Department of Accounting & Information Systems BBA Program.

A Term Paper on Portfolio Management

Course Name : Financial Management Course No : 2104 Date of Submission : 5th July, 2009
Prepared For
S.N. Ghosh Professor,
Department of Accounting & Information Systems,

University of Dhaka. Prepared By:

Md. Omar Faruk Section: A; Roll no: 14067 BBA; 14th Batch

Department of AIS, University Of Dhaka.

Acknowledgement:
All the praise for the Almighty Allah whose grace has enabled me to bring out the term paper on Portfolio Management. The primary objective of this term paper is to provide some up-to-date theories and information about portfolio management by the famous writers of today. I do express my heartiest gratitude to the respected Professor Shanti Narayan Ghosh, Professor of Department of Accounting & Information Systems at University of Dhaka whose inspiration and encouragement dares me to write this term paper. Also thank to all of my fellow classmates for their help and suggestions. This term paper is mainly based on information from the web and different books. If there is any misrepresentation of any fact, I, myself is to be confess the fault obligely.

Abstract:
For any kind of financial decision in any organization a manager must think about its strengths, weaknesses, opportunities and threats. Portfolio management allows him to do this. This paper talks about the risks and returns associated in any project to decide the three major managerial functions; investment decisions, financing decisions, and distributing decisions. It also tried to describe the most recent portfolio formation model briefly.

Table of Content:
Portfolio Management: Definition Investment management Investment managers and portfolio structures
Asset allocation Long-term returns Investment styles Diversification

5 6 7
7 7 8

Portfolio (finance)
Portfolio formation Models Returns Attribution

9
10 10 11 11

Market portfolio Risk management

Principles of risk management Process of Risk Management: Limitations

12 13
14 15 16

Modern portfolio theory

Risk and return Mean and variance Mathematically Capital allocation line The efficient frontier

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17 17 18 20 20

The risk-free asset Portfolio leverage The market portfolio Capital market line Asset pricing Systematic risk and specific risk Capital asset pricing model Securities market line Applications to project portfolios and other "non-financial" assets Applications of Modern Portfolio Theory in Other Disciplines Comparison with arbitrage pricing theory Conclusion Bibliography

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Portfolio Management
Definition:

The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance.

Portfolio management is all about strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other tradeoffs encountered in the attempt to maximize return at a given appetite for risk.

Portfolio Management according to nvestopedia: In the case of mutual and exchange-traded funds (ETFs), there are two forms of portfolio management: passive and active. Passive management simply tracks a market index, commonly referred to as indexing or index investing. Active management involves a single manager, co-managers, or a team of managers who attempt to beat the market return by actively managing a fund's portfolio through investment decisions based on research and decisions on individual holdings. Closed-end funds are generally actively managed.

Investment management
Investment management is the professional management of various securities (shares, bonds etc.) and assets (e.g., real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes e.g. mutual funds or Exchange Traded Funds) .

The term asset management is often used to refer to the investment management of collective investments, (not necessarily) whilst the more generic fund management may refer to all forms of institutional investment as well as investment management for private investors. Investment managers who specialize in advisory or discretionary management on behalf of (normally wealthy) private investors may often refer to their services as wealth management or portfolio management often within the context of socalled "private banking". The provision of 'investment management services' includes elements of financial analysis, asset selection, stock selection, plan implementation and ongoing monitoring of investments. Investment management is a large and important global industry in its own right responsible for caretaking of trillions of dollars, euro, pounds and yen. Coming under the remit of financial services many of the world's largest companies are at least in part investment managers and employ millions of staff and create billions in revenue.

Investment managers and portfolio structures

At the heart of the investment management industry are the managers who invest and divest client investments. A certified company investment advisor should conduct an assessment of each client's individual needs and risk profile. The advisor then recommends appropriate investments.

