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HBF 2404: Contemporary Issues in Financial Management Notes

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Summary

HBF 2404: Contemporary Issues in Financial Management Notes

LESSON 1
Modern portfolio theory
Chapter objectives:
By the end of this chapter, the learners should;
1. Analyze and explain theories of modern portfolio
2. Analytically evaluate emerging issues in financial management
1.1. 1.1 Introduction
Welcome to the first lecture in contemporary issues in financial management. We
shall start our lesson by introducing several concepts related to contemporary issues
in financial management.
1.2. Modern portfolio theory
Modern portfolio theory (MPT) is a theory of finance that attempts to maximize
portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions
of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory, in recent
years the basic assumptions of MPT have been widely challenged by fields such as
behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets
that has collectively lower risk than any individual asset.
This is possible, intuitively speaking, because different types of assets often change
in value in opposite ways. For example, to the extent prices in the stock market
move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification
lowers risk even if assets’ returns are not negatively correlated—indeed, even if they
are positively correlated. More technically, MPT models an asset’s return as a normally distributed function (or more generally as an elliptically distributed random
variable), defines risk as the standard deviation of return, and models a portfolio as
a weighted combination of assets, so that the return of a portfolio is the weighted
combination of the assets’ returns
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