Financial Theories and Strategies
Financial Theories and Strategies Paper
FIN 554
February 15, 2005
Introduction
Financial theories are the building blocks of today 's corporate world. "The basic building blocks of finance theory lay the foundation for many modern tools used in areas such asset pricing and investment. Many of these theoretical concepts such as general equilibrium analysis, information economics and theory of contracts are firmly rooted in classical Microeconomics" (Oaktree, 2005)
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.
Modern Portfolio Theory (MPT)
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.
Risk in this model is identified with the standard deviation of portfolio return. Rationality is modeled by supposing that an investor choosing between several portfolios with identical expected returns will prefer that portfolio which minimizes risk." (Wikipedia, 2005) Figure 1 and Figure 2 are examples on how this theory can be illustrated on a graph.
Using the Modern Portfolio Theory, overtime risk assets will provide a higher expected rate of return, as compensation to the investors for accepting a high risk. The high risk will eventually lower collecting asset classes to the
FIN 554
February 15, 2005
Introduction
Financial theories are the building blocks of today 's corporate world. "The basic building blocks of finance theory lay the foundation for many modern tools used in areas such asset pricing and investment. Many of these theoretical concepts such as general equilibrium analysis, information economics and theory of contracts are firmly rooted in classical Microeconomics" (Oaktree, 2005)
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.
Modern Portfolio Theory (MPT)
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.
Risk in this model is identified with the standard deviation of portfolio return. Rationality is modeled by supposing that an investor choosing between several portfolios with identical expected returns will prefer that portfolio which minimizes risk." (Wikipedia, 2005) Figure 1 and Figure 2 are examples on how this theory can be illustrated on a graph.
Using the Modern Portfolio Theory, overtime risk assets will provide a higher expected rate of return, as compensation to the investors for accepting a high risk. The high risk will eventually lower collecting asset classes to the
References: Dimensional (2005) History. Retrieved on February 15, 2005 from http://www.dfaus.com/philosophy/history/ Fact (2005). General Equilibrium. Retrieved on February 16, 2005, from http://www.fact-index.com/g/ge/general_equilibrium.html Malkiel, B Financial Review, 40(1), 1-9.Retrieved February 15, 2005, from EBSCOhost database Moneychimp (2002). Index Funds and Optimal Portfolios. Retrieved on February 15, 2005 from http://www.moneychimp.com/articles/risk/index_investing.htm Oaktree (2005). Finance Theories. Oaktree Research. Retrieved on February 16, 2005, from http://www.oaktree-research.com/content/category/26/69/ Orion (2005). Arbitrage Pricing Theory. Retrieved on February 15, 2005 from http://orion.math.uwaterloo.ca/~hwolkowi/henry/teaching/f97/370.f97/studsprojs/Group17/apt.htm Quiggin, John (July 7, 2004). Why does the efficient markets hypothesis matter? Commentary on Australian & world events from a social-democratic perspective. Retrieved on February 15, 2005 from http://littlehurt.gsia.cmu.edu/Phd/GE/ Wikipedia (2005).Modern Portfolio Theory on February 16, 2005, from http://en.wikipedia.org/wiki/Modern_portfolio_theory Wikipedia b (2005).Modern Portfolio Theory Retrieved on February 16, 2005, from http://en.wikipedia.org/wiki/Efficient_market_hypothesis