Finance

This article discusses modern portfolio theory and capital asset pricing model in finance. It explains how diversification of risks can be achieved by choosing the portfolio of assets having higher expected return and vice versa. The article also covers the fundamentals and assumptions of modern portfolio theories and how the relationship between the risk and return of portfolio of financial assets is explained using the capital assets pricing model.

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Finance
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Table of Contents
Answer to Question 1:................................................................................................................2
Requirement a:.......................................................................................................................2
Requirement b:.......................................................................................................................2
Requirement c:.......................................................................................................................3
Requirement d:.......................................................................................................................3
Requirement e:.......................................................................................................................4
Requirement f:........................................................................................................................4
Answer to Question 3:................................................................................................................5
Bibliography:..............................................................................................................................8

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Answer to Question 1:
Requirement a:
Requirement b:

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Requirement c:
Requirement d:

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Requirement e:
Requirement f:

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Answer to Question 3:
The application of modern portfolio theory helps in explaining the concept of
measures of interpretation of return and risks of investment. When it comes to perform the
analysis of finance and investment by individual investors and company as a whole, one of
the most influential theories is modern portfolio theory. The mathematical formulation of
diversification of risks in investing is explained in the modern portfolio theory. Objective of
portfolio theory is to select a portfolio with the maximum possible expected return with
minimum level of risks (Berk and Van 2016). Or it can also happen that investor’s tries to
minimize the risks associated with investment at its lowest level for certain level of expected
return. Therefore, the theory is viewed as the form of diversifying the risks associated with
the financial assets by finding the best diversification strategy using the theoretical concepts.
Since the model is based on standard deviation and expected returns of several portfolios of
assets, the analysis of several portfolio of given assets helps in making the most efficient
selection. In the event of investors have chosen assets that are not moving together, theory
assist them in reducing the level of risks (DeFusco et al. 2015).
Several fundamentals and assumptions form the basis on which the modern portfolio
theories have been constructed. No transaction costs are involved in selling and buying of
assets and the determination factors for buying securities is risk. There is infinite market
liquidity and investors can make investment of any size in the securities. Tax is not
considered by investors while making investment decisions and any form of capital gains and
dividends does not make investors differential towards investment. On risk measurement,
identical views are shared by investors. Buyers will be interested in buying the securities
because it will have a level of risks that will be corresponding to returns sought by him. On
the other hand, sellers will be interested in selling their security because there would be
another security having volatility level corresponds to desired returns. In order to choose the

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best portfolio from among the given set of portfolios, it is necessary to make two essential
decisions each having respective opportunities of return and risks. The first decision would be
to determine an efficient set of portfolio and the second decision would be to chose the best
portfolio out of the efficient set of given portfolio. Therefore, this particular theory is about
diversification of risks by choosing the portfolio of assets having higher expected return and
vice versa.
However, the relationship between the risk and return of portfolio of financial assets
is explained using the theory or model of capital assets pricing model. This particular model
introduce the risk free rate and investors are capable of leveraging their portfolio using
riskless rate by buying more shares and short selling risk free rate in the market. By making
investment in risk free rates, investors can also deleverage their investments. Diversification
of unsystematic risks is the main reason that is associated with the formation of portfolio of
financial assets. Nevertheless, due to presence of systematic risks, there cannot be complete
elimination of risk factor. Investors would find it easy to diversify the risks associated with
their portfolio of stocks is there is low coefficient between the portfolios of assets
(Zabarankin et al. 2014).
The proxy risk free rate that is assumed in the model is 2.66%. Beta value of case
company stood at 0.45% and the value of market risk premium is 6.5%. Value of beta of
hypothetical company is -0.25%. It can be seen that the expected return of case company is
5.59% while that of hypothetical company is 1.04%. Hence, a case company stock is
generating significantly higher return compared to hypothetical company. Variations in the
portfolio can be reduced as per the theory by choosing assets class having low or negative
covariance as costs can be reduced using such diversification measure.

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The value of beta depicts that security is not much volatile with respect to the market.
Negative beta value of hypothetical company depicts that investment in stocks of such
company would have movement that are in the opposite directions of the stock market.
Therefore, it can be concluded as per the capital asset pricing model that the movement of
value of portfolio is aligned with the market value. Beta value plays a considerable role in
aligning the investment with risk profiles. Risk averse investors for avoiding excessive
volatility and overweighing of portfolio, stocks with higher beta value is preferred by such
inventors. When the stocks are put together in a portfolio, it is essential to consider the value
of beta of each individual stocks (Dhrymes 2017). It is required to ensured by investors that
computation of beta value is done by identifying the past price fluctuations. However, the
security will move in the same direction cannot be ensured. For forecasting the portfolio
value expected return value, it is essential to consider the value of beta. The portfolio of
stocks of hypothetical company and case company comprise of equal proportion of shares.
Investors are able to diversify the risks associated with the investment as the value of beta
gets further reduced to -0.13 and 0.23 for hypothetical and case company. The value of
portfolio beta is further reduced to 0.10 and the total expected return of portfolio stood at
3.31%. Therefore, it can be seen that forming the portfolio of financial assets helps in
diversification of risks by reducing the value of beta and increasing the expected returns.
However, since there are both systematic and unsystematic risks, assets diversification will
help in reducing the systematic risks as against unsystematic risk that arises due to
unavoidable external factors.

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Bibliography:
Bloomberg.com. (2018). Australian Rates & Bonds. [online] Available at:
https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
Editorial, R. (2018). ${Instrument_CompanyName} ${Instrument_Ric} Quote| Reuters.com.
[online] U.S. Available at: https://www.reuters.com/finance/stocks/overview/JBH.AX