Capital Market Instruments and Characteristics of Securities Market

PORTFOLIO THEORY

QUESTION 1
A
i) Risk premium
Risk premium refers to investment return which the asset is expected to yield in the
excess of risk free return. Risk premium of the asset is form of the compensation for investors.
Risk premium represents payment to the investors to tolerate extra risk in the given investments
over the risk free asset. Investors are to be compensated for risk undertaken by them making the
investments. It comes in form of risk premium. Equity risk premium refers to premium which the
investors expects of making to take relatively high risk of buying the stocks.
It could be better understood as, high quality bonds of established corporations who are
earning large profits that typically face default risk (Platanakis and Urquhart, 2020). These bonds
therefore pay lower interest rate as compared with the bonds issued by companies that are less –
established with uncertain profitability and high default risk. These companies pay higher rate of
interest to the investors for higher degree of risk tolerance
Risk premium could be construes as the true earning reward as risky investments are
more profitable as they succeed. Paradigm shifting breakthrough are likely to come from the new
& risky initiatives. These type of investments offer potentially superior returns that business
owner uses for rewarding the investors.
Major sources of uncertainty
Certainty could be defined as lack of surety or certainty of event. In the accounting or
financial terms uncertainty means inability of telling in advance outcomes or consequences as
due to lack of bases or knowledge on which predictions are to be made. It is widely used in the
financial accounting as there are number of events which are beyond the control of company and
could greatly affect the transactions. It is harder to make the financial decisions at times of
uncertainty (Heaton, Polson, and Witte, 2016). There are several sources of uncertainty that
might affect the returns and risks.
The major sources of uncertainty are like political changes that leads organisations to
change different operations of the business. Economic uncertainty which have significant impact
over the returns like increase in inflation rate or change in interest rates, lowering economy.
Sudden change in the social factors impacting the organisation could lead the business to suffer

various issues impacting profitability. Environment factors such as the current pandemic which
was totally uncertainty but impacted the investment decisions of all the investors around the
world. There are several sources of uncertainty out of which some may be controlled where some
are beyond the control.
B
Expected Returns
x Probability P(x)
-0.10 0.3 -0.03
0.00 0.1 0
0.10 0.3 0.03
0.25 0.3 0.075
E(R) 7.50%
Reference
Platanakis, E. and Urquhart, A., 2020. Should investors include bitcoin in their portfolios? A
portfolio theory approach. The British Accounting Review. 52(4). p.100837.
Heaton, J.B., Polson, N.G. and Witte, J.H., 2016. Deep portfolio theory. arXiv preprint
arXiv:1605.07230.
QUESTION 2
A
“The asset allocation decision is not an isolated choice; rather, it is a component of a portfolio
management process.”
Asset allocation refers to process of dividing the investment across several categories of
the assets. Bonds, stocks and cash alternatives are common components of asset allocation
strategy (Jiang and Liang, 2017). The portfolio management process is a process through which
company or person tries to manage all the asset included in portfolio of company. There is a
process or a series of steps which are to be followed in effectively manage the portfolio which
are as follows-
Planning- this is the most important and crucial stage in the process of portfolio
management process. Under the planning stage all the planning part is done which starts with
identification of objectives. The is the most essential stage as under this the objective of study is

being identified whether investment need to be done for long- term or short- term purpose
(Portfolio management process, 2020). Further, after knowing the objective, investment policy
statement is being prepared which includes the draft of list of investment matching the
objectives. Further the capital market expectations are also analysed that is the investment option
in which company is planning to invest is likely to grow or not and what are their growth
potential (Im, Nam and Cho, 2020). Further, under planning comes asset allocation strategy
which is very important for managing portfolio. Under this there are two ways that is strategic
asset allocation and tactical asset allocation. Under the strategic allocation investment policy
statement and capital market expectations are merged and analysed. Whereas in tactical all short
term change in the strategy of portfolio with respect to changes in market expectation are
analysed.
Execution- this is the next stage in portfolio management process wherein a portfolio is
created or selected on basis of objectives identified in planning stage. Under portfolio selection
expectation of capital market is combined with investment allocation strategy in order to choose
specific asset for investor's portfolio. The next stage in execution is implementation of portfolio
wherein the portfolio selected finally is implemented.
Feedback- this is the last stage of the portfolio management process under which
continuous monitoring of the portfolio is done. This monitoring is essential as this will assist in
continuous review that whether the working of asset in portfolio is going in same manner or not.
Hence, after the monitoring the performance of investment is evaluated and necessary action are
taken.
B
“The performance of portfolio should be compared to guidelines specified in policy
statement, not on portfolio’s overall return.” this statement is not much correct because of the
reason that policy statement includes the guidelines relating to investment but it is not necessary
that what is specified in policy is currently working in the same manner in capital market. Hence,
because of this reason it is necessary that company assess the value of portfolio on the basis of
overall return of portfolio and not on basis of guidelines specified in policy statement. There are
many different ways or standards against which company can calculate the performance of
portfolio. These are listed as follows-