Financial Assets, Markets, and Portfolio Management

Posted on Jan 30, 2025 in Finance

Financial Assets and Derivatives

Asset: An asset is any object, tangible or intangible, that holds value for its owner.

Derivative: A derivative is a financial security whose value is derived from an underlying asset or group of assets.

Valuation Concepts

Capitalize: Estimate Future Values. Discount: Estimate Present Values.

Effective Annual Rate

The effective annual rate is the rate expressed on an annual basis, taking into account compounding interest.

Net Present Value (NPV) and Internal Rate of Return (IRR)

  • NPV: The net present value is the difference between the present value of cash inflows and outflows over a period of time. NPV = PV including initial CF, CF0 (Price).
  • IRR: The internal rate of return is the discount rate that makes the net present value (NPV) of all cash flows equal to zero. IRR is the discount rate that makes CF0 = PV, and thus NPV=0.

Capital and Financial Markets

Capital markets determine the interest rate for resources used to buy physical capital assets. Elasticity to interest rates varies across physical markets.

  • Higher interest rates increase savings and the quantity of capital supplied.
  • Markets do not require a physical location.

Financial Markets – Role

  • Assign savings to funds demand.
  • Determine the interest rate.
  • Determine the risk premium.
  • Dilute the effect of risk and time.

Attributes of Good Financial Markets

  • Liquidity: How easily assets can be converted into cash.
  • Price continuity: Small difference between offer prices from buyers and requested prices from sellers.
  • Low transaction cost: Minimal expenses when buying or selling.
  • Informational efficiency: How quickly and completely an asset’s price reflects available information.

Types of Financial Markets

  1. Primary Markets: Where new issues are sold.
  • Corporate Bonds: Debt securities issued by firms.
  • Government Bonds: Debt securities issued by governments.
  • Equities – IPOs (Initial Public Offerings): Lead by underwriters (Banks), with Direct Listings increasing. EU listed companies can use ‘Passports’ to list in multiple countries.
Secondary Markets: Where outstanding securities trade. Not necessarily a physical location.
  • Pure auction or order-driven system (centralized)
  • Dealer market (decentralized where dealers provide liquidity)

Portfolio Diversification

Diversification means investing in multiple assets to construct a risky portfolio. It reduces total portfolio risk (σp) by reducing variability.

Limits to risk reduction exist due to different sources of risk:

  1. Firm-specific risk (unsystematic risk): Can be eliminated by diversification.
  2. Market risk (systematic risk): Affects all firms and cannot be eliminated by diversification.

Markowitz’s Portfolio Selection Model

This model addresses how investors choose between:

  • Risk-free assets
  • Optimal portfolios of risky assets

Investors are risk-averse, meaning:

  • Given the same expected return, they choose the investment with less risk (lower σp).
  • Given the same risk, they choose the investment with a higher expected return (higher E(Rp)).

Markowitz’s model maximizes expected return subject to:

  1. Any target risk level.
  2. Investment budget fully vested.
  3. No short sales allowed.

The Efficient Frontier

The feasible set of risky assets is determined by:

  • Individual stocks (no diversification).
  • All possible portfolios or combinations of stocks with varying degrees of diversification.

Combining Risk-Free Assets with the Efficient Frontier

The best combination of a risk-free asset with a risky portfolio is determined by the straight line joining the risk-free interest rate with the efficient portfolio (P*) at the tangency point on the frontier of risky assets. P* is better than all other portfolios.

The Capital Market Line

The capital market line represents portfolios that optimally combine risk and return. It expresses the expected return on a portfolio as a function of its total risk.

The Separation Theorem (Tobin, 1958)

If borrowing and lending at the same rate are allowed, the determination of the optimal risky portfolio is independent of investors’ risk attitudes.

The portfolio choice problem is separated into two stages:

  1. Determining the best portfolio of common stocks (P*), which is the same for all investors.
  2. Allocating funds between the optimal risky portfolio P* and Treasury bills to suit the investor’s risk preferences.

In the second stage, the investor is a decision-maker, but not in the first. This choice classifies investors into different types based on their risk preferences.