FInancial Eco and Asset Pricing Essay Example | Topics and Well Written Essays - 2000 words

FInancial Eco and Asset Pricing - Essay Example Transitivity of preferences suggests that consumer is able to make a choice between different alternatives and these choices are transitivite i.e. if choice A is preferred over choice B and B is preferred over C than A is preferred over C. The choices made by the investors therefore need to follow these axioms in order to make them rational. The assumptions of expected utility hypothesis suggest that out of different choices available to the individual investor, only those choices will be preferred which can offer the highest expected value. The use of the expected utility hypothesis is specially more meaningful under the uncertain risk environment because investors tend to chose those investments which offer the higher expected values. However, higher expected values are often associated with the higher risk also. Considering the above discussion, the different assumptions of the mean variance theory under the simple decision problem as well as on the market equilibrium model sugges t that that at the given mean values, lower variance is preferred whereas at the given variance levels, higher mean values are preferred. Thus the assumptions of mean variance theory and analysis suggest that in any case the investor will be concerned with the mean and variance of his portfolio over the given period of time. The overall shape of the opportunity set however, depends upon the covariance of different assets in the portfolio. Properties of the indifference curve under the mean variance analysis are based on the assumption that the returns are elliptically distributed. Based on this, the optimal portfolio is constructed when the asset returns are tangential to the capital market line. Portfolios with higher returns will be tangential on the upper part of the capital market line suggesting that the higher indifference curves will lie where the overall standard deviation of the portfolio is lower and mean returns are higher. It is also implied from this analysis that for a n individual investor, the optimal portfolio will lie on the CML in such a manner that his total wealth will be divided between the tangency portfolio and the risk free assets. The optimal portfolio however, is achieved where the slope i.e. the sharpe ratio is at the highest. In order to understand as to how the mean variance assumptions help to generate the market equilibrium, it is important to assume the homogeneity of the expectations held by all the investors. According to the two fund separation theorem, all the investors actually held the efficient portfolios and that the holding of risky securities is always done in the same proportion thus in order to generate the market equilibrium, it is important that the market portfolio is constructed by having the same portfolio weights. Under these assumptions the CAPM will therefore generate the market equilibrium in such a manner that the above equation provide the equilibrium relationship between the risk and return under the assu mptions made under mean variance analysis and CAPM. 2) A model is always considered as good if it attempt to provide answers to the different emerging problems and help to sort them out. However, every model is based on certain assumptions under which the different propositions of the model work and if these assumptions