Fin 402 Modern Portfolio Theories. Essay

1212 words - 5 pages

William Sharpe, Harry Markowitz and Merton Miller are the three economists who shared a Nobel prize in 1990 for their pioneering work in the theory of financial economics.Harry Markowitz was awarded the Prize for developing the theory of portfoliochoice; William Sharpe, for his contributions to the theory of price formation for financial assets, the so-called, Capital Asset Pricing Model (CAPM); and Merton Miller, for his fundamental contributions to the theory of corporate finance.According to Markowitz, the process of selecting a portfolio may be divided into two stages. The first stage starts with the observation and experience ends with belief about the future performance of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. In our paper, we are concerned with the second stage and will consider the rule stating our portfolio maximizes discounted expect or anticipated return. We will then look at how our portfolio considers expected return a desirable thing and variance of the return and undesirable thing.Sharpe Ratio.The Sharpe Ratio, named after Nobel Laureate William Sharpe, is the measure of a portfolio's excess return and is measured in relation to the total variability of the portfolio. Sharpe was responsible for the development of the capital asset pricing model. The Sharpe Ratio Equation (2005) is as follows:After adding all of the securities in our portfolio together, we found that our Sharpe Ratio equated to 2.3. However, this figure is not very informative if we do not have any benchmarks to compare it to, although some economists believe the higher the Sharpe Ratio the better the portfolio but this view has been widely debated.Treynor Index:The Treynor index, named after Jack Treynor, relates to the return per unit of risk in a portfolio. Excess return is defined as the difference of the portfolio's return and the risk free rate of return. The unit of risk is the portfolios beta. Of course all of these variables must represent the portfolio over same rate of time and the equation (2004) is as follows:Treynor = (Portfolio Return - Risk-Free Return) / BetaIn short, the higher the rate of return for the Treynor, the greater amount of return the portfolio is receiving per unit of risk. The Treynor can also be plotted on a line graph and assessed for the superiority of the portfolio. After applying the above formula to our portfolio we came up with a result of 5.4, an average number in relation to the market average but we did not outperform the market by any means.Jensen Index:The Jensen Index uses the capitol Asset Pricing Model in order to determine whether the portfolio constructor outperformed the market index. The Jensen Index is slightly more complex to calculate than the other ratios above and the equation is as follows:(Rp- Rrf) = áp+ (Rm- Rrf)âp+ e twhere:Rp = return on portfolio p,Rrf = risk-free return,Áp =...

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