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The Portfolio Theory Essay Example

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The Portfolio Theory

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The Portfolio Theory. The portfolio expected return is E(r portfolio) = 4 %. Using the predicted value of return of Average stock for each economic state and probability, we can calculate the risk of the portfolio. In this case, it is 3.89 %. This value is lower than individual risk values for Auto stock and Gold stock.Cost of capital is the rate of return of the given investment of a company. The portfolio theory uses to evaluate the cost of capital. This model considers the risk of return and historical return of stock market. The formula for the evaluation of rate of return is Expected rate of return on a security = Rate of risk free investment + (Volatility of a security, relative to the asset class) x (market premium), or ri = rf + ß

(rm-rf).Investment is associated with risk and return, which are quantified, and interdependent; less risk less return, and more risk more return. We can graphically display this dependency on risk – return plane using CAPM model. In this model, risk is expressed through a parameter ß, and return through another parameter E (Ri). Algebraic expression of the model is E (Ri) = Rf The straight line represented by the equation E (Ri) = Rf + [E (Rm) – Rf] x ß is called security market line or SML. This straight line illustrates the market risk versus return of the entire market at a certain time (Shapiro). Conceptually the SML equation demonstrates the relationship between expected return and covariance of an asset i. For CAPM equilibrium condition, any asset should appear on the SML. The parameter ß of the equation of i asset is expressed as ßi = σiM/ σ2M = Cov (ri, rM)/ σ2M. It should be noted that σ indicates risk, and σ2 variance in the portfolio theory. Coefficient ß measures systematic risk of the portfolio. The index M in the formula is the efficient market portfolio, whereas the index i indicates a single stock. Thus, the ß expresses relation of covariance of return of a single stock and market portfolio to the variance of the market portfolio. The Portfolio Theory.

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References

INVESTOPEDIA. Market Portfolio. Retrieved from http://www.investopedia.com/terms/m/market-portfolio.asp

Sepand Jazzi. (n.d.). Stock and Portfolio Variance and Standard Deviation [Video]. Retrieved from http://www.youtube.com/watch?v=q69sfKgsxEc

Shapiro, A. (n.d.). Foundations of Finance: The Capital Asset Pricing Model (CAPM). NYUSTERN. Retrieved from http://pages.stern.nyu.edu/~ashapiro/courses/B01.231103/FFL09.pdf

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