Posted: May 13th, 2015

Risk Control for the Firm

RISK CONTROL FOR THE FIRM

Modern portfolio theory is a theory used by risk adverse investors to create portfolios that will optimize or maximize their expected returns. The basis of the theory is that the higher risk in the market, the higher the possibility of obtaining high returns.Harry Markowitz founded this theory, it says that it is possible to create optimal portfolios that would give the maximum possible return at a given level of risk. There are three principles in this portfolio; one is holding constant variance, second is maximizing the expected returs, third is holding constant the expected returns to minimize the variance. Every investor, according to this theory, should be aware of how the risk and return of any financial asset relates. The relationship between risk and return is a positive one. The meaning of this is that the more risk that an investor is willing to take; the likelier it is that he gets compensated for it (Elton and Martin 1744-1745).

If an investor wishes to boost the return that he expects, then he should brace himself to take up more risk. Initially, most investors focused on selecting securities that offered the best chance for gain and those that involved the least amount of risk. Out of this, they would proceed to create a portfolio. According to Markowitz, this was not wise. Instead, he proposed that an investor should diversify his or her risk. That means that the investor should focus on portfolios and consider their overall risk instead on focusing on singular securities. The assumptions of this theory are that; returns from a portfolio are distributed normally, the correlations between stocks are either constant or fixed; the goal of the investors is to maximize their overall gain, that all market players in the market are rational as well as risk adverse, and finally that information is available to all market players (Elton and Martin 1746).

In the long term, modern portfolio theory gives the advisors the power to spread their clients risks and attain wealth. However, Markowitz model is based on the assumption that stock markets are not distributed. But the theory is defended by the fact that the mean variance portfolio gives a good approximation of the values expected (Lavine 17) .

The Capital Asset Pricing Model is a model used to determine the price of risky securities. It describes the relationship between the expected return and the risk involved. It is used in determining the theoretically required rate of return if a security is to be added into an already diversified portfolio. The model is a build up from the work of Harry Markowitz by four others who did it independently. These are; William Sharpe, John Lintner, Jan Mossin and Jack Treynor. The model gets support from the formula that says that the expected return of a security or a portfolio for that matter is equal to the rate of a risk free security in the addition of a risk premium. In case the required return does not hit the target of the required return, the investment should be abandoned. Regardless of the manner of diversification that an investor may try, risk cannot be entirely eliminated. Thus, an investor should be compensated for taking up the risk. CAPM is the model used to calculate the risk and return that can be expected. According to William Sharpe, every investment has two types of risk. These are the Systematic Risk and the unsystematic risk. The systematic risk is the risk that cannot be done away with by diversification. Examples of such are interest rates, recessions or wars. The unsystematic risk, is the risk that can be reduced when the investor increases the number of stocks in his or her portfolio. The assumptions of this theory are that all investors agree on the beta and the expected return of the assets (Clarke, Harindra and Steven 3-5).

Efficient Market Hypothesis is an investment theory that states that it would be impossible to achieve returns that are above the average market returns. This is because the stock market efficiency makes existing share prices reflect all the relevant information. This means that, stocks in the market always trade at their fair value and thus it is impossible for investors to buy undervalued or overvalued stocks. It is, therefore, impossible for an investor to outperform the market either through proper timing or expert portfolio selection except by purchase of riskier investments. The assumptions of this theory are; investors are rational, markets are rational, there are no taxes, and transaction costs do not exist. There are other assumptions but these are the most relevant (Clarke, Roger, Harindra and Steven 6).

The adoption of the modern portfolio theory has had its effect on how risk management practices are carried out.Risk management is valuable to investors because it provides guidance on the type of funds to offer. Assuming that riskless lending and borrowing is allowed freely, it is likely that more and new types of funds enter the set decision. For instance, allowing different rates for riskless borrowing and lending for risky assets with short sales results in the need for four funds. Risk management helps the firms in making indipedent strategic decisions (Elton and Martin 1746).

In practice, the assumptions of these theories are unreasonable and to get the ideal situations that the theories propose is unrealistic.The main shortcoming is the in ability to estimate the expected security returns. Some economists rely on information efficiency while others ignore the inefficiently priced returns and opt to search for data with signals that may predict returns. These methods are in accurate and therefore unreliable (Clarke, Harindra and Steven 1).

The reaction of the market to the QE3 is that it proves the modern portfolio theory is dead. Markowitz in his theory stated that the way to minimize and reduce risk is by diversifying the securities in the portfolio. He was among the first people to link investment risk and return. The view is that his theory can only be used to reduce unsystematic risk and not all manner of risks. Analysts feel that QE3 is an indication that failure to manage risk over the years has brought the country to that level. The economy has over the years been bent on taking up more and more risk without consideration of what that would do in the future. Many analysts, after the announcement of QE3, felt that it was an announced of the death of Markowitz theory. According to this theory the recent huge market losses in 2008 could have been avoided if the portfolios had been optimized. However this was only evident after the market losses (Lavine 11-14) .