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ASC712 Portfolio Theory And Application UITM Assignment Sample Malaysia

ASC712 Portfolio Theory and Application is a course offered at UITM in Malaysia. It provides students with an introduction to modern portfolio theory and general equilibrium models, specifically capital asset pricing models and arbitrage pricing models. The course focuses on the theory and practice of optimizing portfolios by combining securities in an optimal manner. It also explores techniques for simplifying the portfolio problem and computational procedures for identifying desirable portfolios.

Additionally, the course discusses equilibrium in capital markets and demonstrates how portfolio theory can be utilized to predict equilibrium returns and prices for individual securities. Furthermore, it explores the application of equilibrium theory in portfolio management, offering insights into managing portfolios effectively.

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Assignment Activity 1 : Illustrate the basic principles underlying rational portfolio choices and their meaning with respect to formation of prices in the capital market.

Rational portfolio choices are based on the principles of modern portfolio theory (MPT), developed by Harry Markowitz in the 1950s. MPT assumes that investors are rational and seek to maximize their returns while minimizing risk. 

Here are the key principles underlying rational portfolio choices:

  • Diversification: Rational investors understand the benefits of diversification, which involves spreading investments across different asset classes (e.g., stocks, bonds, real estate) and within each asset class (e.g., different industries, countries). Diversification helps reduce the specific risk associated with individual investments, as losses in one investment can be offset by gains in others. By diversifying, investors aim to achieve a more efficient trade-off between risk and return.
  • Risk-Return Tradeoff: Rational investors recognize that there is a tradeoff between risk and expected return. Higher-risk investments tend to offer the potential for higher returns, but they also carry a greater chance of losses. Investors must determine their risk tolerance and choose an appropriate asset allocation that aligns with their risk preferences and financial goals.
  • Efficient Frontier: The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. Rational investors aim to construct portfolios that lie on or close to the efficient frontier. Markowitz’s mean-variance analysis is used to determine the optimal asset allocation that maximizes returns for a given level of risk or minimizes risk for a given level of returns.
  • Capital Asset Pricing Model (CAPM): The CAPM is a widely used model in finance that helps explain the relationship between risk and expected return. According to CAPM, the expected return of an asset is determined by its beta, which measures the asset’s sensitivity to systematic risk (market risk). Rational investors use CAPM to estimate the expected returns of individual assets and construct portfolios that provide an appropriate level of risk-adjusted return.

The formation of prices in the capital market is influenced by the rational portfolio choices made by investors. When investors allocate their capital across different assets, the demand and supply dynamics in the market are affected, which, in turn, influence the prices of those assets. If a particular asset becomes more desirable due to its expected return or perceived risk characteristics, its price may increase as demand outpaces supply. Conversely, if an asset becomes less attractive, its price may decline. Thus, rational portfolio choices play a crucial role in shaping the pricing of assets in the capital market.

Assignment Activity 2 : Analyze the general equilibrium models.

General equilibrium models are economic models that aim to analyze the overall functioning of an economy by considering the interactions between various markets and agents. These models are based on the concept of equilibrium, where all markets simultaneously clear, meaning that the quantity supplied equals the quantity demanded. Here are some key aspects of general equilibrium models:

  • Interconnected Markets: General equilibrium models recognize that different markets, such as goods markets, labor markets, and financial markets, are interconnected. Changes in one market can have ripple effects on other markets, leading to overall adjustments in the economy.
  • Supply and Demand: General equilibrium models rely on the basic principles of supply and demand. They consider the behavior of producers (supply) and consumers (demand) in determining prices and quantities in each market.
  • Efficiency: General equilibrium models often incorporate the concept of Pareto efficiency, which suggests that an allocation of resources is efficient if it is not possible to make someone better off without making someone else worse off. These models analyze how the economy’s allocation of resources can be efficient or inefficient based on the interactions between agents and markets.
  • Equilibrium Conditions: General equilibrium models aim to find a set of prices and quantities that satisfy equilibrium conditions in all markets simultaneously. These conditions typically involve ensuring that the quantity demanded equals the quantity supplied in each market, considering production technologies, preferences, and resource endowments.

By using general equilibrium models, economists can analyze the interactions and feedback effects between different markets and agents in an economy. These models help understand how changes in one aspect of the economy can affect other sectors, and they provide insights into the overall efficiency and functioning of the economy.

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Assignment Activity 3 : Evaluate empirically how well each model describes the behaviour of actual capital markets.

Empirically evaluating the performance of models in describing the behavior of actual capital markets involves testing the model’s predictions against real-world data. Here are some common approaches used in evaluating models:

  • Statistical Analysis: Researchers analyze historical data from capital markets and apply statistical techniques to measure the model’s explanatory power and goodness of fit. They compare the model’s predictions (e.g., expected returns, risk levels) with observed market data and assess the degree of correlation or accuracy.
  • Hypothesis Testing: Researchers formulate hypotheses based on the model’s predictions and test them using statistical methods. They examine whether the empirical evidence supports or contradicts the model’s assumptions and predictions.
  • Backtesting: Backtesting involves applying the model’s rules or strategies to historical market data to evaluate its performance. This approach assesses how well the model would have performed in the past and provides insights into its potential effectiveness in predicting market behavior.
  • Robustness Checks: Researchers conduct robustness checks to evaluate how sensitive the model’s predictions are to changes in assumptions or input parameters. By varying key model parameters or introducing different scenarios, they assess whether the model’s performance remains consistent or if it breaks down under different conditions.

It is important to note that while models can provide valuable insights and help understand the general behavior of capital markets, they are simplifications of complex real-world systems. Empirical evaluation helps gauge the degree to which a model captures the essential characteristics of actual capital markets and provides a basis for assessing its reliability and practical usefulness.

Overall, empirical evaluation provides a rigorous testing framework to determine the strengths and limitations of models in describing the behavior of actual capital markets, contributing to ongoing advancements in the field of finance and investment.

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