1.

Describe the portfolio theories in modern investment

Solutions:
The Portfoli Theory
The quantitative analysis of how investors can diversify their portfolio in order to minimize risk
and maximize returns. The theory was introduced in 1952 by University of Chicago economics
student Harry Markowitz, who published his doctoral thesis, “Portfolio Selection,” in the Journal
of Finance. Markowitz assumed that investors wanted to avoid risk, so he advocated analyzing
individual security vehicles to determine how they contribute to the portfolio’s overall risk. The
analysis requires close examination of how investments move in relation to one another.
Portfolio theory also is called modern portfolio theory or portfolio management theory. In 1990,
Markowitz received the Nobel Prize in Economics for his research.
2. Explain four aspects of theory
Solutions:
There are four aspects of portfolio theory:
Individual security valuation: - which describes a universe of assets by their expected returns
and risks.
Asset allocation: - which determines how much an individual should invest into stocks, bonds
and other asset classes.
Portfolio optimization: - which determines which investments offer the best return given the
level of the risk.
Performance measurement: - which divides each investment’s performance into risk categories
based upon its own performance market-related risk and industry-related risk.
3. Mention the two components of risk and explain each component of risk
Solutions:
The two components of risk
Modern portfolio theory states that the risk for individual stock returns has two components:
 Systematic Risk – These are market risks that cannot be diversified away. Interest
rates, recessions and wars are examples of systematic risks. Systematic Risks:
Risks that are associated with market factors that are beyond the control of the
investor. There is a systematic relationship between the market and the investment
and therefore this risk is non-diversifiable.
 – Interest Rate Risk
 – Re-investment Risk
 – Exchange Rate Risk
 – Market Risk
 – Purchasing Power Risk
 – Political Risk
Risk that influences a large number of assets. Also called market risk.
 Unsystematic Risk – Also known as "specific risk," this risk is specific to
individual stocks, such as a change in management or a decline in operations. This
kind of risk can be diversified away as you increase the number of stocks in your
portfolio (see Figure). It represents the component of a stock's return that is
not correlated with general market moves.
 For a well-diversified portfolio, the risk – or average deviation from the mean—of
each stock contributes little to portfolio risk.
Instead, it is the difference—or covariance—between individual stock's levels of
risk that determines overall portfolio risk. As a result, investors benefit from
holding diversified portfolios instead of individual stocks.
Risk that influences a single company or a small group of companies. Also called
unique or asset-specific risk.
Unsystematic Risk: Risk Associated with the operations of a company and its way
of doing business or risks associated with a specific investment instrument.
– Business Risk - Financial Risk
– Default Risk - Credit Risk
– Liquidity Risk - Event Risk

4. Discus the difference between concentration and diversification investment and explain
their advantages and disadvantages
Solutions:
Definition of Diversification
The definition of diversification is the act of, or the result of, achieving variety. In finance
and investment planning, portfolio diversification is the risk management strategy of
combining a variety of assets to reduce the overall risk of an investment portfolio.
Purpose of Portfolio
Diversification
The purpose of portfolio diversification is portfolio risk management. A risk management
plan should include diversification rules that are strictly followed.
Portfolio diversification will lower the volatility of a portfolio because not all asset
categories, industries, or stocks move together. Holding a variety of non-correlated assets
can nearly eliminate unsystematic risk (specific risk).In other words, by owning a large
number of investments in different industries and companies, industry and company
specific risk is minimized. This decreases the volatility of the portfolio because different
assets should be rising and falling at different times; smoothing out the returns of the
portfolio as a whole.
“There is a close logical connection between the concept of a safety margin and the
principle of diversification.”
Benjamin Graham
In addition, diversification of non-correlated assets can reduce losses in bear markets;
preserving capital for investment in bull markets. Portfolio optimization can be achieved
through proper diversification because the portfolio manager can invest in a greater
number of risk assets (i.e. stocks) without accepting more risk than planned in the whole
portfolio.
In other words, portfolio managers with a target amount of total risk are able to invest a
greater percentage of their assets in risk assets with a diversified portfolio versus a non-
diversified portfolio. This is because holding a variety of non-correlated assets lowers the
total risk of the portfolio. This is why some say diversification is the only free ride.
Concentration vs. Diversification
Correlation
The tendency of the returns on two assets to move together. Imperfect correlation is the
key reason why diversification reduces portfolio risk as measured by the portfolio
standard deviation.
Positively correlated assets tend to move up and down together, while negatively
correlated assets tend to move in opposite directions.
Diversification
by combining stocks into portfolios, we can create an asset with a better risk-return
tradeoff.
The reduction of risk in a portfolio occurs because of diversification. By combining
different assets into a portfolio, we can diversify risk and reduce the overall volatility of
the portfolio.
Let us review the factors that affect how risk can be diversified.
Factors that affect diversification in an equally weighted portfolio
There are two main factors that affect the extent to which volatility can be reduced: the
number of assets in the portfolio, and the correlation between the assets.
Increasing the number of assets reduces the volatility of the portfolio.
Adding an asset with a low correlation with the existing assets of a portfolio also helps to
reduce the volatility of the portfolio.
1. For all positive correlation, there is a threshold beyond which we cannot reduce the
portfolio volatility. This threshold depends on the magnitude of the correlation. If the
correlation is zero or less than zero, then it is possible to bring down the portfolio
volatility to zero by having a large number of assets. This threshold represents the
undiversifiable or the systematic risk of the portfolio.
2. As the correlation decreases, the more we can reduce the portfolio volatility. However,
it takes more assets to bring down the portfolio volatility to its theoretical minimum.
3. The extent to which you can decrease the volatility of the portfolio depends also on the
correlation. The lower the average correlation of the stocks in your portfolio, the lower
you can decrease the volatility of your portfolio.
Why Diversification Works
Diversification is enhanced depending upon the extent to which the returns on assets
“move” together.
This movement is typically measured by a statistic known as “correlation” as shown in
the figure below.

