A General Framework for Portfolio Theory—Part I: Theory and Various Models
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Financial Literacy and Portfolio Diversification
WORKING PAPER NO. 212 Financial Literacy and Portfolio Diversification Luigi Guiso and Tullio Jappelli January 2009 University of Naples Federico II University of Salerno Bocconi University, Milan CSEF - Centre for Studies in Economics and Finance DEPARTMENT OF ECONOMICS – UNIVERSITY OF NAPLES 80126 NAPLES - ITALY Tel. and fax +39 081 675372 – e-mail: [email protected] WORKING PAPER NO. 212 Financial Literacy and Portfolio Diversification Luigi Guiso and Tullio Jappelli Abstract In this paper we focus on poor financial literacy as one potential factor explaining lack of portfolio diversification. We use the 2007 Unicredit Customers’ Survey, which has indicators of portfolio choice, financial literacy and many demographic characteristics of investors. We first propose test-based indicators of financial literacy and document the extent of portfolio under-diversification. We find that measures of financial literacy are strongly correlated with the degree of portfolio diversification. We also compare the test-based degree of financial literacy with investors’ self-assessment of their financial knowledge, and find only a weak relation between the two measures, an issue that has gained importance after the EU Markets in Financial Instruments Directive (MIFID) has required financial institutions to rate investors’ financial sophistication through questionnaires. JEL classification: E2, D8, G1 Keywords: Financial literacy, Portfolio diversification. Acknowledgements: We are grateful to the Unicredit Group, and particularly to Daniele Fano and Laura Marzorati, for letting us contribute to the design and use of the UCS survey. European University Institute and CEPR. Università di Napoli Federico II, CSEF and CEPR. Table of contents 1. Introduction 2. The portfolio diversification puzzle 3. The data 4. -
The Capital Asset Pricing Model (CAPM) Prof
Foundations of Finance: The Capital Asset Pricing Model (CAPM) Prof. Alex Shapiro Lecture Notes 9 The Capital Asset Pricing Model (CAPM) I. Readings and Suggested Practice Problems II. Introduction: from Assumptions to Implications III. The Market Portfolio IV. Assumptions Underlying the CAPM V. Portfolio Choice in the CAPM World VI. The Risk-Return Tradeoff for Individual Stocks VII. The CML and SML VIII. “Overpricing”/“Underpricing” and the SML IX. Uses of CAPM in Corporate Finance X. Additional Readings Buzz Words: Equilibrium Process, Supply Equals Demand, Market Price of Risk, Cross-Section of Expected Returns, Risk Adjusted Expected Returns, Net Present Value and Cost of Equity Capital. 1 Foundations of Finance: The Capital Asset Pricing Model (CAPM) I. Readings and Suggested Practice Problems BKM, Chapter 9, Sections 2-4. Suggested Problems, Chapter 9: 2, 4, 5, 13, 14, 15 Web: Visit www.morningstar.com, select a fund (e.g., Vanguard 500 Index VFINX), click on Risk Measures, and in the Modern Portfolio Theory Statistics section, view the beta. II. Introduction: from Assumptions to Implications A. Economic Equilibrium 1. Equilibrium analysis (unlike index models) Assume economic behavior of individuals. Then, draw conclusions about overall market prices, quantities, returns. 2. The CAPM is based on equilibrium analysis Problems: – There are many “dubious” assumptions. – The main implication of the CAPM concerns expected returns, which can’t be observed directly. 2 Foundations of Finance: The Capital Asset Pricing Model (CAPM) B. Implications of the CAPM: A Preview If everyone believes this theory… then (as we will see next): 1. There is a central role for the market portfolio: a. -
An Overview of the Empirical Asset Pricing Approach By
AN OVERVIEW OF THE EMPIRICAL ASSET PRICING APPROACH BY Dr. GBAGU EJIROGHENE EMMANUEL TABLE OF CONTENT Introduction 1 Historical Background of Asset Pricing Theory 2-3 Model and Theory of Asset Pricing 4 Capital Asset Pricing Model (CAPM): 4 Capital Asset Pricing Model Formula 4 Example of Capital Asset Pricing Model Application 5 Capital Asset Pricing Model Assumptions 6 Advantages associated with the use of the Capital Asset Pricing Model 7 Hitches of Capital Pricing Model (CAPM) 8 The Arbitrage Pricing Theory (APT): 9 The Arbitrage Pricing Theory (APT) Formula 10 Example of the Arbitrage Pricing Theory Application 10 Assumptions of the Arbitrage Pricing Theory 11 Advantages associated with the use of the Arbitrage Pricing Theory 12 Hitches associated with the use of the Arbitrage Pricing Theory (APT) 13 Actualization 14 Conclusion 15 Reference 16 INTRODUCTION This paper takes a critical examination of what Asset Pricing is all about. It