Professional Documents
Culture Documents
(BOOK ID-B1035)
Portfolio Construction
This step identifies those specific assets in which to invest as well as determining the
proportion of the investor’s wealth to put into each one. Here selectivity, timing an
diversification issues are addressed. Selectivity refers to security analysis and focuses on
price movements of individual securities. Timing involves forecasting of price movements of
stock relative to price movements of fixed income securities (such as bonds). Diversification
aims at constructing a portfolio in such a way that the investor’s risk is minimized.
The Following table summarizes how the portfolio is constructed for an active and a passive
investor
The money market exists as a result of the interaction between the suppliers and
demanders of short-term funds (those having a maturity of a year or less). Most
money market transactions are made in marketable securities which are short-term
debt instruments such as T-bills and commercial paper. The term “money market” is
a misnomer. Money (currency) is not actually traded in the money markets. The
securities traded in the money
market are short-term with high liquidity and low-risk; therefore they are close to
being money. Money market provides investors a place for parking surplus funds for
short periods of time. It also provides low-cost source of temporary funds to
borrowers like firms, government and financial intermediaries. The money markets
are associated with the issuance and trading of short-term (less than 1 year) debt
obligations of large corporations, financial institutions (FIs) and governments. Only high-
quality entities can borrow in the money markets. Individual issues are large. Thus
the money market is characterized by low default risk and large denomination of
instruments. Money market transactions can be executed directly or through an
intermediary. Investors in money market Instruments include corporations and FIs
who have idle cash but are restricted to a short-term investment horizon. The
money markets essentially serve to allocate the nation’s supply of liquid funds among
major short-term lenders and borrowers. The characteristics of money market
instruments are: Short-term debt instruments (maturity of less than 1 year)
Large denominations
In theory, the banking industry should handle the needs for short-term loans and accept
short-term deposits and therefore there should not be any need for money markets to
exist. Banks have an information advantage on the creditworthiness of participants
- they are better able to deal with the asymmetric information between savers
and borrowers. However banks have certain disadvantages. They are heavily
regulated. Regulation creates a distinct cost advantage for money markets over banks.
Banks also have to deal with reserve requirements; these create additional expense for
banks that money markets do not have. Also money markets deal with creditworthy
entities- governments, large corporations and banks; therefore the problem of
asymmetric information is not severe for money markets. Thus money market exists
for short term loans and short term deposits of high-quality entities like
governments, large corporations and banks.
Any share portfolio will perform as well as or better than a special trading
rule designed to outperform the market:
A monkey choosing a portfolio of shares for a ‘buy and hold’ strategy is nearly,
but not exactly, what the EMH suggests as a strategy that is likely to be as rewarding as
any trading rule proposed to exploit inefficiencies in the market. The portfolio required
by EMH for investing must be a fully diversified one. A monkey does not have
the financial expertise that is required to construct a broad-based portfolio.
Therefore, it is wrong to conclude from Efficient Market Hypothesis that it does not
matter what the investor does, and that any portfolio is acceptable. Market efficiency
does not mean that it does not make a difference how you invest, since the risk/return
trade-off applies at all times. What it means is that you cannot expect to consistently
"beat the market" on a risk-adjusted basis using costless trading strategies.
EMH presumes that all investors have to be informed, skilled, and able to
constantly analyze the flow of new information. Still, the majority of common
investors are not trained financial experts. Therefore market efficiency cannot be
achieved:
This too is wrong. Not all investors have to be informed. In fact, market efficiency can
be achieved even if only a relatively small core of informed and skilled investors
trade in the market. It only needs a few trades by informed investors using all
the publicly available information to drive the share price to its semi-strong-form
efficient price.
MBA –III SEMESTER
(BOOK ID-B1035)
Years to maturity: 6
YTM : 9 %
At the end of 6 years, the principal of Rs. 100 will be returned to the investor.
Cash flow in year 6= Principal + Interest = Rs. 100 + Rs. 9 = Rs. 109
Year (t) Annual PVIF Present Explanation PV of cash Explanation
Cash flow @10% Value of Time x flow
Annual
Cash Flow
PV(Ct)
2. Why did James Tobin call the portfolio T as super-efficient portfolio? Explain
Now, let us combine the risk-free asset with a risky asset on the efficient frontier.
(Refer to the diagram below). Being on this line means that the investor is
investing part of his money in the risk free asset and the remaining money
in the risky asset. The risk free asset can be combined with any portfolio (say
X or T) on the efficient frontier (EF). But all these combinations would not be
optimal. Why would a rational investor choose any risky asset portfolio except the
single one that lies at the point of tangency between the efficient frontier and
the straight line extending from the risk free asset? Only the tangency portfolio
(portfolio T) would be optimal for the investor. The tangent line (r -L), – which
we will see in unit 10 is called the capital market line – drawn to the
efficient frontier passing through the risk-free rate dominates all portfolios
below it, including the efficient frontier. Thus Portfolio T is the optimal risky
portfolio that is held by all investors regardless of their degree of risk aversion.
Tobin called the portfolio T as the super-efficient portfolio.
In unit 8, we studied that if investors can borrow and lend, then everybody holds a
combination of two portfolios: i) a portfolio of risky assets (tangency portfolio) that lies on
the efficient frontier and ii) the risk free asset. The risk free asset and the tangency
portfolio is the same for all investors if they live in a world of homogenous expectations,
have the same one-period horizon, and the same risk free rate and if information is freely
and instantly available to all. Thus investors differ from each other (depending on their
relative risk preferences) only by the proportions of the risk-free asset and
tangency portfolio they choose to hold in their portfolio. Thus portfolio construction is a
two-step process. First, determine the risky portion of their portfolio-the tangency
portfolio on the efficient frontier that an investor would hold. The next step is to leverage
(borrow at the risk free rate and invest further in the tangency portfolio) or de-leverage
(sell part of the tangency portfolio and lend the proceeds at the risk free rate) this
portfolio to achieve whatever level of risk that they desire. We have seen that the
composition of the tangency portfolio on the efficient frontier is the same for all
investors and is independent of the investor's appetite for risk as it lies on the line
drawn through the risk-free rate and tangent to the efficient frontier. Therefore, the
two decisions that the investors have to make: (i) choosing the composition of the
risky portion of the investor’s portfolio, and (ii) deciding on the amount of leverage to
use, are entirely independent of each another. One decision does not affect the other.
This is called Tobin's separation theorem. It states that that "the optimal combination
of risky assets for an investor can be determined without any knowledge of the
investor's preferences toward risk and return."