Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crises

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The article “Modern Portfolio Theory, Financial Engineering, and Their Roles in Financial Crises” discusses modern portfolio theory, and the financial engineering. The author mentions roles that modern portfolio theory and financial engineering played in the financial crises. Also, the author states the issue of why elegant mathematics leads to bad polices. In this assignment, I will summarize most of the points that are discussed in the article. The author begins the article by defining the concept of modern portfolio theory (MPT). Modern portfolio theory can be defined as a theory on how investors can have optimal portfolios that generate the heights expected return based on a given level of risk. In other words, it is possible to build efficient frontier of optimal portfolios that generate maximum expected return at a given level of risk. The article presents the optimization process in the theory by its inputs and outputs. The first inputs is the expected returns for each security, which can be estimated using historical returns. The second input is the covariance matrix that includes the correlation coefficient, the standard deviation, and the variance of each security. The last input is the constraints in the selection of portfolio such as the turnover of the portfolio or liquidity. On the other hand, the optimization process has to outputs. The first is the efficient frontiers that represent the risk-return trade-off portfolios. The second output is the choice of portfolio that has the risk and return optimization for the investor. Financial Engineering (FE) is the second point that the article discusses. To fully understand financial engineering, we should understand the Black-Scholes-Merton (BSM), which is an option-... ... middle of paper ... ...fication is important to reduce risk, however, a pair of security should be negative to make diversification effective. Investors, especially in Black Monday crisis, did not pay attention to the correlation. As a result, they invested in securities that have positive correlations. I believe that if investors had understood the concept of correlation, their portfolio would have had less overall risk. In conclusion, Modern Portfolio Theory and Financial Engineering have been great financial models that helped investors all around the world. However, they have been associated with some crisis because of their assumptions. Generally, financial models assume in order to simplify the reality, so most of the time the assumptions should work. The article described each models and the roles they played in financial crises as well as some best practice of them in the future.

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