Mpt lec 1


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modern portfolio theory, iqra university islamabad,pakistan

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Mpt lec 1

  1. 1. Modern Portfolio Theory MS Lecture # 1: Introduction Lecturer: Muhammad Usman
  2. 2. Today’s Lecture  Introduction: teaching staff and the module  What is “Modern Portfolio Theory” ?  Risk  Capital Markets  Market Efficiency  Quiz
  3. 3. Teaching  Muhammad Usman Zafar (me!)  Room: 5:00)  (If you can't make these times email me and we can try to arrange an alternative)  (feel free to email me, I am here to help!)  Module Outline Office hours: Tuesday(4:00-
  4. 4. Study material  8th Edition 6th Edition Edwin J. Elton et al John C. Hull
  5. 5. What you can expect from us…     Students have a wide range of academic and vocational experience Necessarily this means we need to start from the beginning (a degree in Finance & Economics is not a prerequisite for this module!) We are here to help you to learn something about finance, but also to help you pass the module and ultimately your Master’s degree If you have a problem or aren’t happy about something come and see me to talk about it, before it is too late...
  6. 6. And what is expected from you…      Attendance Just the lecture material is not enough The lectures provide a brief introduction to important concepts – the real work gets done on your own! You will need to spend significant time doing private study - this will involve a significant amount of reading This is a master’s program and the work you submit will be assessed as measured by this standard
  7. 7. What is Modern portfolio theory?  A hypothesis put forth by Harry Markowitz in his paper "Portfolio Selection," (published in 1952 by the Journal of Finance) 
  8. 8. What is Modern portfolio theory?  Risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk  risk is an inherent part of higher reward  Also called "portfolio theory" or "portfolio management theory"
  9. 9. Risk..  Common Risk  – Risk that is perfectly correlated   Independent Risk  –Risk that is uncorrelated   Risk that affects all securities •Risk that affects a particular security Diversification  –The averaging out of independent risks in a large portfolio
  10. 10. Firm-Specific Versus Systematic Risk  –Firm Specific News Good or bad news about an individual company  –Market-Wide News News that affects all stocks, such as news about the economy
  11. 11. Firm-Specific Versus Systematic Risk  Independent Risks  Due to firm-specific news       –Also known as: »Firm-Specific Risk »Idiosyncratic Risk »Unique Risk »Unsystematic Risk »Diversifiable Risk
  12. 12. Firm-Specific Versus Systematic Risk  Common Risks   Due to market-wide news –Also known as:  »Systematic Risk  »Un diversifiable Risk  »Market Risk
  13. 13. Firm-Specific Versus Systematic Risk  Firm-Specific Versus Systematic Risk  –When many stocks are combined in a large portfolio, the firm-specific risks for each stock will average out and be diversified.  –The systematic risk, however, will affect all firms and will not be diversified.
  14. 14. Example  Consider two types of firms:  Type S firms are affected only by systematic risk. There is a 50% chance the economy will be strong and type S stocks will earn a return of 40%; There is a 50% change the economy will be weak and their return will be –20%. Because all these firms face the same systematic risk, holding a large portfolio of type S firms will not diversify the risk.  
  15. 15. Example 2  Consider two types of firms:  Type I firms are affected only by firm-specific risks. Their returns are equally likely to be 35% or –25%, based on factors specific to each firm’s local market. Because these risks are firm specific, if we hold a portfolio of the stocks of many type I firms, the risk is diversified.  
  16. 16. Firm-Specific Versus Systematic Risk  Actual firms are affected by both market-wide risks and firm-specific risks.  When firms carry both types of risk, only the unsystematic risk will be diversified when many firm’s stocks are combined into a portfolio.  The volatility will therefore decline until only the systematic risk remains.
  17. 17. Firm-Specific Versus Systematic Risk
  18. 18. No Arbitrage and the Risk Premium  The risk premium for diversifiable risk is zero, so investors are not compensated for holding firmspecific risk.  –If the diversifiable risk of stocks were compensated with an additional risk premium, then investors could buy the stocks, earn the additional premium, and simultaneously diversify and eliminate the risk.
  19. 19. No Arbitrage and the Risk Premium  The risk premium of a security is determined by its systematic risk and does not depend on its diversifiable risk.  –This implies that a stock’s volatility, which is a measure of total risk (that is, systematic risk plus diversifiable risk), is not especially useful in determining the risk premium that investors will earn.
  20. 20. No Arbitrage and the Risk Premium    Standard deviation is not an appropriate measure of risk for an individual security. There should be no clear relationship between volatility and average returns for individual securities. Consequently, to estimate a security’s expected return, we need to find a measure of a security’s systematic risk.
