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ECOM033 Theory Of Finance

tag 0 Download 0 Pages / 0 Words tag 21-06-2022
  • Course Code: ECOM033
  • University: University Of Surrey
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  • Country: United Kingdom

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Synopsis of the Grandfather Article

Academic Content of Article

The article prescribes that the selection of stocks becomes difficult when the number of stocks are greater than two and some of the stocks are better in providing high returns while some are better in reducing the risk (Weyel, 2011). In this situation, the investor finds it difficult to select the stocks because if high return stocks are selected, the risk will not optimize and if low risk stocks are selected, the return will not optimize. Thus, it was perceived crucial to develop a suitable system which can be used in analyzing the stocks and selecting them in a manner that optimizes the risk and return both. The article of Harry Markowitz taken for analysis in this paper has a great impact on the stock selection and optimizing the risks and returns (Weyel, 2011).

Original Contributions

The selection of stocks to make a portfolio involves careful analysis of the risks and returns of the securities. However, the decision as regards selection of the stocks or portfolios can not be resolved merely analyzing the risks and returns. The analysts are required to take into consideration various aspects apart from analyzing the risk and return while finalizing the investment choice. In this regard, Harry Markowitz developed the portfolio theory to assist the analysts in selecting the stocks or portfolios for investment. The article selected for analysis in this paper is of Harry Markowitz on portfolio selection which was published way back in the year 1952 (Markowitz, 1952). This article provides description of the model developed by Harry Markowitz on portfolio selection.

 Consequences of Original Contribution   

The portfolio theory developed by Harry Markowitz assumes that the investors take risk and return as the primary factor to take decision for investment. Further, it assumes that all the investors are risk averse, which means that the investors do not want to take risk (Francis and Kim, 2013). In this situation, the investor would prefer the portfolios with low risk it does not matter that the return will also be low. However, practically it is hardly seen that the investorswill always look to invest in the low risk securities. The Harry Markowitz introduced the concept of efficient frontier for selection of portfolios. This concept of efficient frontier proved to be historic as far as task of selection of portfolio with optimization of the risk and return is concerned (Francis and Kim, 2013). In this context, this paper will discuss the contributionof Harry Markowitz’s article on portfolio selection in the academic field. Further, the discussion in this paper will also extend to the original contribution of the article in the finance domain.

Development of Original Contribution

Paper-1: A simplified model for portfolio analysis by Sharpe, W.F. (1963)

The work of Harry Markowitz was revolutionary in the field of finance. The concepts of portfolio selection and the approach of risk and return analysis as deployed by Harry Markowitz changed the perception of people toward investment analysis. Followed by article of Harry Markowitz, William F. Sharpe published an article providing simplified model for portfolio analysis in the year 1963 (Sharpe, 1963). The model developed by William F. Sharpe is considered as an extension to the Harry Markowitz model. The modern portfolio theory developed by Harry Markowitz provided for analysis and selection of the portfolios by separating the available options between efficient and inefficient. William F. Sharpe further extended the research on finding out the factors that cause the return and risk to change (Sharpe, 1963).

The Sharpe model reiterated that the efficient portfolio is the one which either provides higher return at the same level of risk or low risk at same level of return. This implies that in order to be efficient the stock should be superior in terms of returns or in terms of the risk (Schneider, 2009). Further, the Sharpe model also provided the portfolio evolution ratio which is used in analyzing and comparing the portfolios. The ratio of Sharpe model is computed by dividing the return in excess of risk free rate by the risk measured by standard deviation. Thus, effectively the Sharpe ratio computes excess return per unit of risk, which is considered one of the most useful factors to compare two portfolios with each other (Sharpe, 1963).

Further, the Sharpe model provided for application of critical line method in selection of the portfolios. As per the principles enunciated in this model, the work of portfolio analysis becomes easier on studying the two important characteristics of efficient portfolio (Sharpe, 1963). The first is analysis of relationship between the two portfolios being considered for selection and second is analysis of relationship between the two corner portfolios.Further, Sharpe also provided for another model namely diagonal model which provided for the methodology to implicate the assumptions in the analysis. The diagonal method makes an assumption that the returns of various securities are related to each other in some or other way. As per the diagonal method the return of stock can be computed by using the risk index, risk free rate, and the market return. However, the risk index used in this model could be related to market (beta) or it could be related to gross national product of the country (Oniyilo, 2016).