critically takes an overview of its historical background, the model and Theory-Capital Asset Pricing Model and Arbitrary Pricing Theory as well as those who introduced/propounded them. This paper critically examines how securities are priced, how their returns are calculated and the various approaches in calculating their returns. In this Paper, two approaches of asset Pricing namely Capital Asset Pricing Model (CAPM) as well as the Arbitrage Pricing Theory (APT) are examined looking at their assumptions, advantages, hitches as well as their practical computation using their formulae in their examination as well as their computation. This paper goes a step further to look at the importance Asset Pricing to Accountants, Financial Managers and other (the individual investor). -
Post-Modern Portfolio Theory Supports Diversification in an Investment Portfolio to Measure Investment's Performance
A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Rasiah, Devinaga Article Post-modern portfolio theory supports diversification in an investment portfolio to measure investment's performance Journal of Finance and Investment Analysis Provided in Cooperation with: Scienpress Ltd, London Suggested Citation: Rasiah, Devinaga (2012) : Post-modern portfolio theory supports diversification in an investment portfolio to measure investment's performance, Journal of Finance and Investment Analysis, ISSN 2241-0996, International Scientific Press, Vol. 1, Iss. 1, pp. 69-91 This Version is available at: http://hdl.handle.net/10419/58003 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend -
Arbitrage Pricing Theory∗
ARBITRAGE PRICING THEORY∗ Gur Huberman Zhenyu Wang† August 15, 2005 Abstract Focusing on asset returns governed by a factor structure, the APT is a one-period model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The APT, however, does not preclude arbitrage over dynamic portfolios. Consequently, applying the model to evaluate managed portfolios contradicts the no-arbitrage spirit of the model. An empirical test of the APT entails a procedure to identify features of the underlying factor structure rather than merely a collection of mean-variance efficient factor portfolios that satisfies the linear relation. Keywords: arbitrage; asset pricing model; factor model. ∗S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave Macmillan, reproduced with permission of Palgrave Macmillan. This article is taken from the authors’ original manuscript and has not been reviewed or edited. The definitive published version of this extract may be found in the complete The New Palgrave Dictionary of Economics in print and online, forthcoming. †Huberman is at Columbia University. Wang is at the Federal Reserve Bank of New York and the McCombs School of Business in the University of Texas at Austin. The views stated here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System. Introduction The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a, 1976b). It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. -
The Use of Leveraged Investments to Diversify a Concentrated Position1 by Craig Mccann, Phd, CFA and Dengpan Luo Phd
The Use of Leveraged Investments to Diversify a Concentrated Position1 By Craig McCann, PhD, CFA and Dengpan Luo PhD Introduction Brokerage firms recently recommended that investors holding a concentrated position in a single stock borrow and invest in a portfolio of additional stocks to reduce risk. For example, Merrill Lynch distributed the following2: Five Strategies for Diversifying a Concentrated Position … There are several strategies that may be appropriate for diversifying concentrated positions and reducing a portfolio’s risk. … 2. Borrow Against the Position and Reinvest to Diversify Another strategy is to borrow against your shares – up to 50% of their market value – and invest the loan proceeds in other securities. Borrowing generates liquidity without triggering a tax liability and may not trigger a reporting obligation to your company or the Securities and Exchange Commission. The key to success with this strategy is for the investments affected with borrowed funds to generate a higher return than the loan’s interest rate and result in a more diversified portfolio. The current low cost of borrowing may make this strategy attractive. Of course, borrowing against or margining your portfolio securities entails special risks, including the potential that the securities may be liquidated in the event of market declines. Contrary to Merrill Lynch’s claim, the strategy to borrow against the concentrated position and buy additional securities virtually always increases risk. In this note, we explain the error of this “leveraged diversification” strategy. We also report results of simulations that demonstrate the virtual impossibility of reducing the risk of a concentrated position by leveraged investments in other stocks. -
