portfolio & economics terms

8/7/2019 Portfolio & Economics Terms

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Modern Portfolio Theory MPT

According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios

offering the maximum possible expected return for a given level of risk. This theory was

pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the

Journal of Finance.

There are four basic steps involved in portfolio construction:

-Security valuation

-Asset allocation

-Portfolio optimization

-Performance measurement

For every level of return, there is one portfolio that offers the lowest possible risk, and for every

level of risk, there is a portfolio that offers the highest return. These combinations can be plottedon a graph, and the resulting line is the efficient frontier.

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum expected

return for a given level of risk. A rational investor will only ever hold a portfolio that lies

somewhere on the efficient frontier.

Efficient Frontier is the combinations of securities portfolios that maximize expected return for

any level of expected risk, or that minimizes expected risk for any level ofexpected return.

Capital Structure Theory:

MM1: The firm value is independent of the proportion of debt to equity.MM2: The expected rate of return on the common stock of a levered firm increases inproportion to the debt-equity ratio (D/E), expressed in market values.
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The efficient market hypothesis:

The efficient market hypothesis means that the financial markets do not allow investors to earn

above-average returns without accepting above average risks.

CAPM FORMULA

The linear relationship between the return required on an investment and its systematic risk is

represented by the CAPM formulaDeveloped by Sharpe in 1964)

CAPM ASSUMPTIONS

Single-period transaction horizon

Perfect capital market

Investors can borrow and lend at the risk-free rate of return

For a given level of risk, investors prefer higher returns to lower returns

Arbitrage Pricing Theory

The Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to identifyan asset, such as a share of common stock, which is incorrectly priced. The APT model was firstdescribed by Steven Ross in 1976. The Arbitrage Pricing Theory assumes that each stock's (orasset's) return to the investor is influenced by several independent factors:

Inflation GNP or Gross National Product Investor Confidence

Shifts in the Yield Curve

The CAPM is really just a simplified version of the APT, whereby the only factor is considered-Beta. The basis of arbitrage pricing theory is the idea that the price of a security is driven by anumber of factors. These can be divided into two groups: macro factors, and company specificfactors.


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Microeconomics

The branch of economics that analyzes the market behavior of individual consumers and firms inan attempt to understand the decision-making process of firms and households. It is concernedwith the interaction between individual buyers and sellers and the factors that influence the

choices made by buyers and sellers. Microeconomics focuses on patterns of supply and demandand the determination of price and output in individual markets (e.g. coffee industry).

Comparative advantage:

The ability to produce a good at a lower cost, relative to other goods, compared to anothercountry.Currency appreciation:

An increase in the value of one currency relative to another currency. Appreciation occurs when,because of a change in exchange rates; a unit of one currency buys more units of anothercurrency. Opposite is the case with currency depreciation.

Double taxation:Corporate earnings taxed at both the corporate level and again as a stockholder dividend.

Duopoly:

A market structure in which two producers of a commodity compete with each other.

Economic growth:

An increase in the nation's capacity to produce goods and services.

Elasticity of demand:

The degree to which consumer demand for a product or service responds to a change in price,

wage or other independent variable. When there is no perceptible response, demand is said to beinelastic.Exchange rate: The price of one currency stated in terms of another currency, when exchanged.

General Agreement on Tariffs and Trade (GATT)An international body set up in 1947 to probe into the ways and means of reducing tariffs oninternationally traded goods and services. Between 1947 and 1962, GATT held sevenconferences but met with only moderate success. Its major success was achieved in 1967 duringthe so-called Kennedy Round of talks when tariffs on primary commodities were drasticallyslashed and then in 1994 with the signing of the Uruguay Round agreement. Replaced in 1995 byWorld Trade Organization (WTO).

Gross domestic product (GDP):

Gross Domestic Product: The total of goods and services produced by a nation over a givenperiod, usually 1 year. Gross Domestic Product measures the total output from all the resourceslocated in a country, wherever the owners of the resources live.
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Gross national product (GNP):

The value of all final goods and services produced within a nation in a given year, plus incomeearned by its citizens abroad, minus income earned by foreigners from domestic production. TheFact book, following current practice, uses GDP rather than GNP to measure national

production. However, the user must realize that in certain countries net remittances from citizensworking abroad may be important to national well being. GNP equals GDP plus net propertyincome from abroad.

Inflation: The percentage increase in the prices of goods and services.

Mixed economic systems:

Economic systems that are a mixture of both capitalist and socialist economies. Most developingcountries have mixed systems.

Monetary policy:

The regulation of the money supply and interest rates by a central bank in order to controlinflation and stabilize currency.

Monopoly:A market situation in which a product that does not have close substitutes is being produced andsold by a single seller.

Opportunity cost:

The opportunity cost is the implied cost of not doing something that could have led to higherreturns.

Perfect competition:A market situation characterized by the existence of very many buyers and sellers ofhomogeneous goods or services with perfect knowledge and free entry so that no single buyer orseller can influence the price of the good or service.

Poverty gap:

The sum of the difference between the poverty line and actual income levels of all people livingbelow that line.

Poverty line:

A level of income below, which people are deemed poor. A global poverty line of $1 per personper day was suggested in 1990.

Price elasticity of demand:

The responsiveness of the quantity of a commodity demanded to a change in its price, expressedas the percentage change in quantity demanded divided by the percentage change in price.

Price elasticity of supply:
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The responsiveness of the quantity of a commodity supplied to a change in its price, expressed asthe percentage change in quantity supplied divided by the percentage change in price.

Repo rate:

This is one of the credit management tools used by the Reserve Bank to regulate liquidity. The

bank borrows money from the Reserve Bank to cover its shortfall. The Reserve Bank only makesa certain amount of money available and this determines the repo rate.

Tax avoidance: A legal action designed to reduce or eliminate the taxes that one owes.

Tax evasion: An illegal strategy to decrease tax burden by underreporting income, overstatingdeductions, or using illegal tax shelters.

Terms of trade: The ratio of a country's average export price to its average import price.

Opportunity costThe amount of other products that must be forgone or sacrificed to produce a unit of a product.

Law of increasing opportunity costsThe principle that as the production of good increases, the opportunity cost of producing anadditional unit rises.

Production possibilities curve

A curve showing the different combinations of two goods or services that can be produced in afull-employment, full-production economy where the available supplies of resources andtechnology are fixed.

Free rider problem:

Public goods are non-excludable. Once the product is provided, other consumers cannot beexcluded from benefiting from the good. This means some consumers may avoid payment andbecome free riders.Example: Traffic signal of a country.

Positive externalities:

The social returns from investment in education & training or the positive benefits from healthcare and medical research.

Absolute advantage

Absolute advantage occurs when a country or region can create more of a product with the samefactor inputs.

Macroeconomics

Macroeconomics is more concerned with the economy as a whole. For example, how the levelsof output, inflation, employment, growth, imports and exports are determined.
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