It could be observed that the portfolio theory of Harry Markowitz provided the basic principles to assess the risk and return. These principles as provided in the portfolio theory of Harry Markowitz assisted Sharpe in developing the new model of portfolio selection. Further, the concept of risk and return as enunciated in the portfolio theory of Harry Markowitz also assisted in the development of Sharpe ratio. The Sharpe ratio used three components such as expected return, risk free rate of return, and the standard deviation to compare the portfolios with each other (Sharpe, 1963).  

Paper-2: The Capital Asset Pricing Model by Perold, A.F., (2004)

The portfolio selection article of Harry Markowitz published in the year 1952 provided a solid foundation to the risk and return analysis. However, the analysis of risk in the Markowitz model was not thorough but still it was enough to provide a strong base for further research. Taking the base from the work of Harry Markowitz, William F. Sharpe evolved the model of capital asset pricing in the early 1960s. The capital asset pricing model (CAPM) is considered to be the revolutionary development in the field of finance. This model introduced to the world for first time as to how the risk affects the future expected returns (Perold, 2004). The CAPM model was based on three crucial factors such as risk free return, market return, and the beta. The beta was taken as the primary and relevant risk indicator in framing the CAPM model. This is because the developers of CAPM model believed that only the risk linked to the market is unavoidable and hence this risk can only affect the returns on the stocks (Perold, 2004).

The CAPM model provides for computation of the expected return while incorporating the risk in the form of beta (Levy, 2011). The expected return computed in the CAPM model can be used not only in analyzing the stocks, but also in evaluating the capital investment projects. The CAPM return works as the discount rate in computing the present value of cash inflows and outflows (Perold, 2004). Thus, with the help of CAPM, the analyst can evaluate the project’s net presented value. Further, the CAPM return is also used as an alternative to the cost of equity. Prior to the development of the CAPM model, the cost of equity was used to be computed by applying the dividend growth model. The dividend growth model takes an assumption that the company will grow at the defined growth rate for ever. This assumption being taken in the dividend growth rate model makes it a little inflexible for use in computing the cost of equity. The CAPM model is used as an alternative to the dividend growth rate model in computing the cost of equity (Perold, 2004).

The modern portfolio theory provided that the diversification can help achieve the risk reduction. However, this reduction in risk is achievable in respect of company specific risk only because the market specific risk can not be diluted. Thus, in order to address the market specific risk, the CAPM model was invented. The market specific risk which is measured by the beta was incorporated in the CAPM model to address the concerns of the investors (Sharifzadeh, 2010). Therefore, it could be inferred that CAPM is also an improvement over the modern portfolio theory in terms of risk analysis. Further, the modern portfolio theory assumed that all the assets are risky. However, the CAPM model segregated the assets into risk free and risky assets. The CAPM model combined the impact of risky and the risk free assets to arrive at the conclusion (Perold, 2004).

As per Perold (2004), the capital assets pricing model suits the most in analyzing the asset’s prices and the behavior of the investors. The CAPM model is highly useful in evaluating the worth of the stock and comparing the same with real world prices. The investors need comparison of the worth of the stock with the prices prevailing in the market to find out that whether the stock is overvalued or undervalued. Further, the decision to invest is based on this assessment that whether the stock is undervalued or overvalued. In case the stock is undervalued, the investor would want to invest in the stock in the hope earn high profits in future when the prices of the stock pick up. On the other hand, in case the stock is undervalued, the investor would not want to put his money on stake by purchasing the stock (Perold, 2004).

