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Markowitz Mean-Varience Theory

This is the oldest theory or return and risk concept derived from consumer behaviour
concept. It tries to maximize the utility of the the investor and it believes that utiity has
only two factors.
1. Risk
2. Return
When return increases, utility also increses but at decreasing rate. When risk increases
utility decrease at increasing rate. Markowitz measures returns through mean average and
risk through standard deviation.

Drawbacks of Markowitz Theory Model


1. It measures risk through standard deviation.
2. It does not provide any guideline as to the forecasting of the security risk premiums that
are necessary to compute the efficient frontier of risky assets.
3. It directly co-relates two stocks.
4. It requires a huge number of data.
5. The most significant and most frequently cited critique is that the model requires a huge
number of estimates to construct the covariance matrix.
6. Extensive calculations are required to construct the efficient frontier.

CAPM
(Captital Assets Pricing Model)
Essential Conclusions of CAPM:
1. Return is Linearly Related to Systematic Risk
2. The Market does not Pay for Accepting Unsystematic Risk, since such risk can be avoided
by the simple process of diversification is a measure of Systematic Risk and that optimal
portfolios may be constructed by varying the mix between a risk-free asset & the market
portfolio.

Basic ASSUMPTIONS ( In order for CAPM to work)

1. All investors Attempt to find an optimum portfolio on the Efficient Frontier so as to


maximize the utility of their Wealth rather than to maximise their wealth (itself).
2. Investors are Risk Averse.
3. Information is freely and simultaneously available to all Investors. Their expectations
regarding important economic variables are unbiased in accordance with the Economic
Theory of rational expectations. (interest rates are Normally distributed around the
anticipated interest rate level i.e., they overestimate as often as underestimate future
inflation levels)
4. Investor Expectations are homogenous.
5. All investors have the same expectations regarding the Expected Return and Risk of All
Assets. Assumes the probability distribution of asset returns is normally distributed.
6. All Investors have an identical time horizon. This is required in order to have a unique
Risk-free rate (unless the yield curve is flat)
7. Capital Markets are in equilibrium so that all assets are Properly priced with respect to
their risks
8. Investors can borrow (and Invest) at the risk-free rate (else the Market line becomes
kinked (non-linear) for investor who want portfolio betas greater than 1.0)
9. There are no Taxes and transaction costs, or short sale restrictions.
10. Total Asset quantity is fixed and all assets are Fully Marketable and Divisible. (means the
liquidity of an asset can be ignored as an independent factor in determining the desirability
of the asset)

Time Value of Money


Time value of money is the study of relationship between value of money and the passage of
time. Since money has a time value means we must take this time value of money into
consideration when we are making financial decisions.
Money has different value at different point of time. Money at present is the most precious
money and its value is more than the value it will be having tomorrow. Its value reduces
with the passage of time.
We cant directly compare the cash flows of two different time periods. Because as the time
passes the same money looses the value. The only one way to compare them is to bring them
at a single point of time, either at present or at future.
The time value of money has two main techniques ie.
1. Present Value ( Discounting Technique )
2. Future Value ( Compounding Technique)

Importance of Time Value of Money


Time Value of Money (TVM) is an important concept in financial management. It can be used
to compare investment alternatives and to solve problems involving loans, mortgages,
leases, savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more than the
promise or expectation that you will receive a dollar in the future. Money that you hold
today is worth more because you can invest it and earn interest. After all, you should
receive some compensation for foregoing spending. For instance, you can invest your dollar
for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You
can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year
period. It follows that the present value of the $1.06 you expect to receive in one year is
only $1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value today.
Conversely, you can determine the value to which a single sum or a series of future
payments will grow to at some future date.
Since money has a time value means we must take this time value of money into
consideration when we are making financial decisions. We do this by restating money values
through time with Time Value of Money Calculations. Time value of money calculations are
used to shift dollar values through time. They can be used to state future dollar flows in
present value terms or to restate present value amounts into future dollar values. The
calculations are the most powerful tool available for making financial and business decisions.
Once the methods of restating money values through time is mastered, they can be used for
restating cash flows in such a way as to make them comparable in the financial decision
making process. The calculation of present values is the foundation for many financial
decisions facing both individuals and managers in all types of firm. The process allows
numerous calculations related to the earning of interest, the earning of non-interest returns
on investments, loan related problems, capital budgeting decision processes, insurance
programming problems, and almost any business asset purchase or investment decision. They
also provide the foundation for some of the most widely used valuation concepts and
valuation models employed in finance.