Asset allocation
The different asset class definitions are widely debated, but four common divisions are stocks, bonds, real-estate and commodities. The exercise of allocating funds among these assets (and among individual securities within each asset class) is what investment management firms are paid for. Asset classes exhibit different market dynamics, and different interaction effects; thus, the allocation of monies among asset classes will have a significant effect on the performance of the fund. Some research suggests that allocation among asset classes has more predictive power than the choice of individual holdings in determining portfolio return. Arguably, the skill of a successful investment manager resides in constructing the asset allocation, and separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing funds, bond and stock indices).

Long-term returns
It is important to look at the evidence on the long-term returns to different assets, and to holding period returns (the returns that accrue on average over different lengths of investment). For example, over very long holding periods (eg. 10+ years) in most countries, equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is because equities are riskier (more volatile) than bonds which are themselves more risky than cash.

Investment styles
There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.

Diversification
Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences) and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated by Markowitz and effective diversification requires management of the correlation between the asset returns and the liability returns, issues internal to the portfolio (individual holdings volatility), and cross-correlations between the returns. Inefficient diversification can result in unnecessary risk. To cite a recent example, many investors can confirm that what went up in 1999 did, indeed, come down in 2000. It was the year of the fall of the technology titans. The new economy was badly battered and bruised. Some investors suffered greatly in the net worth area.

Efficient diversification can reduce risk. Eficient diversification was developed by Harry Markowitz, PhD., who won a Nobel Prize for his work. Pension managers, who are responsible for wisely investing billions of retirement dollars, have used this strategy for more than 30 years. The idea, put very simply, is that some asset classes tend to move up when others move down. A good example of this relationship would be the airline industry and the oil/gas industry. When oil/gas prices are stable or moving down, airline profits (and airline stock prices) tend to go up. When oil/gas prices (and profits) move up, airline profits tend to move down. Of course, economic conditions are constantly changing, and, therefore, what went down can, eventually go up, and what was up can come down. The matter gets more complicated as new and different situations and factors enter the picture. Some companies never recover, and new ones are born. But the basic axiom of cyclicality remains nonetheless.

Portfolio (finance)
In finance, a portfolio is an appropriate mix of collection of investments held by institutions or a private individual. Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value.

In building up an investment portfolio a financial institution will typically conduct its own investment analysis, whilst a private individual may make use of the services of a financial advisor or a financial institution which offers portfolio management services. Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected return from portfolios of different asset bundles are compared. The unique goals and circumstances of the investor must also be considered. Some investors are more risk averse than others.

Portfolio formation
Many strategies have been developed to form a portfolio.

equally-weighted portfolio capitalization-weighted portfolio price-weighted portfolio optimal portfolio (for which the Sharpe ratio is highest) It is most important for economic developments.

Models
Some of the financial models used in the process of Valuation, stock selection, and management of portfolios include:

Maximizing return, given an acceptable level of risk. Modern portfolio theorya model proposed by Harry Markowitz among others. The single-index model of portfolio variance.

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Capital asset pricing model. Arbitrage pricing theory. The Jensen Index. The Treynor Index. The Sharpe Diagonal (or Index) model. Value at risk model.

Returns
There are many different methods for calculating portfolio returns. A traditional method has been using quarterly or monthly money-weighted returns. A money-weighted return calculated over a period such as a month or a quarter assumes that the rate of return over that period is constant. As portfolio returns actually fluctuate daily, money-weighted returns may only provide an approximation to a portfolios actual return. These errors happen because of cashflows during the measurement period. The size of the errors depends on three variables: the size of the cashflows, the timing of the cashflows within the measurement period, and the volatility of the portfolio. A more accurate method for calculating portfolio returns is to use the true time-weighted method. This entails revaluing the portfolio on every date where a cashflow takes place (perhaps even every day), and then compounding together the daily returns.

Attribution
Performance Attribution explains the active performance (i.e. the benchmark-relative performance) of a portfolio. For example, a particular portfolio might be benchmarked against the S&P 500 index. If the benchmark return over some period was 5%, and the portfolio return was 8%, this would leave an active return of 3% to be explained. This 3% active return represents the component of the portfolio's return that was generated by the investment manager (rather than by the benchmark).