Paper-3: Post-Modern Portfolio Theory Supports Diversification in an Investment Portfolio to Measure Investment’s Performance by Rasiah, D. (2012)  

This article written by Rasiah (2012) brings a new theory called post modern portfolio theory. The article took its base from the modern portfolio theory originally developed by Harry Markowitz in the year 1952. The modern portfolio theory of Harry Markowitz provided the process of selection of portfolios. As per this theory, the selection of portfolios should be made in such a manner that the expected return is achieved at the given level of risk. Thus, the theory taught as to how to optimize the risk and return when considering investing in portfolios. In other terms, the theory of modern portfolio brought in the concept of risk diversification and risk reduction (Rasiah, 2012).

The current article furthered the research of Harry Markowitz’s modern portfolio theory by exploring more measures to diversify and reduce the risk. The post-modern portfolio theory which has been developed in the current article focuses on finding out the other measures to further diversify the risk (Rasiah, 2012). As per the post modern theory the evaluation of portfolio’s performance can be made by looking at the level of its diversification. The post modern portfolio theory aims at achieving more diversification using multiple risk factors such as beta and alpha. Here, it could be observed that post modern portfolio theory used beta as the measure of risk which was also used in the modern portfolio theory of Harry Markowitz (Rasiah, 2012).

Further, the post modern portfolio theory expanded the scope of risk analysis when analyzing the stocks and portfolios. The theory states that volatility is one the measures to evaluate the risk, but it could not be taken as the foolproof measure (Rasiah, 2012). The modern portfolio theory based its analysis in regards to risk on the volatility being measured by standard deviation. However, the empirical work of author in the current article found out currency risk as one of the crucial components of the risk of portfolio. The post modern portfolio theory brought in the concepts of downside risk, excess return, and Sortina ratio (excess return/ downside risk). The concept of Sortina ratio is same as that of Sharpe ratio. Both measures the excess return per unit of risk, but the components of risk are different in both. Sortina ratio uses the downside risk while the Sharpe ratio uses the standard deviation (Rasiah, 2012).

Therefore, there were two most crucial improvement points being added by the post modern portfolio theory over the modern portfolio theory. These two points were the consideration of downside risk and asymmetric return distribution (Rasiah, 2012). Further, the broad coverage over risk and the flexibility in analysis which were missing in the modern portfolio theory were provided by the post modern portfolio theory. The concept of downside risk being used in the post modern portfolio theory can be considered to be an alternative to the mean variance being used in the modern portfolio theory of Harry Markowitz. The post modern portfolio theory is an improved version, but it got the basic conceptual background from the modern portfolio theory (Rasiah, 2012).

Paper-4: A Simplified Perspective of the Markowitz Portfolio Theory by Mangram, M.E. (2013)

Harry Markowitz developed a theory in the year 1952 that provided for risk and return optimization and selection of the portfolios. Further, based in this theory, Harry Markowitz developed a model which paves the way to segregate the portfolios between efficient and inefficient. Further, this article provided a solid basis to study the behavior of the stock market and analyze the risk in more detail. In the mid nineties the work of Harry Markowitz was appreciated greatly due his enormous contribution to the field of economics and corporate finance (Mangram, 2013).

The modern portfolio theory of Harry Markowitz addressed various aspects of investment such as creation of portfolio, risk and return analysis, correlation between the securities, and achieving diversification (Mangram, 2013). The diversification of investment is considered necessary to reduce the risk and optimizing the risk with the return of portfolio. In order to achieve diversification in the investment portfolio and reduce the risk, it was necessary to identify the relationship between the returns of different securities. The modern portfolio of Harry Markowitz ensured this aspect through calculation and analysis of correlation between the returns of the securities. The correlation is the statistical measure which helps in analyzing the relation between the returns of two securities. Further, the understanding of relationship between the returns of two securities is crucial to achieve perfect diversification and reduce the risk to optimal level (Mangram, 2013).

Further, the theory of Harry Markowitz also provided for use of standard deviation in analyzing the risk of securities. Harry Markowitz analyzed the volatility of returns using standard deviation as the primary measure (Markowitz, 2009). The standard deviation is another statistical measure which measures the degree of deviation of return from the mean value. The use of standard deviation was first made by Harry Markowitz in measuring the risk of securities and then it was later on used by other economists in their models such as Fama and French and Sharpe. Therefore, the modern theory of Harry Markowitz formed a solid basis for risk analysis and provided a direction to the other economists in their empirical works in the finance domain (Markowitz, 2009).   

