Financial markets - Coursework Example

An asset manager while creating a portfolio diversifies the total investment into an optimal mix of asset class with an aim of either to increase return or reduce risk, so as to create a balanced portfolio. Traditionally asset managers allocated a structure of 45% of assets were invested in equities, 25% in bonds, 15% in property and 15% in cash, based on the client’s need of asset classes which would provide long term capital appreciation for the level of risk that the client is willing to undertake.

As per the offered portfolio, 45% of assets were invested in equity which generated high return with high amount of risk, 25% in bonds which generated constant return with reduced risk, 15% in property or real estate which generated substantial amount of return with substantial risk, and 15% in cash or money market instruments which generated constant promised return with low risk. Thus it can be said that the portfolio offered by the asset manager as on one way generated return to the client with low risk as well as paved the way to earn higher return if high risk is undertaken.

Thus with an aim to diversify risk and attain balanced returns this balanced portfolio could be achieved. . + ((PA * ?A) = (50% * 0) + (50% * 10%) = 5% (ii) Expected Return of Mutual Fund F (E(RMF)) = 20% Expected return of stock A (E(RA)) = 15% Risk free rate of return (RF) = 5% Investment in risk free security (PF) = ? Investment in stock A (PA) = ? It is known that, (E(RMF)) = (PF * (RF)) + (PA * E(RA)) Or, 20% = (PF * 5%) + (PA * 15%) So as to increase return, investment in Stock A needs to be increased since it gives higher return than the risk free security.

Even if 90% of the total investment is invested in stock A and 10% invested in risk free security, still the Expected return of 20% cannot be reached, as the expected return in that case would be 13.5 + 0.5 = 14%. If we refer to Markowitz portfolio theory so as find the proportion of investment in the portfolio we need to find the correlation coefficient (rAF) of the portfolio. rAF= CovAF / ?F* ?A Where, Covariance of the assets (CovAF) = P* ([(RF) - E(RF)]* [(RA) - E(RA)]) In the absence of the value of E(RF) and (RA) in the problem, E(RF) is considered to be 5% as equal to (RF), and 10% as the value of E(RA).

Therefore, (CovAF) = 50% ([0.05-0.05]*[0.10-0.10]), which is equal to 0. Therefore, rAF = 0/ 0*0.10, which is also equal to 0. As per Markowitz, If rAF=0, PF = ?A 2/ (?A 2 + ?F 2) PA = ?F 2/ (?A 2 + ?F 2) Therefore, PF = 0.102/ (0.102 + 0) = 1 PA = 0/ (0.102 + 0) = 0 So, (E(RMF)) = (1 * 0.05) + ( 0*0.15 ) = 0.05 = 5% But as the investor wants maximum return so he may choose to invest fully in Stock A which would generate a return of 15%, which is greater than 5%. Thus, it is found that 20% return cannot be generated from the portfolio. (iii) As discussed earlier the portfolio cannot achieve an expected return of 20% so standard deviation of such a portfolio cannot be found.

Reference Marling, H. and