Financial Theories and Strategies Paper

Financial Theories and Strategies Paper

FIN 554

February 15, 2005

Introduction

Financial theories are the building blocks of today's corporate world. "The basic building blocks of finance theory lay the foundation for many modern tools used in areas such asset pricing and investment. Many of these theoretical concepts such as general equilibrium analysis, information economics and theory of contracts are firmly rooted in classical Microeconomics" (Oaktree, 2005)

This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.

Modern Portfolio Theory (MPT)

The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.

Risk in this model is identified with the standard deviation of portfolio return. Rationality is modeled by supposing that an investor choosing between several portfolios with identical expected returns will prefer that portfolio which minimizes risk." (Wikipedia, 2005) Figure 1 and Figure 2 are examples on how this theory can be illustrated on a graph.

Using the Modern Portfolio Theory, overtime risk assets will provide a higher expected rate of return, as compensation to the investors for accepting a high risk. The high risk will eventually lower collecting asset classes to the portfolio, thus reducing the volatile risk, and increasing the expected rates of return. Furthermore the purpose of this theory is to develop the most optimal investments portfolio which would yield the highest rate of return while ascertaining the risk for the individual or corporate investor. This theory impacts global and domestic financial managers by basing their portfolio using capital market line, capital asset pricing, and securities as a foundation for investments. When used, the MPT establishes investment portfolios, which are used by companies such as Fidelity or Scott Trade for both long-term and short-term strategies.

Fig 1 Fig 2

Tobin Separation Theorem

"James Tobin ... in a 1958 paper said if you hold risky securities and are able to borrow - buying stocks on margin - or lend - buying risk-free assets - and you do so at the same rate, then the efficient frontier is a single portfolio of risky securities plus borrowing and lending....

Tobin's Separation Theorem says you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there's only one portfolio plus borrowing and lending, it's got to be the market" (Moneychimp, 2005). The following diagram illustrates the theorem:

"As usual you're trying to build an optimal portfolio for your risk tolerance; and as before, it will lie somewhere on the straight line joining the cash rate Rf to some optimal mix on the efficient frontier. We're specifically assuming what Sharpe said, that high risk investors can and will buy on margin, with money borrowed at the low rate Rf. That's why there is just one straight line in the picture, and one unique optimal mix on the efficient frontier; so the problem of building an optimal portfolio is "separated" into somehow finding the optimal mix and then combining it with cash to give you your desired risk tolerance" (Moneychimp, 2005).

Tobin's Separation Theorem can be applied on a global scale by financial managers. One concern, however, would be to determine if it is the market increasing the risk in the security or the risk is resulting from the security itself.

Equilibrium Theory

"General Equilibrium analysis focuses on the question of how a market economy allocates resources. This analysis builds on the theories of consumer and producer behavior developed in the study of microeconomics by examining how the interactions of economic agents determine equilibrium in the markets for all goods simultaneously" (Spear, 2005). The theory also attempts to give an understanding of the whole economy using a bottom-up approach, which starts with an individual markets and agents. An example of this theory is that both the prices of goods and their production are inter-twined. For example, "the change in the price of one good, say bread, may affect another price, for example, the wages of bakers. If bakers differ in tastes from others, the demand for bread might be affected by a change in bakers' wages, with a consequent effect on the price of bread. Calculating the equilibrium price of just one good, in theory, requires an analysis that accounts for all of the millions of different goods that are available" (Fact, 2005).

Arbitrage Pricing Theory (APT)

"This theory is derived from a factor model by using diversification and arbitrage to manage risk, and increase returns. It illustrates that the expected return on any risky asset is a linear combination of various risk factors" (Orion, 2005).

In a single-factor model (CAPM), this is expressed as: R = Ra + FB + E

Where:

* R is the actual return of the asset

* Ra is the expected return on the asset

* B is the beta representing the security's responsiveness to factor F

* F is the market risk factor

* E is non-systematic risk (Orion, 2005)

In essence, the APT takes multiple factors into consideration, such as inflation, changes in taxes,