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There are different models for performance attribution, corresponding to different investment processes. For example, one simple model explains the active return in "bottom-up" terms, as the result of stock selection only. On the other hand, sector attribution explains the active return in terms of both sector bets (for example, an overweight position in Materials, and an underweight position in Financials), and also stock selection within each sector (for example, choosing to hold more of the portfolio in one bank than another).

Market portfolio
A market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market (with the necessary assumption that these assets are infinitely divisible). Neha Tyagi's critique (1977) states that this is only a theoretical concept, as to create a market portfolio for investment purposes in practice would necessarily include every single possible available asset, including real estate, precious metals, stamp collections, jewelry, and anything with any worth, as the theoretical market being referred to would be the world market. As a result, proxies for the market (such as the FTSE100 in the UK, DAX in Germany or the S&P500 in the US) are used in practice by investors. Roll's critique states that these proxies cannot provide an accurate representation of the entire market. The concept of a market portfolio plays an important role in many financial theories and models, including the Capital asset pricing model where it is the only fund in which investors need to invest, to be supplemented only by a risk-free asset (depending upon each investor's attitude towards risk).

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Risk management

Example of risk management: NASA's illustration showing high impact risk areas for the International Space Station".

Risk Management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. Several risk management standards have been developed including the Project Management Institute, the National Institute of Science and Technology, actuarial societies, and ISO standards.
[

Methods, definitions and goals vary widely according to whether the risk management

method is in the context of project management, security, engineering, industrial processes, financial portfolios, actuarial assessments, or public health and safety. For the most part, these methodologies consist of the following elements, performed, more or less, in the following order. 13

1. identify, characterize, and assess threats 2. assess the vulnerability of critical assets to specific threats 3. determine the risk (i.e. the expected consequences of specific types of attacks on specific assets) 4. identify ways to reduce those risks 5. prioritize risk reduction measures based on a strategy The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. Risk management also faces difficulties allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. Again, ideal risk management minimizes spending while maximizing the reduction of the negative effects of risks.

Principles of risk management

The International Organization for Standardization identifies the following principles of risk management:

Risk management should create value. Risk management should be an integral part of organizational processes. Risk management should be part of decision making. Risk management should explicitly address uncertainty. Risk management should be systematic and structured. Risk management should be based on the best available information. Risk management should be tailored. Risk management should take into account human factors. Risk management should be transparent and inclusive. Risk management should be dynamic, iterative and responsive to change. Risk management should be capable of continual improvement and enhancement.

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Process of Risk Management:

According to the standard ISO 31000 "Risk management -- Principles and guidelines on implementation", the process of risk management consists of several steps as follows:

01.Establishing the context

1. Identification 2. Planning. 3. Mapping out 4. Defining a framework. 5. Developing an analysis. 6. Mitigation

02.Identification

Source analysis. Problem analysis[Objectives-based risk identification. Scenario-based risk identification Taxonomy-based risk identification Common-risk checking. Risk charting (risk mapping

03. Assessment 04. Potential risk treatments

Avoidance (eliminate) Reduction (mitigate) Transfer (outsource or insure) Retention (accept and budget)

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05.Risk avoidance 06.Risk reduction 07.Risk retention 08.Risk transfer

Create a risk-management plan Implementation Review and evaluation of the plan

.

Limitations
If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur. Qualitative risk assessment is subjective and lack consistency. The primary justification for a formal risk assessment process is legal and bureaucratic.

Modern portfolio theory

Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing

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model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of return.

Risk and return

The model assumes that investors are risk averse, meaning that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile i.e., if for that level of risk an alternative portfolio exists which has better expected returns.

