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Discussion of Portfolio Theory - Coursework Example

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Author : weststanley
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Finance & Accounting
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The portfolio theory originated with the use of asset-pricing concept as an investment instrument. Investment instrument is an asset that can be bought and sold. The portfolio theory defines that an investor will buy a single risky fund plus a risk-free asset. …

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Discussion of Portfolio Theory

The combination depends on the investor’s risk appetite. Thus, the whole concept of portfolio theory relates to the fund used to buy risky asset. Let us assume, the entire financial market consists of three stocks, those of company X, company Y, and company Z in the following manner; X’s market capitalization is $1 billion; Y’s is $2 billion, and Z’s is $3 billion (INVESTOPEDIA). Thus, total financial market value is $6 billion, and market portfolio would consist of 17 % X stock; 33% Y stock, and 50% Z stock. Corporate investors use the same concept when they build up a portfolio. The above discussion demonstrates that asset is a weight in the portfolio. An investor never buys all securities of the financial market; rather selects a combination of securities. This is when the concept of risk arises. Thus, portfolio theory has two important parameters: weight of an asset in the portfolio and its risk. The concept risk relates to the return on investment. Let us consider a single stock A. The stock A has predicted returns for different economic states as well as the probability of occurring these states. Theoretically three states are considered: boom, average, and recession. Using formulas, one can calculate expected return, E (rA), and risk of the return of the stock A. The risk of return is expressed through standard deviation ?, and in percentage. ...
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