Portfolio Theory MBA-Finance & Banking Assignment Solution
Assignment Detail:-
Number of Words: 3500
Answer any six (6) of the following questions. Each question carries 15 Marks.
Question 1
A. “An investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for the time the funds are committed, the expected rate of inflation, and the uncertainty of the future payments.”- Discuss
Risk Premium
The major sources of uncertainty.
B. You are considering acquiring shares of common stock in the Madison Corporation. Your rate of return expectations is as follows:
Compute the expected return [E(Ri)] on your investment in Madison.
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Question 2
A.“The asset allocation decision is not an isolated choice; rather, it is a component of a portfolio management process.” Discourse the process.
B. “The portfolio’s performance should be compared to guidelines specified in the policy statement, not on the portfolio’s overall return.” – Elucidate the standards for evaluating portfolio performance.
Question 3
A.“Capital market instruments are fixed-income obligations that trade in the secondary market, which means you can buy and sell them to other individuals or institutions.” – Expound the types of securities.
Question 4
A. “It is necessary to understand the different securities markets around the world and the changes that are occurring” – Expound
Market and Characteristics of a Good Market
Primary Capital Market and
Secondary Financial Market.
Question 5
“There is an intuitive notion that most individual stocks or bonds move with the aggregate market. Therefore, if the overall market rose, an individual’s portfolio probably also increased in value. To supply investors with a composite report on market performance, some financial publications or investment firms have developed stock market and bond market indexes.” Give an account of
Uses of security market indexes
Efficient capital market
Assumptions of capital market
Question 6
“In general, an industry’s prospects within the global business environment will determine how well or poorly an individual firm will fare, so industry analysis should precede company analysis. Few companies perform well in a poor industry, so even the best company in a poor industry is a bad prospect for investment.”
Elucidate:
Industry analysis
The business cycle and industry sectors
Question 7
“Firm Competitive Strategies” continues the Porter discussion of an industry’s competitive environment. The basic SWOT analysis, is intended to articulate a firm’s strengths, weaknesses, opportunities, and threats. These two analyses should provide a complete understanding of a firm’s overall strategic approach. Expound.
Answer 1:
A. An investment refers to the current allocation of funds for a period of time with the objective of obtaining future payments that will reimburse the investor for the time their funds were committed, the expected rate of inflation, and the uncertainty of the future payments. In essence, investment is an act of committing money to an asset with the hope of receiving returns in the future. The returns can be in the form of income, capital appreciation, or both.
Investing inherently involves risk, and the investor’s primary concern is to balance risk and reward. In finance, this concept is referred to as risk-return trade-off. Risk refers to the possibility of losing some or all of the invested capital, while return refers to the gain or profit that the investor receives from the investment. The higher the risk of an investment, the higher the expected return. Conversely, the lower the risk, the lower the expected return.
Risk Premium:
The risk premium is the excess return over the risk-free rate that investors demand as compensation for taking on additional risk. It is the amount of extra return that investors demand for holding a risky asset over and above the return on a risk-free asset. The risk premium varies depending on the level of risk involved, the type of asset, and the economic conditions.
The major sources of uncertainty:
Investments are uncertain because of various factors, such as economic conditions, market conditions, political instability, and unforeseen events. These factors create uncertainty and volatility in the investment market, making it difficult to predict the future performance of an investment. The major sources of uncertainty in investing are:
Market risk: The risk of an investment losing value due to market conditions or economic factors.
Interest rate risk: The risk of an investment losing value due to changes in interest rates.
Inflation risk: The risk of an investment losing value due to the effects of inflation.
Business risk: The risk of an investment losing value due to the operations or performance of the underlying company.
Credit risk: The risk of an investment losing value due to the default of the issuer.
B. Calculation of expected return on Madison Corporation stock:
Assuming the probability of the stock prices to increase by 20% is 0.3, and the probability of prices to decrease by 10% is 0.7.
Expected return = (0.3 x 20%) + (0.7 x -10%) = 6% – 7% = -1%
Therefore, the expected return on investment in Madison Corporation stock is -1%.
Answer 2:
A. The asset allocation decision is a crucial component of the portfolio management process. It refers to the process of dividing an investment portfolio among different asset classes, such as stocks, bonds, and cash, with the aim of achieving a particular investment objective. The process of asset allocation involves considering the investor’s risk tolerance, investment goals, and time horizon.
The portfolio management process includes several steps, as follows:
Defining investment objectives: This involves determining the investor’s financial goals, risk tolerance, and time horizon for achieving those goals.
Asset allocation: This involves dividing the portfolio into different asset classes based on the investor’s objectives, risk tolerance, and time horizon.
Security selection: This involves selecting securities within each asset class to achieve the desired portfolio balance.
Portfolio monitoring: This involves regularly monitoring the portfolio’s performance to ensure that it continues to meet the investor’s objectives.
Rebalancing: This involves adjusting the portfolio periodically to maintain the desired asset allocation mix.
B. The portfolio’s performance should be compared to the guidelines specified in the policy statement rather than the portfolio’s overall return. The policy statement is a document that outlines the investor’s objectives, risk tolerance, and investment