Mean and variance

It is further assumed that investor's risk / reward preference can be described via a quadratic utility function. The effect of this assumption is that only the expected return and the volatility (i.e., mean return and standard deviation) matter to the investor. The investor is indifferent to other characteristics of the distribution of returns, such as its skew (measures the level of asymmetry in the distribution) or kurtosis (measure of the thickness or so-called "fat tail"). Note that the theory uses a parameter, volatility, as a proxy for risk, while return is an expectation on the future. This is in line with the efficient market hypothesis and most of the classical findings in finance such as Black and Scholes European Option Pricing

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(martingale measure: in short means that the best forecast for tomorrow is the price of today). Recent innovations in portfolio theory, particularly under the rubric of PostModern Portfolio Theory (PMPT), have exposed several flaws in this reliance on variance as the investor's risk proxy: The theory uses a historical parameter, volatility, as a proxy for risk, while return is an expectation on the future. (It is noted though that this is in line with the and efficiency hypothesis most of the classical findings in finance which make use of the martingale measure, i.e. the assumption that the best forecast for tomorrow is the price of today).

The statement that "the investor is indifferent to other characteristics" seems not to be true given that skewness risk appears to be priced by the market

Under the model:

Portfolio return is the proportion-weighted combination of the constituent assets' returns. Portfolio volatility is a function of the correlation of the component assets. The change in volatility is non-linear as the weighting of the component assets changes.

Mathematically
In general:

Expected return:Where Ri is return and wi is the weighting of component asset i.

Portfolio variance:,

where ij. Alternatively the expression can be written as: , where ij

= 1 for i=j.

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Portfolio volatility:-

For a two asset portfolio:

Portfolio return: Portfolio variance:

matrices are preferred for calculations of the efficient frontier. In matrix form, for a given "risk tolerance" , the efficient front is found by minimizing the following expression: where

w is a vector of portfolio weights. Each and

w =1
i

is the covariance matrix for the assets in the portfolio q is a "risk tolerance" factor, where 0 results in the portfolio with minimal risk and
results in the portfolio with maximal return

R is a vector of expected returns

The front is calculated by repeating the optimization for various . Many software packages, including Microsoft Excel, MATLAB, Mathematica and R, provide optimization routines suitable for the above problem.

Capital allocation line

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The capital allocation line (CAL) is the line of expected return plotted against risk (standard deviation) that connects all portfolios that can be formed using a risky asset and a riskless asset. It can be proven that it is a straight line and that it has the following equation. In this formula P is the risky portfolio, F is the riskless portfolio, and C is a combination of portfolios P and F.

The efficient frontier

Efficient Frontier. The hyperbola is sometimes referred to as the 'Markowitz Bullet' Every possible asset combination can be plotted in risk-return space, and the collection of all such possible portfolios defines a region in this space. The line along the upper edge of this region is known as the efficient frontier (sometimes "the Markowitz frontier"). Combinations along this line represent portfolios (explicitly excluding the risk-free alternative) for which there is lowest risk for a given level of return. Conversely, for a given amount of risk, the portfolio lying on the efficient frontier represents the combination offering the best possible return. Mathematically the Efficient Frontier is the intersection of the Set of Portfolios with Minimum Variance (MVS) and the Set of Portfolios with Maximum Return. Formally, the efficient frontier is the set of maximal elements with respect to the partial order of product order on risk and return, the set of portfolios for which one cannot improve both risk and return.

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The efficient frontier is illustrated above, with return p on the y-axis, and risk p on the x-axis; an alternative illustration from the diagram in the CAPM article is at right. The efficient frontier will be convex this is because the risk-return characteristics of a portfolio change in a non-linear fashion as its component weightings are changed. (As described above, portfolio risk is a function of the correlation of the component assets, and thus changes in a non-linear fashion as the weighting of component assets changes.) The efficient frontier is a parabola (hyperbola) when expected return is plotted against variance (standard deviation). The region above the frontier is unachievable by holding risky assets alone. No portfolios can be constructed corresponding to the points in this region. Points below the frontier are suboptimal. A rational investor will hold a portfolio only on the frontier.