Correlations

Even if two assets are not perfectly negatively correlated, an investor can still realize
diversification benefits from combining them in a portfolio as shown in the figure below.
Diversification

There is a debate between investors who believe in concentration and those that believe
in diversification. My belief is there are few stock analysts competent enough to
concentrate in less than 10 stocks.
Intense concentration leaves no room for errors in your analysis. It also inflicts a large
penalty when something unforeseen causes a severe reduction in price of a single stock or
a particular industry.
 Those who concentrate in one stock are particularly at risk. This is usually done by
investors who are employees, or former employees, of a company. They have an
emotional bias that causes them to take undue risk.
5. Explains the different between risk free assets and risky assets
Solutions:
Capital Allocation Between a Risk-Free Asset and a Risky Asset
Investors want to earn the highest return possible for a level of risk that

they are willing to take. So how does an investor allocate her capital to maximize her
investment utility — the risk-return profile that yields the greatest satisfaction? The
simplest way to examine this is to consider a portfolio consisting of 2 assets: a risk-free
asset that has a low rate of return but no risk, and a risky asset that has a higher expected
return for a higher risk. Investment risk is measured by the standard deviation of
investment returns—the greater the standard deviation, the greater the risk. By varying
the relative proportions of the 2 assets, an investor can earn a risk-free return by investing
all her money in the risk-free asset, or she can potentially earn the maximum return by
investing entirely in the risky asset, or she can select a risk-return trade-off that is
anywhere between these 2 extremes by selecting varying proportions of the 2 assets.
6. Explain the capital market line.
Solutions:
The capital market line (CML) is the capital allocation line formed when the risky asset is
a market return rather than a single-asset return.
No investment is totally risk-free, but United States Treasuries come close. Although T-
bills are often cited as being closest to the ideal risk-free asset for their short terms and
low interest rate risk, they do have reinvestment risk. Another security that is close to the
ideal are Treasury-Inflation Protected Securities (TIPS), which pay a fixed interest rate
on a principal that is adjusted for inflation. For their term length, which can be 5, 10, or
20 years, there is no reinvestment risk, and the interest rate risk is mitigated by the
increasing principal, since some of the change in prevailing interest rates results from
changes in inflation.
For the risky asset, many investors choose a mutual fund or an exchange-traded fund
based on a market index, which provides some diversification in the risky asset without
 the need for security analysis. This passive strategy of selecting a market index security
or investment for the risky asset is sometimes called the mutual fund theorem.
7. Mention the steps by step portfolio planning process and explain each step
Solutions:
Step 1 – Assess the current situation
Planning for the future requires having a clear understanding of an investor’s current
situation in relation to where they want to be. That requires a thorough assessment of
current assets, liabilities, cash flow and investments in light of the investor’s most
important goals. Goals need to be clearly defined and quantified so that the assessment
can identify any gaps between the current investment strategy and the stated goals. This
step needs to include a frank discussion about the investor’s values, beliefs, and priorities,
all of which set the course for developing an investment strategy.
Important – portfolio planning is not a one-and –done deal-it requires ongoing
assessments and adjustments as you go through different stages of life.
Step 2- Establish investment objectives
Establishing investment objectives centers on identifying the investor’s risk return
profile. Determining how much risk an investor is willing and able to assume, and how
much volatility the investor can withstand, is key to formulating a portfolio strategy that
can deliver the required returns with an acceptable level of risk. Once an acceptable risk-
return profile is developed, benchmarks can be established for tracking the portfolio’s
performance. Tracking the portfolio’s performance against benchmarks allows smaller
adjustments to be made along the way.
Step 3- Determine asset allocation
Using the risk-return profile, an investor can develop an asset allocation strategy.
Selecting from various assets classes and investment options, the investor can allocate
assets in a way that achieves optimum diversification while targeting the expected
returns. The investor can also assign percentages to various asset classes, including
stocks, bonds, cash and alternative investments, based on an acceptable range of volatility
for the portfolio. The asset allocation strategy is based on a snapshot of the investor’s
current situation and goals and is usually adjusted as life changes occur. For example, the
closer an investor gets to his or her retirement target date, the more the allocation may
change to reflect less tolerance for volatility and risk.
Step 4 – select investment options
Individual investments are selected based on the parameters of the asset allocation
strategy. The specific investment type selected depends in large part on the investor’s
preference for active or passive management. An actively managed portfolio might
include individual stocks and bonds if there are sufficient assets to achieve optimum
