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Modern Portfolio Theory/ Arbitrage Pricing Theory

March 24, 2016 | Author: | Posted in finance, mathematics and economics

Modern Portfolio Theory and Arbitrage Pricing Theory

Introduction

Harry Markowitz pioneered the Modern Portfolio theory . For the first time in history he gave to the investors a formula through which they could invest in assets and maximize their profits at lower risk . The most significant and path breaking proposal that he gave was that of diversification of the portfolio to increase profits and minimize risks Later Sharpe , Lintner and Mossin developed this theory . In recent times it has been shown that the modern portfolio theory contains quite a few weaknesses and [banner_entry_middle]

thus cannot be completely relied upon to make investment decisions . Ross developed a related theory , called the Arbitrage Pricing Theory , to counter these weaknesses and to provide a better indicator of investment in assets . We compare the two theories in this , and analyze how the arbitrage pricing theory is better than the modern portfolio theory

Modern Portfolio Theory

The core idea of modern portfolio theory is the use of diversification of portfolio to reduce risk and maximize returns to the investors . Harry Markowitz , who proposed this theory in his , Portfolio Selection (1956 , believed that diversification of a portfolio into assets , which are not perfectly correlated , reduces the risk in the portfolio of an investor . Before the proposal of this theory by Markowitz , diversification was considered a cardinal sin by investors It was thought to increase the risk of investing in stocks . But Markowitz dispelled these notions by showing mathematically how it is possible to reduce overall risk of a portfolio by diversifying into assets , which are not perfectly correlated

The main premise of this theory is that the correlation coefficient between the assets in the portfolio should never be equal to 1 . This offsets the drop in some assets with a rise in others , reducing risk at same returns or alternately , maximizing returns at the same risk

The concepts introduced by Markowitz in his theory are diversification beta coefficient , efficient frontier , the capital asset pricing model capital allocation line , the capital market line , and the securities market line

The Modern Portfolio Theory model links the risk and returns of a portfolio of securities and proposes that investors choose to select an asset in terms of its risk relative to the market ‘ rather than its individual risk reward characteristics . A portfolio of securities or assets is chosen with the aim to diversify and reduce the overall risk of the portfolio in comparison with the individual risks of the assets in the portfolio . Thus , the MPT proposes the following ( Modern Portfolio Theory , Wikipedia

1 .Portfolio return is the mean of the component-weighted returns of all the assets in the portfolio . Return has a linear relation with the component weightings

2 . Secondly , the risk in a portfolio is a function of how the component assets in the portfolio are correlated . This function between the risk and component weights of the assets is non-linear in relation to each other ?Wi E (Ri

Where E (Rp Expected Portfolio Returns

E (Ri Expected… [banner_entry_footer]

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