The risk-free asset

The risk-free asset is the (hypothetical) asset which pays a risk-free rate. It is usually provided by an investment in short-dated Government securities. The risk-free asset has zero variance in returns (hence is risk-free); it is also uncorrelated with any other asset (by definition: since its variance is zero). As a result, when it is combined with any other asset, or portfolio of assets, the change in return and also in risk is linear. Because both risk and return change linearly as the risk-free asset is introduced into a portfolio, this combination will plot a straight line in risk-return space. The line starts at 100% in the risk-free asset and weight of the risky portfolio = 0 (i.e., intercepting the return axis at the risk-free rate) and goes through the portfolio in question where risk-free asset holding = 0 and portfolio weight = 1.

Portfolio leverage

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An investor adds leverage to the portfolio by borrowing the risk-free asset. The addition of the risk-free asset allows for a position in the region above the efficient frontier. Thus, by combining a risk-free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are superior to those on the efficient frontier.

An investor holding a portfolio of risky assets, with a holding in cash, has a positive risk-free weighting (a de-leveraged portfolio). The return and standard deviation will be lower than the portfolio alone, but since the efficient frontier is convex, this combination will sit above the efficient frontier i.e., offering a higher return for the same risk as the point below it on the frontier.

The investor who borrows money to fund his/her purchase of the risky assets has a negative risk-free weighting i.e., a leveraged portfolio. Here the return is geared to the risky portfolio. This combination will again offer a return superior to those on the frontier.

The market portfolio

The efficient frontier is a collection of portfolios, each one optimal for a given amount of risk. A quantity known as the Sharpe ratio represents a measure of the amount of additional return (above the risk-free rate) a portfolio provides compared to the risk it carries. The portfolio on the efficient frontier with the highest Sharpe Ratio is known as the market portfolio, or sometimes the super-efficient portfolio; it is the tangencyportfolio in the above diagram. This portfolio has the property that any combination of it and the risk-free asset will produce a return that is above the efficient frontieroffering a larger return for a given amount of risk than a portfolio of risky assets on the frontier would.

Capital market line

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When the market portfolio is combined with the risk-free asset, the result is the Capital Market Line. All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier. Just the special case of the market portfolio with zero cash weighting is on the efficient frontier. Additions of cash or leverage with the risk-free asset in combination with the market portfolio are on the Capital Market Line. All of these portfolios represent the highest possible Sharpe ratio. The CML is illustrated above, with return p on the y-axis, and risk p on the x-axis. One can prove that the CML is the optimal CAL and that its equation is

Asset pricing
A rational investor would not invest in an asset which does not improve the risk-return characteristics of his existing portfolio. Since a rational investor would hold the market portfolio, the asset in question will be added to the market portfolio. MPT derives the required return for a correctly priced asset in this context.

Systematic risk and specific risk

Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through diversification (specific risks "cancel out"). Specific risk is also called diversifiable, unique, unsystematic, or idiosyncratic risk. Systematic risk (a.k.a. portfolio risk or market risk) refers to the risk common to all securities - except for selling short as noted below, systematic risk cannot be diversified away (within one market). Within the market portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated with the risk (standard deviation) of the market portfolio. Since a security will be purchased only if it improves the risk / return characteristics of the market portfolio, the risk of a security will be the risk it adds to the market portfolio. In this context, the volatility of the asset, and its correlation with the market portfolio, is historically observed and is therefore a given (there are several approaches to asset

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pricing that attempt to price assets by modelling the stochastic properties of the moments of assets' returns - these are broadly referred to as conditional asset pricing models). The (maximum) price paid for any particular asset (and hence the return it will generate) should also be determined based on its relationship with the market portfolio. Systematic risks within one market can be managed through a strategy of using both long and short positions within one portfolio, creating a "market neutral" portfolio.

Capital asset pricing model

The asset return depends on the amount for the asset today. The price paid must ensure that the market portfolio's risk / return characteristics improve when the asset is added to it. The CAPM is a model which derives the theoretical required return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. Limations of CAPM: CAPM has the following limitations: 1. It is based on unrealisic assumptions. 2. It is difficult to test the validity of CAPM. 3. Betas do not remain stable over time.