The popularity of Harry Markowitz theory still persists and it is still considered of immense use in the field of finance. The modern portfolio theory has provided the basis for the analysts to further the research work in the field of finance (Mangram, 2013). However, despite its commendable contribution to the field of finance, there are certain limitations of this theory. The modern portfolio theory of Harry Markowitz assumes that all the investors are rationale and they look for maximizing the returns while minimizing the risk. However, it does not happen in every case because some investors look to earn speculative gains and for that they are willing to take higher risk as well. Further, the modern portfolio theory assumes that market is perfect and all the information is available to the investors. This is also rare to happen because market imperfections are always there. Further, the most crucial thing is that modern portfolio theory assumes that there exist risk free assets to invest. However, practically there is no investment as risk free (Mangram, 2013).    

Conclusion

In this paper, the grandfather article which is based on the Harry Markowitz modern portfolio theory has been discussed with its contribution to the academic field in the finance domain. The Harry Markowitz modern portfolio theory was based on the selection of efficient portfolios by segregating the portfolios between efficient and inefficient. Further, this theory provided new dimensions to the risk and return analysis. The work of Harry Markowitz on portfolio selection provided basic principles to the further developments in the finance such as Sharpe model, Fama and French Model, and CAPM model. The assessment of risk based on the mean variance was introduced first time by Harry Markowitz in his theory of portfolio selection. Further developments in the direction of risk assessment brought in the concepts of beta, alpha, and random error to measure the risk. Later on the CAPM model was developed which interlinked the risk with the return. The CAPM model provided as to how the risk can be incorporated in the return. The CAPM model also resolved the problems in determining the discounting rate while analyzing the financial viability of the projects. Further, Mangram wrote an article in 2013 providing simplified approach to understand the work of Harry Markowitz. In this article, the author expanded on the discussing the limitations of the portfolio theory of Harry Markowitz. Further, the author also discussed about risk diversification in more detail and in the simplified manner. The author described that in order to achieve perfect diversification in the risk, it is crucial to understand the correlation between the returns of securities comprised within a portfolio. The analysis of correlation provides understanding of the relationship between the returns of two securities. It should be remembered that perfect diversification in risk is achieved when the return of two securities runs in opposite direction on happening of undesirable event. In order to maintain balance between the returns and risk and achieving stability, it is important to diversify the risk adequately.          

References

Francis, J.C. and Kim, D. 2013. Modern Portfolio Theory: Foundations, Analysis, and New Developments. John Wiley & Sons.

Levy, H. 2011. The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioral Perspectives. Cambridge University Press.

Mangram, M.E. 2013. A simplified perspective of the Markowitz portfolio theory.Global Journal of Business Research, 7(1), pp. 59-69.

Markowitz, H. 1952. Portfolio selection.The journal of finance, 7(1), pp.77-91.

Nobelprize.org. 1990.The SverigesRiksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990.[Online]. Available at: http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1990/press.html [Accessed on: 23 February 2017].

Oniyilo, T. 2016. How Stock Investors Can Evaluate Portfolio Performance. Lulu.com.

Perold, A.F. 2004.The Capital Assets Pricing Model.Journal of Economic Perspectives, 18(3), pp. 3-24.

Rasiah, D. 2012. Post-modern portfolio theory supports diversification in an investment portfolio to measure investment’s performance. Journal of Finance and Investment Analysis, 1(1), pp. 69-91.

Schneider, C. 2009. How Useful is the Information Ratio to Evaluate the Performance of Portfolio Managers? diplom.de.

Sharifzadeh, M. 2010. An Empirical and Theoretical Analysis of Capital Asset Pricing Model. Universal-Publishers.

Sharpe, W.F. 1963. A Simplified Model for Portfolio Analysis.Institute for operations research and the management science 9(2), pp. 227-293.   

Weyel, P. 2011. Harry M. Markowitz - Portfolio Theory and the Financial Crisis. GRIN Verlag.

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