How modern portfolio theory can be used to manage the portfolio of Essay

How modern portfolio theory can be used to manage the portfolio of your own_ - Essay Example The pros barely edged the DJIA by a margin of 51 to 49 contests† (Investor Home, 2011). An investor simply parking their money in the Dow would have beaten the specific picks of the professionals about half the time, even without transaction costs or taxes. Even worse, later research found that the pros got a break due to the announcement effect of the stock (Liang, 1996). When the pros made an announcement, others invested naively, but these stocks later reversed quite quickly: When taking this into account, the pros did not beat the dartboard! And in the last year of the contest, the readers won slightly (Jasen, 2002). All of this seems to sink the idea of portfolio analysis: If the best pros in the world using the best techniques can't beat random chance, how can anyone? But modern portfolio tools have given investors, particularly newer ones, skills for constructing an asset portfolio that will beat out mutual funds and naive investment. The Failure of Mutual Funds It's not just professionals that struggle to create value. Mutual funds are also very bad at generating growth, and they have the advantage not only of many investors and many analysts but also time and a diverse portfolio! â€Å"By and large, what you're going to find is that very, very few active funds consistently match the performance of the various indexes over the long-term, much less beat them... Finding a fund that consistently beat its index is like looking for a needle in a haystack† (Distad, 2009). Distad's data shows that very few funds beat out the market over time. Further, he notes that many of these actively managed funds are highly unreliable in terms of their fidelity. 80% had performance history only going back a year, out of a random sample of almost 3500 funds! Investors need to construct their own portfolio, not just rely on mutual funds that have had a mixed record of success and have certainly suffered after events like Enron, WorldCom and the 2008 collapse. A ssets Chosen I chose two assets: Whole Foods (WFMI) and Nintendo (NTDOY.PK). I wanted to pick two assets, one of which was more of a growth asset and another which was an asset that produced products I was familiar with and that I knew something about the likely market response to. The goal for both was risk control first and growth second: That is, I wanted there to be a steadiness to the line, whether it was going horizontally or sloping upwards. I selected based off of a visual analysis of both companies over five years, then used iQfront's analysis to see what the statistics were, and was pleasantly surprised. Modern portfolio theory emphasizes that risk has to be measured based on the variance of the stock (Goetzmann, 2011). Indeed, the core idea is that a tangency line can be created that has a riskless asset used as a baseline for comparison where both risk-averse and risk-accepting investors could invest comfortably, a perfect middle ground (Goetzmann, 2011). But finding tha t perfect portfolio is difficult, because â€Å"a major difficulty in estimating an efficient frontier accurately is that errors grow as the number of assets increase. You cannot just dump all the means, std's and correlations for the world's assets into an optimizer and turn the crank† (Goetzmann, 2011). We will return to why analyzing risk this way is compelling since other forms of risk are so appallingly inaccurately determined (Danielsson, 2009). In any respect, while growth is easy to measure (just look at how it's

Risk management Essay Example | Topics and Well Written Essays - 1000 words

Risk management - Essay Example Banks therefore, make investments in various areas in order to be able to reduce the adversity risks due to price movements in a security it trades in simply by taking a position that will offset the related security. The Bank of England has played a very pivotal role in the economic development of the country primarily, by diversifying risks for all the economic agents. As with any other bank, the greatest financial risk it faced was the interest rate risk. During the last financial crisis i.e. the financial crisis of the year 2007, banks were able to employ certain strategies before and after the crisis which were geared towards mitigating them from such risks brought about by the crisis (Dietrich, 2006). The Bank of England was among those banks which were affected by this crisis and had to therefore apply a risk management theory such as the Forward Trade Agreement before and after the crisis to mitigate itself from the various forms of interest rate exposure. This is because, fl uctuations in its interest rate had the capability of altering its interest income and value thus, making the management of interest rate risk using hedging methods vital to its success. The Asset and Liability Committee of the Bank of England as the body tasked with ensuring that interest rates are properly maintained and managed to avoid any interest rate risk exposures before and after the financial crisis, applied the following strategies to hedge out the risk. Hedging strategies/methods used a. The use of interest rate swaps Interest rate swaps refers to a type of highly popular instrument as a liquid financial derivative that is used by two parties in the exchange of interest rate cash flows. The two parties agree exchange the cash flows of the interest rate basing their agreement on a specified notional amount obtained from a rate that is fixed to a floating rate or even vice versa. The same can also be from a floating rate to any other rate. A clear understanding of how the Bank of England used it would be to consider the two parties agreeing to pay a rate fixed or floating, denominated in the pound to the other party. The rate was then multiplied by a notional principal amount in the US$. The outcome was given an appropriate accrual value for the day count convention. If both the legs featured in similar currency, the notional amount was typically not exchanged between the parties but, instead used to calculate the cash flow sizes to be exchanged (Dietrich, 2006). The notional amount was exchanged if the legs appeared in different currencies. A more common interest rate swap in use has been the LIBOR. With the LIBOR there is a ‘payer’ and a ‘receiver’. One party pays the LIBOR plus a trade percentage plus the rate offered by the other party in this kind of trade activity. Since interest rate swaps are over-the-counter (OTC) instruments, the various varieties the bank could have used include: floating for floating rate swap wi th different currencies, the floating for floating rate swap with similar currencies, and the fixed for fixed rate swaps. Regardless of the changes in the LIBOR rates in future, the rolling deposit value will always equal the notional amount at the reset date. b. Used of forward derivatives The bank also used derivatives during the period to manage the risks. A particular one used was the forward contracts. In the management