  21. 21. Example
  22. 22. Example
  23. 23. Capital markets  Capital markets allow firms looking for investment to meet investors  Firms can use capital markets to raise equity finance (i.e. issue more shares) or debt finance (i.e. borrow)  Clearly it is in the interest of firms (and their shareholders) that these forms of finance are as cheap as possible
  24. 24. Key concepts: Capital markets  Capital markets are where government and corporate debt is traded, along with other types of corporate financing securities  Capital markets are primary markets – by which we mean a company can issue new shares or a government can sell bonds  Capital markets are secondary markets in that shares etc., that have already been issued, can be bought and sold
  25. 25. Capital markets  Probably the simplest example of capital markets for us to consider relate to the stock markets that feature in the daily news...  ...these „indices‟ reflect the prices that shares are trading in a secondary market  Key examples include the KSE 100, FTSE 100, the Dow Jones, the SSE
  26. 26. KSE 100: last 6 months
  27. 27. KSE 100:Top 10 Sectors
  28. 28. Capital markets    The KSE 100 index is an indication of how these 100 companies‟ share prices are moving (and therefore some indication of how the Pakistan economy is performing, business confidence, expectations about the future and so on...) Since these are big companies, these 100 companies reflect the total capitalization of around 80% of all Pakistan listed companies Since some companies are much larger than others the component companies are weighted by size
  29. 29. Capital markets  As a shareholder you can make a return in two ways:  A capital gain – the share increases in value A dividend payment – a share of profits that, as a shareholder, you are entitled   Dividend – a cash payment made to shareholders out of after-tax profits
  30. 30. Maximizing shareholder wealth  The dividend and capital gain from owning a share are both relevant to increasing the shareholders‟ wealth – they both form part of the return for holding the asset  Suppose you hold a share in a company that decides to stop paying a £0.10 dividend for each share you hold…  …your asset (the share) might be considered to be worth less to other people and we might expect the share price to decrease (more on dividend policy in a
  31. 31. Equity returns
  32. 32. Market efficiency       A perfect market has the following characteristics: No taxes or transaction costs to inhibit buying or selling Similar expectations amongst participants regarding asset prices, interest rates and other economic factors Free entry and exit to and from the market All information available freely to everyone Many buyers and sellers (perfect competition)
  33. 33. Market efficiency      Since no capital market can possibly meet these requirements it is enough for capital markets to offer fair prices & to be efficient in order to allow reasoned investment and financial decisions In practice an efficient capital market should satisfy: Operational efficiency: fast trading at low cost Pricing efficiency: prices should reflect all available information Allocation efficiency: efficient pricing leads to optimal allocation of investment funds
  34. 34. Market efficiency  Since operational and allocational efficiency are hard to test much focus has been on pricing efficiency  The big question is whether or not it is possible to make abnormal (or excess) returns  Of particular interest is whether professional investors can out perform a simple strategy of buying and holding a balanced portfolio
  35. 35. Different forms of market efficiency  Weak form efficiency is said to be when share prices reflect all historically available data. This would mean it is impossible to predict future changes in share prices from past data. There would be no profitable trends in the data.  Weak form efficiency is strongly supported by empirical evidence (although there is some evidence that emerging capital markets are not weak form efficient)
  36. 36. Different forms of market efficiency    Semi-strong form efficiency is said to be when share prices reflect all historically available data and all publicly available information and share prices react quickly and accurately to new information as it becomes available This would mean it is impossible to make abnormal profits using historical prices and currently available information Empirical studies broadly support the view that markets are semi-strong form efficient
  37. 37. Different forms of market efficiency  Strong form efficiency is said to be when share prices reflect all information, whether public or not.  This would mean it is impossible to make abnormal profits under any circumstances
  38. 38. Quiz  What does Modern Portfolio Theory Suggest?  What is the difference between common risk and independent risk?  Explain why the risk premium of diversifiable risk is zero.  Why is the risk premium of a security determined only by its systematic risk?