diversification, which is typically over $ 1 million in assets. Smaller portfolios can
achieve the proper diversification through professionally managed funds, such as mutual
funds or with exchange – traded funds. An investor might construct a passively managed
portfolio with index funds selected from the various asset classes and economic sectors.
Step 5 – Monitor, Measure and Rebalance
 After implementing a portfolio plan, the management process begins. This includes
monitoring the investments and measuring the portfolio’s performance relative to the
benchmarks. It is necessary to report investment performance at regular intervals,
typically quarterly, and to review the portfolio plan annually. Once a year, the investor’s
situation and goals get a review to determine if there have been any significant changes.
The portfolio review then determines if the allocation is still on target to track the
investor’s risk –reward profile. If it is not, then the portfolio can be rebalanced, selling
investments that have reached their targets, and buying investments that offer greater
upside potential.
When investing for lifelong goals, the portfolio planning process never stops. As
investors move through their life stages, changes may occur, such as job changes, births,
divorce, deaths or shrinking time horizons, which may require adjustments to their goals,
risk-reward profiles or asset allocations. As change occur, or as market or economic
conditions dictate, the portfolio planning process begins anew, following each of the five
steps to ensure that the right investment strategy is in place.

8. Write the investment process and explain each investment process briefly
Solutions:
An investment process is a set of guidelines that govern the behavior of investors in a
way which allows them to remain faithful to the tenets of their investment philosophy,
that is the key principles which they hope to facilitate outperformance. An investment
process should allow the manager to stay the course in periods of underperformance or
other source of self-doubt. It is the process which gives investment managers a better
chance of making good decisions consistently though a market cycle. The investment
process is a set of inputs that are designed to drive an output satisfactory investment
returns.
There are basically 5 investment process steps that help you in selecting and
investing in the best asset class according to your needs and preferences.
Step 1 – Understanding the client
The first and the foremost step of investment process is to understand the client or the
investor his / her needs, his risk taking capacity and his tax status. After getting an insight
of the goals and restraints of the client, it is important to set a benchmark for the client’s
portfolio management process which will help in evaluating the performance and check
whether the client’s objectives are achieved.
Step 2 – asset allocation decision
This step involves decision on how to allocate the investment across different asset
classes, i.e. fixed income securities, equity, real estate etc. it also involves decision of
whether to invest in domestic assets or in foreign assets. The investor will make this
decision after considering the macroeconomic conditions and overall market status.
Step 3 – Portfolio strategy selection
Third step in the investment process is to select the proper strategy of portfolio creation.
Choosing the right strategy for portfolio creation is very important as it forms the basis of
 selecting the assets that will be added in the portfolio management process. The strategy
that conforms to the investment policies and investment objectives should be selected.
There are two types of portfolio strategy.
1. Active Management
2. Passive Management
Active portfolio management process refers to a strategy where the objective of
investing is to outperform the market return compared to a specific benchmark by either
buying securities that are undervalued or by short selling securities that are overvalued. In
this strategy, risk and return both are high. This strategy is a proactive strategy it requires
close attention by the investor or the fund manager.
Passive portfolio management process refers to the strategy where the purpose is to
generate returns equal to that of the market. It is a reactive strategy as the fund manager
or the investor reacts after the market has responded.
Step 4 – Asset selection decision
The investor needs to select the assets to be placed in the portfolio management process
in the fourth step. Within each asset class, there are different sub asset-classes. For
example, in equity, which stocks should be chosen? Within the fixed income securities
class, which bonds should be chosen ?
Also, the investment objectives should conform to the investment policies because
otherwise the main purpose of investment management process would become
meaningless.
Step 5- Evaluating portfolio performance
This is the final step in the investment process which evaluates the portfolio management
performance. This is an important step as it measures the performance of the investment
with respect to a benchmark, in both absolute and relative terms. The investor would
determine whether his objectives are being achieved or not.
Conclusion
After all the above points have been followed, the investor needs to kep monitoring the
portfolio management performance at an appropriate interval. If the investor finds that
any asset is not performing well, he/she should ‘re balance’ the portfolio. Re balancing
means adding or removing (or better call it adjusting) some assets from the portfolio to
maintain the target level. Re balancing helps the investor to maintain his/her level of risk
and return.

