Introduction
Mean Variance Optimization Model and Capital Assets Pricing Model will be compared in the assignment because the models are important in investment. MVOM is that find the best method to share investment to get highest return and lowest risks from calculate the variance of risk and rate of return in the future. CAPM is that from analysis and calculate expected return and risk to find the best method with highest profits and lowest risks. CAPM is a supplement for MVOM.
The report will discuss the probability distribution assumption, inputs and outputs, pros and cons for two models, how Mean-Variance Optimization model behaves when market imposes constraints and limitations of MVOM.
Probability distribution assumption:
The probability distribution assumption on risky asset return distributions of Mean Variance Optimization Model is a symmetric bell shaped distribution which the parabola opens toward right. And the CAPM Model is normally distributed.
Assumptions are used when deriving Mean Variance Optimization Model which are: 1) Investors only focus on means and variances of the portfolio return in a given period. 2) Investors pursuit higher means and lower variances. 3) The investors are against risk and risk can be represented by variance. 4) Financial markets are frictionless. 5) There are no taxation and transaction cost and the price and quantity of asset have no restriction when they trade.
The assumptions of CAPM Model are: 1) Investors can get all information at same time. 2) There are no taxation and transaction cost. 3) Under risk free rate of interest, investors can borrow and lend unlimited amounts. 4) Rational and risk-averse. 5）Have homogeneous expectations. 6) All assets are perfectly divisible and liq...
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... for CAPM are: firstly, the model is simpleness and definitude. The model just divides all of venture capital to three factors: risk free rate of return, price of risk and calculative unit of risk. It can save a huge workload for investors. Secondly, the practicability of CAPM can help investors evaluate and choose financial assets with absolute risk rather than total risk. The decision is easy to make for the model.
However, the model also has some weakness: firstly, the hypothesis for the model is difficulty to implement. Such as: market is not complete, rate of loan is differently and anticipation of investor is dissimilarly. Secondly, beta stands for mobility of price in the past. But investors need the mobility of price future. And beta is difficulty to calculate with past data. Thirdly, the combination of no-risk asset and market investment is not existence.
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
This table was created with the help of a macro called Map2. Cash flow mapping is map the portfolio to a set of several risk factors by taking the future cash flow and discounting it by the sport rate. In other words, is a procedure for representing a financial instrument as a portfolio of zero-coupon bond for the purpose of calculating its value at risk. This portfolio accounts with three cash flows that have no risk associated in the periods .025, 0.05, and 1 year. The variance of this portfolio is calculated to be 9.37 and a risk of $968,247.29. The Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose, given normal market conditions, in a set time period such as a day. The 10 day 1% VaR for this portfolio is
Assuming that there are no costs applied, and the investors have the ability to buy and sell securities and they also have the knowledge of any change; no costs for buying or selling of securities for brokers for example. Modigliani and Miller’s assumption is that all of these capital market factors which is needed for trading of securities are all perfect.
Brealey, Richard A., and Myers, Stewart C. Principles of Corporate Finance. Sixth ed. McGraw Hill, New York, © 2000.
i.e. a. Fama, Eugene F. “Market Efficiency, Long-Term Returns, and Behavioral Finance.” Journal of Financial Economics 49, no. 1 (September 2011). 3 (1998): 283–306. i.e. a. Daniel K., Hirshleifer D. & Subrahmanyam A. 1998. The.
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...
Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.
The MDA model also showed potential to ease some problems in the selection of securities for a portfolio, but further investigation was recommended.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
Howells, Peter., Bain, Keith 2000, Financial Markets and Institutions, 3rd edn, Henry King Ltd., Great Britain.
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.
Capital markets are markets "where people, companies, and governments with more funds than they need (because they save some of their income) transfer those funds to people, companies, or governments who have a shortage of funds (because they spend more than their income)" (Woepking, ¶3). The two major capital markets are stock and bond markets. Capital markets promote economic efficiency by moving funds from those who do not have an immediate need for it to those who do. Individuals or companies will put money at risk if the return on the intended investment is greater than the return of holding risk-free assets. An example of this would be those that invest in real estate or purchase stocks and bonds. Those that invest want the stock, bond, or real estate to grow in value or appreciate. An example of this concept would be if an individual or company invested an amount saved over the course of a year. While investing may be riskier, these individuals hope that the investment will yield a greater return than leaving the money in a savings account drawing nominal interest. In this example the companies that issue the stocks or bonds have spending needs that exceed their income so the company will finance their spending needs by issuing securities in the capital markets. This is a method of direct finance because the "companies borrowed directly by issuing securities to investors in the capital markets" (Woepking, ¶5).
By using the Capital Asset Pricing Model (CAPM), Cohen calculated a Weighted Average Cost of Capital (WACC) of 8.4%.
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.