Corporate Finance Essay
Question A: For two asset portfolio, demonstrate that portfolio risk can be reduced to zero with perfect negative correlation.
According to the Modern Portfolio Theory (MPT) which is also called “portfolio theory” or portfolio management theory”, which also became a sophisticated approach in investment and is used as a tool to provide advise to the investors. The portfolio risk can be explained through the idea that investors should not only hold a portfolio of investments, but with the relationship or correlation of different investments should also be considered when building a portfolio (CTA, 2004). The value of diversification underlies in the simple explanation – as the number of stocks in the portfolio increases, there will be a reduction in the risk associated with the stocks, and the overall risk of the portfolio should more closely match the systematic risk of the market (Rzepczynski, 2003).
The modern portfolio theory was utilized by the investors in enhancing the performance and risk reduction benefits of diversification in non-correlated investments. Most of the investors recognized the risk reduction benefits of managed the future as if in the form of investments - the higher the ratio or the return on investment, the lower the risk. In addition, the diversification reduces volatility more efficiently. Many investors diversified their portfolios in different investments such as individual stocks, mutual funds, bonds, and international stocks. According to the portfolio theory, the proper diversification is in different asset classes that move independently from one another (CTA, 2004; USF, 2007).
For two assets portfolio which is likely traded in the stock exchange, wherein one is identified as domestically investing while the other is engaged in internationally investment. The portfolios of both international and domestic stocks reduce average portfolio risk as much as 30% more than the domestic portfolios alone. This is because the domestic portfolios provide little additional risk reduction. And diversifying internationally extends the boundaries of domestic equity mutual funds. International securities make a strong contribution to portfolio efficiency and the country allocations play a much larger role than investment style in the international fund performance (Alvares and Boldin, 2006). The idea of combining more investments that are not perfectly correlated to form a portfolio, the risk of the said portfolio can be reduced. Investors must recognize the relationship of the investment for the reason the theory states that if there is a small relationship among the various investment included in a portfolio, the greater of reduction of risk or diversification. The rate of return of an investment considers the fact that there are some total risks associated with the investment that can be diversified (USF, 2007).
Question B: Explain why this is not necessarily a particularly convincing explanation for portfolio effects and demonstrate how portfolio effects arise in a rather different way for correlations close to zero.
Having the opportunity of the investor to measure the efficiency of the portfolio diversification, then the investor or portfolio manager can identify the specific optimal portfolio. If the investors can have the capability to analyze the classical plug-in methods for the estimations of the optimal portfolio, then they can derive to the mean-variance theory. Moreover, the idea of the optimal portfolio is concern with the investing in the universe of the riskless asset, which is also in the form of combining the different investment that can be diversified and reduce the risk (CTA, 2004; Kan and Zhou, 2005; USF, 2007).
The lack of diversification among the investing leaders led them to the under-representation of managed futures. Investors with small holdings on investment are expected to lead diversified but if there are larger portfolios, the investment will have better superior skills at diversifying portfolio risk than smaller investors. In this fact, the international portfolio is more effective in reducing the risk than the domestic portfolio. The only diversification value comes from the number of stocks in the portfolio. Therefore, if there is greater diversification provided many equity and bond investments may serve as diversification enhancer.
Question C: Outline and discuss the reason why there is little or no portfolio effect with a strong positive correlation.
Within the portfolio, the movement of the positive correlations will be simple weighted averages. If the asset were less than perfect positive correlations, definitely there will be a lower with their corresponding weighted averages. The difference between the portfolio measure and the corresponding average is the degree of diversification. With the stocks having the strong positive correlation, the portfolio will be unstable. If it happens to stabilize the stocks, there would be a combination of stocks as being the counterproductive (Weinraub and Kuhlman, 1994).
References:
Alvares, B., & Boldin, R., 2006. Mutual Equity Fund Portfolios: Risk Reduction through Global Diversification. [Online] Available at: http://www.ekf.vsb.cz/shared/uploadedfiles/cul33/Robert.Boldin1.pdf [Accessed 07 June 2010].
CTA, 2004. Modern Portfolio Theory: Dynamic Diversification for Today’s Investor, Commodity Trading Advisors. [Online] Available at: http://www.cta.visionlp.com/pdf/gen/MPT_01062004_online.pdf [Accessed 07 June 2010].
Kan, R., & Zhou, G., 2005. Optimal Portfolio Choice with Parameter Uncertainty [Online] Available at: http://www.rotman.utoronto.ca/~kan/papers/erisk8.pdf [Accessed 07 June 2010].
Rzepczynski, M., (Pres. & CIO) 2003. Portfolio Diversification, Investors Just Don’t Seem to Have Enough. (John W. Henry & Company, Inc.) JWH Journal, Vol. 1, No. 1. [Online] Available at: http://www.jwh.com/Documents/JWHJournal_2003.pdf [Accessed 07 June 2010].
USF, 2007. Risk and Rates of Return, University of South Florida. [Online] Available at: http://www.coba.usf.edu/departments/finance/faculty/besley/notes/risk.pdf [Accessed 07 June 2010].
Weinraub, H.J., & Kuhlman, B.R., 1994. The Effect of Common Stock Beta Variability on the Variability of the Portfolio Beta, Journal of Financial and Strategic Decisions, Vol. 7, No. 2 [Online] Available at: http://www.studyfinance.com/jfsd/pdffiles/v7n2/weinraub.pdf [Accessed 07 June 2010].
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