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Securities market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The intercept is the nominal riskfree rate available for the market, while the slope is E(Rm Rf). The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus: It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Applications to project portfolios and other "non-financial" assets

Some experts apply MPT to portfolios of projects and other assets besides financial instruments. When MPT is applied outside of traditional financial portfolios, some differences between the different types of portfolios must be considered. 1. The assets in financial portfolios are, for practical purposes, continuously divisible while portfolios of projects like new software development are "lumpy". For example, while we can compute that the optimal portfolio position for 3 stocks is, say, 44%, 35%, 21%, the optimal position for an IT portfolio may not

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allow us to simply change the amount spent on a project. IT projects might be all or nothing or, at least, have logical units that cannot be separated. A portfolio optimization method would have to take the discrete nature of some IT projects into account. 2. The assets of financial portfolios are liquid can be assessed or re-assessed at any point in time while opportunities for new projects may be limited and may appear in limited windows of time and projects that have already been initiated cannot be abandoned without the loss of the sunk costs (i.e., there is little or no recovery/salvage value of a half-complete IT project).

Neither of these necessarily eliminate the possibility of using MPT and such portfolios. They simply indicate the need to run the optimization with an additional set of mathematically-expressed constraints that would not normally apply to financial portfolios.

Furthermore, some of the simplest elements of Modern Portfolio Theory are applicable to virtually any kind of portfolio. The concept of capturing the risk tolerance of an investor by documenting how much risk is acceptable for a given return could be and is applied to a variety of decision analysis problems. MPT, however, uses historical variance as a measure of risk and portfolios of assets like IT projects don't usually have an "historical variance" for a new piece of software. In this case, the MPT investment boundary can be expressed in more general terms like "chance of an ROI less than cost of capital" or "chance of losing more than half of the investment". When risk is put in terms of uncertainty about forecasts and possible losses then the concept is transferable to various types of investment.

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Applications of Modern Portfolio Theory in Other Disciplines

In the 1970s, concepts from Modern Portfolio Theory found their way into the field of regional science. In a series of seminal works, Michael Conroy modeled the labor force in the economy using portfolio-theoretic methods to examine growth and variability in the labor force. This was followed by a long literature on the relationship between economic growth and volatility. More recently, modern portfolio theory has been used to model the self-concept in social psychology. When the self attributes comprising the self-concept constitute a welldiversified portfolio, then psychological outcomes at the level of the individual such as mood and self-esteem should be more stable than when the self-concept is undiversified. This prediction has been confirmed in studies involving human subjects.

Comparison with arbitrage pricing theory

The SML and CAPM are often contrasted with the arbitrage pricing theory (APT), which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. The APT is less restrictive in its assumptions: it allows for an explanatory (as opposed to statistical) model of asset returns, and assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies.

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Conclusion:
In fact risk and return are the most important concepts in finance and financial management. The difficulty is to calculate the degree of risk and the degree of return and to relate these two things. For the measurement, the assumptions have a great impact on it. The more precise and logical the assumption is, the measurement is more likely to be of use. And the more the measurement is precise, the more likely the decision is to be logical and fruitful.

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Bibliography:
Text Books: 1. Pandey,I,M, 2001 Financial Management, eighth edition, Delhi, Vikash Publishing House pvt Ltd. 2. Brigham,Eugine, F and Houston, Joel, F. Fundamentals of financial management tenth edition, Singapore, south weastern, thomson Websites: 1. www.investopedia.com/terms/p/portfoliomanagement.asp 2. en.wikipedia.org/wiki/Portfolio_management 3. en.wikipedia.org/wiki/IT_portfolio_management 4. www.npd-solutions.com/portfolio.html 5. www.corporateportfoliomanagement.org/ 6. www.bitpipe.com/tlist/Portfolio-Management-(Finance).html 7. en.wikipedia.org/wiki/Portfolio_(finance) 8. www.performance-measurement.org/ 9. www.euromoneytraining.com/default.asp?Page=16&productid... 10. www.amazon.com/...Portfolio-Performance-

Measurement.../0470856793
11. www.financial-conferences.com/events/E54554.htm?...

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