantages of CAPM: CAPM reflects on only systematic risk, revealing a reality in which a majority of the investors have diversified portfolios from which unsystematic risk has been basically eradicated. It causes a hypothetically-derived association between required return and systematic risk. Problems can arise when we are using the CAPM during the computation of a project-specific discount rate. For instance, one major difficulty is finding appropriate proxy betas, as proxy firms hardly ever carry out only one business activity. One way to do this is to consider the equity beta as an average of the betas of numerous different areas of proxy firm activity, weighted by the comparative share of the proxy firm market value arising from each action (CAPM: Theory, Advantages and Disadvantages, 2008, p. 51-52). Difference between CML and SML: CML computes risk by standard deviation, or overall risk. On the other hand, SML evaluates risk by beta to locate the security’s risk contribution to portfolio, M. CML graphs only describes efficient portfolios whereas SML graphs describes about efficient and non-efficient portfolios. CML eradicates diversifiable risk for portfolios. Alternatively, SML incorporates all portfolios that lie on or below the CML, however only as a division of M, and the applicable risk is the security’s contribution to M’s risk (Chapter 13: Capital Asset Pricing Theory, n.d.). The relevance with the investor: All investors have the same ideas about the opportunities in investment for n number of risky assets. Investors can have access to and lend at the one risk-free rate. Investors can hold any portion of an asset. As discussed above, the CAPM is a significant tool in facilitating investors to understand risk (Shapiro, n.d., p. 5). Conclusion: In the study, we have analyzed the portfolio diversification theory and CAPM. If the company risk of the investment project is not similar to that of the investing organization, the CAPM can be applied to estimate a project-specific discount rate. The benefit lies within this rate. Using the CAPM will bring about improved investment decisions than applying the Weighted Average Cost of Capital (WACC). Research has portrayed the CAPM to stand up to condemnation, even though attacks against it have been growing in recent years. However, the CAPM remains to be a very fundamental tool to help the investors and fund managers in equity markets. References: 1. Brealey, R. A, Myers, S. C, (2003). Principles of corporate finance. McGraw-Hill series in finance. McGraw-Hill (New York). 2. Cochrane, J. H, ( 2007). “Portfolio Theory”. Available at: http://faculty.chicagobooth.edu/john.cochrane/research/Papers/portfolio_text.pdf (Accessed on Nov. 16, 2009). 3. Jiang, W. (2003). “Chp 10: Portfolio theory”. Available at: http://web.mit.edu/15.407/file/Ch10.pdf (Accessed on Nov. 16, 2009). 4. “Why investing in overseas market will diversify your portfolio?” Feb 2, 2009. Monevator. Available at: http://monevator.com/2009/02/02/investing-overseas-can-diversify-portfolio/ (Accessed on Nov. 16, 2009). 5. “Portfolio Diversification”, (Feb 26, 2009). Monevator. Available at: http://monevator.com/2009/02/26/portfolio-diversification/ (Accessed on Nov. 16, 2009). 6. “Capital Asset Pricing Model and Factor Models”, (n.d.) Available at: http://www.math.ust.hk/~maykwok/courses/Fin_econ_05/Fin_econ_05_5.pdf (Accessed on Nov. 16, 2009). 7. “Portfolio Theory, Life-Cycle Investing and Retirement Income”, (n.d.) U.S. Social Security Administration. Office Policy. Available at: http://www.ssa.gov/policy/docs/policybriefs/pb2007-02.html (Accessed on Nov. 16, 2009). 8. Driessen, J, Laeven, L, (n.d.) “International Portfolio Diversification Benefits: Cross-Country Evidence from a Local Perspective”. Available at: http://www.luclaeven.com/papers_files/Diversification_JBF_final.pdf. (Accessed on Nov. 16, 2009). 9. “Introduction to Portfolio Diversification”, (n.d.) Available at: http://www.buyupside.com/makingmoney/diversificationintro.htm (Accessed on Nov. 16, 2009). 10. “Modern Portfolio Theory”, (n.d.) Available at: http://www.pristinecareers.com/frm_india/FRM-sample-material-portfolio-management.pdf (Accessed on Nov. 16, 2009). 11. “CAPM: Theory, Advantages and Disadvantages”, (June/July, 2008). Available at: http://www.accatrainer.com/upload/1804754796.pdf. (Accessed on Nov. 16, 2009). 12. “Chapter 13: Capital Asset Pricing Theory”, (n.d.) Available at: http://myweb.brooklyn.liu.edu/schung/FIN121-ch13.doc (Accessed on Nov. 16, 2009). 13. Shapiro, A, (n.d.) “The Capital Asset Pricing Model”. Available at: http://pages.stern.nyu.edu/~ashapiro/courses/B01.231103/FFL09.pdf. (Accessed on Nov. 16, 2009). Read More