Portfolio Management Under Transaction Costs
Portfolio management under transaction costs: Model development and Swedish evidence Umeå School of Business Umeå University SE-901 87 Umeå Sweden Studies in Business Administration, Series B, No. 56. ISSN 0346-8291 ISBN 91-7305-986-2 Print & Media, Umeå University © 2005 Rickard Olsson All rights reserved. Except for the quotation of short passages for the purposes of criticism and review, no part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior consent of the author. Portfolio management under transaction costs: Model development and Swedish evidence Rickard Olsson Master of Science Umeå Studies in Business Administration No. 56 Umeå School of Business Umeå University Abstract Portfolio performance evaluations indicate that managed stock portfolios on average underperform relevant benchmarks. Transaction costs arise inevitably when stocks are bought and sold, but the majority of the research on portfolio management does not consider such costs, let alone transaction costs including price impact costs. The conjecture of the thesis is that transaction cost control improves portfolio performance. The research questions addressed are: Do transaction costs matter in portfolio management? and Could transaction cost control improve portfolio performance? The questions are studied within the context of mean-variance (MV) and index fund management. The treatment of transaction costs includes price impact costs and is throughout based on the premises that the trading is uninformed, immediate, and conducted in an open electronic limit order book system. These premises characterize a considerable amount of all trading in stocks. -
Arbitrage Pricing Theory
Federal Reserve Bank of New York Staff Reports Arbitrage Pricing Theory Gur Huberman Zhenyu Wang Staff Report no. 216 August 2005 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the authors and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Arbitrage Pricing Theory Gur Huberman and Zhenyu Wang Federal Reserve Bank of New York Staff Reports, no. 216 August 2005 JEL classification: G12 Abstract Focusing on capital asset returns governed by a factor structure, the Arbitrage Pricing Theory (APT) is a one-period model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The APT, however, does not preclude arbitrage over dynamic portfolios. Consequently, applying the model to evaluate managed portfolios is contradictory to the no-arbitrage spirit of the model. An empirical test of the APT entails a procedure to identify features of the underlying factor structure rather than merely a collection of mean-variance efficient factor portfolios that satisfies the linear relation. Key words: arbitrage, asset pricing model, factor model Huberman: Columbia University Graduate School of Business (e-mail: [email protected]). Wang: Federal Reserve Bank of New York and University of Texas at Austin McCombs School of Business (e-mail: [email protected]). This review of the arbitrage pricing theory was written for the forthcoming second edition of The New Palgrave Dictionary of Economics, edited by Lawrence Blume and Steven Durlauf (London: Palgrave Macmillan). -
MODERN PORTFOLIO THEORY: FOUNDATIONS, ANALYSIS, and NEW DEVELOPMENTS Table of Contents
MODERN PORTFOLIO THEORY: FOUNDATIONS, ANALYSIS, AND NEW DEVELOPMENTS Table of Contents Preface Chapter 1 Introduction (This chapter contains three Figures) 1.1 The Portfolio Management Process 1.2 The Security Analyst's Job 1.3 Portfolio Analysis 1.3A Basic Assumptions 1.3B Reconsidering The Assumptions 1.4 Portfolio Selection 1.5 Mathematics Segregated to Appendices 1.6 Topics To Be Discussed Appendix - Various Rates of Return A1.1 The Holding Period Return A1.2 After-Tax Returns A1.3 Continuously Compounded Return PART 1: PROBABILITY FOUNDATIONS Chapter 2 Assessing Risk (This chapter contains six Numerical Examples) 2.1 Mathematical Expectation 2.2 What is Risk? 2.3 Expected Return 2.4 Risk of a Security 2.5 Covariance of Returns 2.6 Correlation of Returns 2.7 Using Historical Returns 2.8 Data Input Requirements 2.9 Portfolio Weights 2.10 A Portfolio’s Expected Return 2.11 Portfolio Risk 2.12 Summary of Conventions and Formulas MODERN PORTFOLIO THEORY - Table of Contents – Page 1 Chapter 3 Risk and Diversification: An Overview (This chapter contains ten Figures and three Tables of real numbers) 3.1 Reconsidering Risk 3.1A Symmetric Probability Distributions 3.1B Fundamental Security Analysis 3.2 Utility Theory 3.2A Numerical Example 3.2B Indifference Curves 3.3 Risk-Return Space 3.4 Diversification 3.4A Diversification Illustrated 3.4B Risky A + Risky B = Riskless Portfolio 3.4C Graphical Analysis 3.5 Conclusions PART 2: UTILITY FOUNDATIONS Chapter 4 Single-Period Utility Analysis (This chapter contains sixteen Figures, four Tables -
