4.2 Portfolio theory As stated earlier, managers are constantly faced with uncertainty, which is something many economic models do not account for. In microeconomics for instance, theory assumes that the competitive firm knows the price at which it will sell the product it produces. However, from the decision to produce, to the time of production and to the actual sale there might be a delay. Therefore the price of the product at the time of selling might differ substantially from what was expected (Markowitz. , 1991). According to Markowitz, this uncertainty cannot be dismissed, simply because if managers and investors could predict the future, they would place all their money on one investment – the one with the highest return. With this in mind, Markowitz developed portfolio theory, in which he proves the value of diversification as it reduces uncertainty. 4.3 Managing FX exposure With the theoretical part on FX exposure serving as background, this part focuses at some more practical issues that arise in terms of assessing the exposure. In order to manage the risk, a …show more content…
Since the rates are going to fluctuate, it is easy to imagine that the party, to whom the contract means a worse result than what the spot rate on the day of settlement will offer, will have a strong incentive to renege. Futures contracts solves this by use of two mechanisms, the first being that parties are required to post collateral, also called a margin, which serves as a guarantee that the parties can meet their obligations. The second mechanism is the daily settlement. Instead of waiting until the date of delivery, gains and losses are settled and exchanged every day through a process called ‘marking to market’ (Berk and DeMarzo, 2013). This means that cash changes hands every day, provided that the price of the contract
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Show MoreIf you have formed a conclusion from the facts and if you know your judgment is sound, act on it- even though others may hesitate or differ”. The investor is not wrong if the crowd disagrees, and the other way around. It is also I important for the investor in both Enterprising and Defensive Investor to diversify with the amount of different Stocks and bonds.
Kaepplinger, Peter (1990). The CPA Journal Online Foreign currency hedging transactions under Section 988Temporary regulations
However, there is still a significant degree of uncertainty as to the effectiveness of one strategy over another amongst institutional investors and scholars alike. The vast majority of experienced investors believe that diversification, patience, and value are the three columns of successful investing. On the other hand, many researchers are still in disagreement about how viable other strategies such as growth, short-term and concentrated investing can be. Do all successful investors share this common thread of patience, value, and diversification in their investments or are there a plethora of investing techniques that investors utilize to achieve
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.
Modern Portfolio Theory as introduced by Markowitz (1952) frames the time dimension of investing as a single period over which the parameters of the probability distribution of asset returns are both known with certainty and are unchanging. However, neither assumption hold in real life.
From my perspective, the usefulness of CAPM is directed towards efficient investment decision making and strategic management. Moosa (2013) remarks CAPM to be a supportive model in ‘evaluating the performance of managed portfolios and for investment purposes’.
The article addresses the issue of being successful in a highly uncertain business environment. Some managers prefer to play it safe by adopting a wait-and-see strategy while others may invest in flexibility that allows their companies to adapt quickly as the market evolves. The companies sometimes neglect the fact that having a successful strategy depends on several factors, including their industry position, assets, or their willingness to take a risk in investing in such strategies. The paper introduced some of the tips and terminologies that could help managers facing uncertainty decide on whether to play safe or bet big. The traditional practice is to put a vision of predicted future events
Ananth Madhavan and Jian Yang (2003), in their article titled, ‘Practical risk analysis for portfolio managers and traders’. This article provides a detailed overview of recent development in risk analysis and modeling with a focus on practical application for both portfolio managers and traders.
With thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor.
Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time. In order to accomplish this goal investors should diversify their portfolios based upon expected returns and standard deviations of individual securities. Investment theory assumes that investors are risk averse, which means that they will choose a portfolio with a smaller standard deviation. (Alexander, Sharpe, and Bailey, 1998). It is also assumed that wealth has marginal utility, which basically means that a dollar potentially lost has more perceived value than a dollar potentially gained. An indifference curve is a term that represents a combination of risk and expected return that has an equal amount of utility to an investor. A two dimensional figure that provides us with return measurements on the vertical axis and risk measurements (std. deviation) on the horizontal axis will show indifference curves starting at a point and moving higher up the vertical axis the further along the horizontal axis it moves. Therefore a risk averse investor will choose an indifference curve that lies the furthest to the northwest because this would r...
...a measure of economic risk). When multiple risky assets are held within a portfolio, it can be expected that some properties will increase in value while at the same time others will decrease in value. By holding risky assets in groups, some of the risk of each asset may be reduced or eliminated through the process of diversification.
Market Risk is also known as Systematic Risk due to its broad impact on investments. The level of Market Risk depends on the probability that the entire market will decline and drag down the values of all companies. With Market Risk, investors stand to lose value irrespective of the companies, business sectors, or investment vehicles they are invested in. It can be difficult for investors to protect themselves against market risk, since investment strategies, like diversification, is mostly ineffective (Investopedia,
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.
Asset allocation decisions made by an investor are considered more important than other decisions such as market timing or security selection. In the research provided by Hensel (1991), performance attribution is one of the main components when choosing the right assets in a portfolio. The impact of any investment decision can be measured by comparing its outcome with the outcome of some alternative decision. Furthermore, according to Hensel (1991), every investor has to incorporate the minimum-risk portfolio, which is a combination of securities or asset classes that reduces the uncertainty of future portfolio returns to a minimum.
After the financial crisis of the late 1990s, the demands for risk management tools have increased. The investors have been effectively utilizing such products as KOSPI 200 futures and options, 3-Year KTB futures and USD futures to meet their hedging needs.