Portfolio Management & Asset Pricing
A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, cash and so on depending on the investor's income, budget and convenient time frame.
The two types of Portfolio are mentioned below:
1. Market Portfolio
2. Zero Investment Portfolio
The art of picking out the correct investment policy for an entity in terms of maximum return and minimum risk is known as portfolio management.
Portfolio management refers to managing an individual's investments in the form of bonds, cash, mutual funds, shares etc so that brings in the maximum profits within the specified time frame.
Portfolio management refers to bringing off money of an individual under the expert guidance of portfolio managers. In general, the art of managing an individual's investment is referred as portfolio management.
Demand for Portfolio Management
ñ Portfolio management presents the best investment plan to the individuals as per their budget, age, ability to undertake risks, income.
ñ Portfolio management minimizes the risks engaged in investing and also raises the chance of making profits.
ñ Portfolio managers understand the financial requirements of client and propose the most beneficial and unique investment policy with minimum risks engaged.
ñ Portfolio management enables the portfolio managers to render customized investment solutions to clients as per their requirements and requirements.
Types of Portfolio Management
Portfolio Management is further classified in the following types:
r Active Portfolio Management: In an active portfolio management service, the portfolio managers are actively engaged in purchasing and selling of securities to ensure maximum profits to individuals.
r Passive Portfolio Management: In a passive portfolio management, the portfolio manager conducts with a fixed portfolio designed to match the current market scenario.
r Discretionary Portfolio management services: In Discretionary portfolio management services, an person empowers a portfolio manager to take care of his financial necessitates on his behalf. The individual issues money to the portfolio manager who in turn takes care of all his investment requirements, documentation, filing , paper work and so on. In discretionary portfolio management, the portfolio manager has entire rights to take decisions on his behalf of his client.
r Non-Discretionary Portfolio management services: In non discretionary portfolio management services, the portfolio manager can merely advise the client of what is good and bad for him but the client sets aside full right to take his own decisions.
Portfolio Management Models
In Portfolio Management, the Capital Asset Pricing Model (CAPM) is an economic model for evaluating stocks, securities, derivatives and/or assets by relating risk and anticipated return. Capital Asset Pricing Model is established on the idea that investors demand additional anticipated return if they are asked to accept additional risk.
The Capital Asset Pricing Model model says that the anticipated return that the investors will demand, is equal to the risk free security rate in summation to a risk premium. If the anticipated return is not equal to or higher than the required return, the investors will deny to invest and the investment should not be undertaken.
Capital Asset Pricing Model decomposes a portfolio's risk into systematic risk and specific risk. Systematic risk is the risk of accommodating the market portfolio. When the market makes a motion, each individual asset is more/ less affected. To the degree that any asset takes part in general market moves, that asset means systematic risk. Specific risk is the risk which is unequaled for an individual asset. It represents the constituent of an asset's return which is not correlated with general market moves.
As per CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is since specific risk can be diversified away. When an investor adjudges the market portfolio, each individual asset in that portfolio means specific risk. But by means of diversification, the investor's net exposure is just the systematic risk of the market portfolio.
The Capital Asset Pricing Model formula is:
anticipated Security Return = Risk less Return + Beta x (anticipated Market Risk Premium)
or:
r = Rf + Beta x (RM - Rf)
This can be written as
r-Rf = Beta x (RM - Rf)
where:
- r is the anticipated return rate on a security;
- Rf is the rate of a "risk-free" investment, i.e. cash;
- RM is the return rate of the suitable asset class.
Beta is the overall risk in investing in a prominent market, such as the New York Stock Exchange. Beta, by outline equals 1,00000 exactly.
Each firm also has its Beta. The Beta of a firm is that risk of the firm compared to the Beta of the overall market. If a firm has a Beta of 4.0, then it is said to be 4 times more risky than the overall market. Beta demonstrates the volatility of the security, relative to the asset class.
Presumptions of the Capital Asset Pricing Model
The Capital Asset Pricing Model is a ceteris paribus model. It is valid within a particular set of assumptions. These are:
Investors are risk antipathetic individuals who make as large as possible the anticipated utility of their end of period wealth.
Investors have homogenous anticipations about asset returns.
Asset returns are allotted by the normal distribution.
There subsists a risk free asset and investors may take over or lend unlimited amounts of this asset at a constant rate, the risk free rate.
There is a distinct number of assets and their quantities are settled on within the one period world.
All assets are perfectly priced and divisible in a perfectly competitive marked.
Asset markets are lacking all friction and information is complimentary and at the same time available to all investors.
There are no market imperfections such as regulations restrictions on short selling or taxes.
By and large, all of the presumptions mentioned above are neither valid nor fulfilled. However, Capital Asset Pricing Model anyway continues to be one of the most employed investments models to ascertain risk and return.
Arbitrage Pricing Theory
Stephen Ross suggested the Arbitrage Pricing Theory in 1976. Arbitrage Pricing Theory spotlights the relationship among an asset and several similar market risk components. As per Arbitrage Pricing Theory, the value of an asset is dependent on macro and company specific components.
Modern Portfolio Theory
Modern Portfolio Theory was brought in by Harry Markowitz. As per Modern Portfolio Theory, while scheming a portfolio, the ratio of each asset must be selected and combined carefully in a portfolio for maximum returns and minimum risks.
In Modern Portfolio Theory emphasis is not laid on a single asset in a portfolio, but how each asset changes in relative to the other asset in the portfolio with acknowledgment to fluctuations in the price. Modern Portfolio theory proposes that a portfolio manager must carefully select versatile assets while scheming a portfolio for maximum guaranteed returns in the future.
Value at Risk Model
Value at Risk Model was suggested to compute the risk engaged in financial market. Financial markets are portrayed by risks and uncertainty over the returns brought in in future on various investment products. Market conditions can waver anytime giving rise to primary crisis. The possible risk engaged and the possible loss in value of a portfolio over a certain period of time is outlined as value at risk model.
Value at Risk model is used by financial experts to estimate the risk engaged in any financial portfolio over a provided period of time.
Jensen's Performance Index
Jensen's Performance Index was suggested by Michael Jensen in 1968. Jensen's Performance Index is used to compute the abnormal return of any financial asset such as shares,bonds, securities as compared to its anticipated return in any portfolio. It is also referred to as Jensen's alpha. Investors opt portfolio with abnormal returns or positive alpha.
Jensen's alpha = Portfolio Return - [Risk Free Rate + Portfolio Beta * (Market Return - Risk Free Rate).
Treynor Index
Treynor Index model named after Jack. L Treynor is used to compute the excess return brought in which could otherwise have been brought in in a portfolio with minimum or no risk components engaged.
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