Asset Securitization (The Case of Australia)
Wealth effects from asset securitization (the case of Australia) Authors: Nicha Lapanan Stefan Anchev Supervisor: Anders Isaksson Student Umeå School of Business Autumn semester 2011 Master thesis, two year, 30 hp Acknowledgement First of all, we want to express our gratitude to our parents and friends. Without their full support and encouragement, we would never be able to complete this Master program. Furthermore, we would like to thank our supervisor, Anders Isaksson, who was guiding us through the writing process and who showed deep understanding for our situation. We would also like to thank Mr. Matias Lampe. The phone conversation with Mr. Lampe made us realize that this study could not be conducted with data from Sweden. He saved us a lot of time and helped us focus our attention someplace else. ………………………... …………………...…… Nicha Lapanan Stefan Anchev Umeå, September 2011 I About the authors: Nicha Lapanan Nicha has Bachelor degree in Business administration, major in accounting from Thammasat University, Thailand. After graduation, Nicha was working for 1 year at “KPMG”, as an assistant auditor. Currently, she is pursuing Master degree in Finance at Umeå School of Business and Economics, Umeå University. Additionally, she is enrolled in the Chartered Financial Analyst (CFA) and Financial Risk Management (FRM) program. Contact info: [email protected] Stefan Anchev Stefan graduated from the Faculty of Business administration at the South East European University, Republic of Macedonia. His major was finance and accounting. After finishing his studies, Stefan was working as an assistant auditor at “Dimitrov Revizija DOO”. Since 2009, Stefan is enrolled in the Master in Finance program at Umeå School of Business and Economics, Umeå University. -
The Capital Asset Pricing Model (CAPM) of William Sharpe (1964)
Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004—Pages 25–46 The Capital Asset Pricing Model: Theory and Evidence Eugene F. Fama and Kenneth R. French he capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a T Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses.1 The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications. The CAPM’s empirical problems may reflect theoretical failings, the result of many simplifying assumptions. But they may also be caused by difficulties in implementing valid tests of the model. For example, the CAPM says that the risk of a stock should be measured relative to a compre- hensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate and human capital. Even if we take a narrow view of the model and limit its purview to traded financial assets, is it 1 Although every asset pricing model is a capital asset pricing model, the finance profession reserves the acronym CAPM for the specific model of Sharpe (1964), Lintner (1965) and Black (1972) discussed here. -
The Capital Asset Pricing Model (Capm)
THE CAPITAL ASSET PRICING MODEL (CAPM) Investment and Valuation of Firms Juan Jose Garcia Machado WS 2012/2013 November 12, 2012 Fanck Leonard Basiliki Loli Blaž Kralj Vasileios Vlachos Contents 1. CAPM............................................................................................................................................... 3 2. Risk and return trade off ............................................................................................................... 4 Risk ................................................................................................................................................... 4 Correlation....................................................................................................................................... 5 Assumptions Underlying the CAPM ............................................................................................. 5 3. Market portfolio .............................................................................................................................. 5 Portfolio Choice in the CAPM World ........................................................................................... 7 4. CAPITAL MARKET LINE ........................................................................................................... 7 Sharpe ratio & Alpha ................................................................................................................... 10 5. SECURITY MARKET LINE ...................................................................................................