9. Explain why there is need to consider risk when evaluating performance

Solutions:
Risk evaluation is defined by the business dictionary as: “determination of risk
management priorities through establishment of qualitative and/or quantitative
relationships between befits and associated risks.” Anyone responsible for a company’s
data, server, network or software must perform a risk evaluation. A risk evaluation can
help determine if those assets are at risk for a cyber attack,virus, data loss through natural
disaster or any other threat.
 The benefit of a risk evaluation is simple –it provides it professionals with knowledge of
where and how their business and reputation are at risk.
Performing a risk evaluation
A risk evaluation can be performed in five simple steps.
1. Identify and prioritize assets . consider all the different types of data, software
applications, servers and other assets that are managed. Determine which of these is
the most sensitive or would be the most damaging to the company if compromised.
2. Locate assets. Find and list the source of those assets. Be it desktop office computes,
mobile devices, internal servers or anything else, you’ll want to trace each asset back
to its source.
3. Classify assets. Categorize each asset as either public information, sensitive internal
information, non-sensitive internal information, compartmentalized internal
information and regulated information.
4. Perform a threat modeling exercise. Identify and rate all the threats faced by your
top-rated assets. Microsoft’s stride method is a popular one.
5. Finalize date and make a plane. Once you have your evaluation, it’s time to start
tackling those risks, beginning with the most critical.
10. Compare and contrast closedˍ end and openˍ end mutual funds
Solutions:
Closed-ended funds issue a fixed number of units when a fund is launched. They are
normally listed on a stock exchange, and investors are only able to enter and exit by
buying and selling existing units in the fund, with units priced by market. Closed- end
funds commonly utilize leverage in their investments.
An investment company with a fixed number of shares that are bought and sold only in
the open stock market.
Open-end funds do not have a fixed number of units and thus can accept new
investments (through the creation of new units) or redemptions (through reducing the
number of units) based on demand for investing in the fund.
An investment company that stands ready to buy and sell shares at any time.
11. What roles do the security markets play in allocating resources within an economy?
Solutions:
The securities market being an integral part of the capital market is known as a market for
long –term funds. It facilitates an efficient transfer of resources from savers to investors
and becomes conduits for channeling investment funds from investors to borrowers.
The first one is to support industrialization through savings mobilization, investment fund
allocation, and maturity transformation. The second one is to be safety and efficiency in
discharging the above role. In a developing country like Bangladesh, such conditions do
not prevail due to the prevalence of informal credit markets. The recent development
towards privatization seeks the need of efficient capital markets. It performs various
functions in the process of economic development. The securities markets provide both
savers and users with a broad spectrum of investment choices that can increase the level
of both savings and investment. Securities markets can attract the investors as it offers a
higher return to the investment portfolio. This investment portfolio easily can draw more
 savers in the investment process that in turn involves institutions like brokerage houses,
investment banking, money investing firms, etc.

12. Explain how exchange rate variation creates and additional uncertainty (risk) in
international market.
Solutions:
Foreign exchange risk ?
Foreign exchange risk refers to the losses that an international financial transaction may
incur due to currency fluctuations. Also known as currency risk FX risk and exchange-
rate risk, it describes the possibility that an investment’s value may decrease due to
changes in the relative value of the involved currencies. Investors may experience
jurisdiction risk in the form of foreign exchange risk.
An import /export business exposes itself to foreign exchange risk by having account
payables and receivables affected by currency exchange rates.
There are three types of foreign exchange risk:
1. Transaction risk: This is the risk that a company faces when it’s buying a product
from a company located in another country. The price of the product will be
denominated in the selling company’s currency. If the selling company’s currency
were to appreciate versus the buying company’s currency then the company doing the
buying will have to make a larger payment in its base currency to meet the contracted
price.
2. Translation risk: A parent company owning a subsidiary in another country could
face losses when the subsidiary’s financial statements, which will be denominated in
that country’s currency, have to be translated back to the parent company’s currency.
3. Economic risk: Also called forecast risk, refers to when a company’s market value
is continuously impacted by an unavoidable exposure to currency fluctuations.
13. Indicate the essential elements of an active strategy of investing in international market,
and briefly describe the importance of each.
Solutions:
1. Effective diversification asset allocation
Traditional views of diversification tend to focus on asset classes (e.g., equity, fixed
income). Although holding various asset classes can help steer you towards
diversification, they don’t go far enough to provide meaningful diversification
benefits. Creating effective diversification requires consideration of an asset’s
underlying sources of risk. Diversifying across the underlying sources of risk,
whether it’s related to the yield curve, the performance of a company or the inflation
environment, is the core of a solid diversification strategy. Let’s look at an example
where holding different asset classes did not have a diversifying effect. Ten years
ago, if you had Lehman Brothers stokes in your equity portfolio and Lehman Brothers
bonds in your fixed-income portfolio, you would have held assets that belong to two
different asset classes, but that wouldn’t have protected you. The risk you held was
not linked to the asset class-it was a company risk linked to Lehman Brothers. By
 implementing effective diversification as a strategy, you may be able to stabilize your
portfolio by minimizing company overlap between your stocks and bonds.
While most portfolios are heavily exposed to the performance of companies (think
equities and high-yield bonds), your greatest retirement risk may actually come from
inflation. During periods of unexpected inflation, equities and fixed-income
investments may both lose money; having assets in your portfolio that generally rise
along with inflation, like commodities, is a central element of effective
diversification.
2. Active management- tactic asset allocation strategy
Research shows that markets are relatively efficient-most information is already
priced into the stock. This makes it difficult to predict the markets or individual
stocks in the short term. However, Nobel Prize-winning research indicates that
markets are actually somewhat predictable over three of five year periods. Another
way to think about this is that markets that look expensive today will tend to perform
worse than markets that appear cheap today and vice versa. By monitoring global
markets, investors may be able to avoid economic bubbles and take advantage of
potential growth opportunities. Use this research with caution-tactical moves based
on valuation isn’t the same as near-term market timing. There is no magic piece of
evidence that tells you when to get in or out of the market. After all, what looks cheap
today can get cheaper. What the research tells us is that the patients are often
rewarded, but that’s not always the case.
3. Cost efficiency
Whether you’re managing your own investments or working with an advisor, paying
fees is a fact of life. So, if you’re going to pay fees, make sure you’re getting good
value. There are several types of fees to consider including advisory and custodian
fees, investment expense ratios and transaction costs-all together you could be paying
almost 3% in fees annually. If you are, that’s too much.
Research from indexing firm powerhouse vanguard shows that the value of a good
financial advisor may cover their fees over time. Advisors add value by building
effectively diversified portfolios, monitoring markets to avoid economic bubbles and
seize opportunities, minimizing the hidden costs embedded in investment products,
reducing clients’ tax burdens, and the list goes on. I do think it’s possible to do better
than passive indexing by using a quantitatively enhanced indexing strategy. Research
shows that by having exposures like value and momentum in your portfolio, you have
a chance of outperforming a purely indexed approach over time. As a result, it may be
worthwhile to pay a little more for a research enhanced index than a passive fund.
Finally, if you can find a strategy that offers a positive expected return with a low,
stable correlation to equity markets, it might be worth paying a higher fee for the
diversification benefits.
4. Tax efficiency
The real measure of success for an investment strategy is how much of your money
you actually get to keep. That’s where incorporating tax efficiencies into the
investment philosophy come in. Research has shown that comprehensive tax planning
can save investors 75 basis points annually. It might not sound like much, but it’s a
big deal.
One why to achieve greater tax efficiency is by increasing your use of tax-advantaged
vehicles. Another approach is to use asset location strategies to minimize taxes by
determining what account types assets should be held in to take advantage of the best
tax treatment based the asset. For example, assets that pay interest and ordinary
dividends should be held in tax-advantaged accounts to avoid ordinary tax rates rather
than in taxable non-retirement accounts where they will generate annual taxable
income. Proactively harvesting losses also helps offset future gains and can future
boister your bottom line.