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Modern portfolio theory

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Definition of Modern portfolio theory

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Modern portfolio theory

Principles underlying the analysis and evaluation of rational portfolio choices
based on risk-return trade-offs and efficient diversification.

Related Terms:

Efficient diversification

The organizing principle of modern portfolio theory, which maintains that any riskaverse
investor will search for the highest expected return for any level of portfolio risk.

Active portfolio strategy

A strategy that uses available information and forecasting techniques to seek a
better performance than a portfolio that is simply diversified broadly. Related: passive portfolio strategy

Agency theory

The analysis of principal-agent relationships, wherein one person, an agent, acts on behalf of
anther person, a principal.

Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.

Bubble theory

Security prices sometimes move wildly above their true values.

Complete portfolio

The entire portfolio, including risky and risk-free assets.

Dedicating a portfolio

Related: cash flow matching.

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Efficient portfolio

A portfolio that provides the greatest expected return for a given level of risk (i.e. standard
deviation), or equivalently, the lowest risk for a given expected return.
Efficient set Graph representing a set of portfolios that maximize expected return at each level of portfolio

Excess return on the market portfolio

The difference between the return on the market portfolio and the
riskless rate.

Factor portfolio

A well-diversified portfolio constructed to have a beta of 1.0 on one factor and a beta of
zero on any other factors.

Feasible portfolio

A portfolio that an investor can construct given the assets available.

Feasible set of portfolios

The collection of all feasible portfolios.

Hedged portfolio

A portfolio consisting of the long position in the stock and the short position in the call
option, so as to be riskless and produce a return that equals the risk-free interest rate.

Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.

Liquidity theory of the term structure

A biased expectations theory that asserts that the implied forward
rates will not be a pure estimate of the market's expectations of future interest rates because they embody a
liquidity premium.

Local expectations theory

A form of the pure expectations theory which suggests that the returns on bonds
of different maturities will be the same over a short-term investment horizon.

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Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.

Market portfolio

A portfolio consisting of all assets available to investors, with each asset held -in
proportion to its market value relative to the total market value of all assets.

Market segmentation theory or preferred habitat theory

A biased expectations theory that asserts that the
shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.

Markowitz efficient portfolio

Also called a mean-variance efficient portfolio, a portfolio that has the highest
expected return at a given level of risk.

Markowitz efficient set of portfolios

The collection of all efficient portfolios, graphically referred to as the
Markowitz efficient frontier.

Mean-variance efficient portfolio

Related: Markowitz efficient portfolio

Minimum-variance portfolio

The portfolio of risky assets with lowest variance.
Minority interest An outside ownership interest in a subsidiary that is consolidated with the parent for
financial reporting purposes.

Normal backwardation theory

Holds that the futures price will be bid down to a level below the expected
spot price.

Normal portfolio

A customized benchmark that includes all the securities from which a manager normally
chooses, weighted as the manager would weight them in a portfolio.

Optimal portfolio

An efficient portfolio most preferred by an investor because its risk/reward characteristics
approximate the investor's utility function. A portfolio that maximizes an investor's preferences with respect
to return and risk.

Passive portfolio strategy

A strategy that involves minimal expectational input, and instead relies on
diversification to match the performance of some market index. A passive strategy assumes that the
marketplace will reflect all available information in the price paid for securities, and therefore, does not
attempt to find mispriced securities. Related: active portfolio strategy

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Passive portfolio

A market index portfolio.


A collection of investments, real and/or financial.

Portfolio insurance

A strategy using a leveraged portfolio in the underlying stock to create a synthetic put
option. The strategy's goal is to ensure that the value of the portfolio does not fall below a certain level.

Portfolio internal rate of return

The rate of return computed by first determining the cash flows for all the
bonds in the portfolio and then finding the interest rate that will make the present value of the cash flows
equal to the market value of the portfolio.

Portfolio opportunity set

The expected return/standard deviation pairs of all portfolios that can be
constructed from a given set of assets.

Portfolio management

Related: Investment management

Portfolio manager

Related: Investment manager

Portfolio separation theorem

An investor's choice of a risky investment portfolio is separate from his
attitude towards risk. Related:Fisher's separation theorem.

Portfolio turnover rate

For an investment company, an annualized rate found by dividing the lesser of
purchases and sales by the average of portfolio assets.

Portfolio variance

Weighted sum of the covariance and variances of the assets in a portfolio.

Preferred habitat theory

A biased expectations theory that believes the term structure reflects the
expectation of the future path of interest rates as well as risk premium. However, the theory rejects the
assertion that the risk premium must rise uniformly with maturity. Instead, to the extent that the demand for
and supply of funds does not match for a given maturity range, some participants will shift to maturities
showing the opposite imbalances. As long as such investors are compensated by an appropriate risk premium
whose magnitude will reflect the extent of aversion to either price or reinvestment risk.

Pure expectations theory

A theory that asserts that the forward rates exclusively represent the expected
future rates. In other words, the entire term structure reflects the markets expectations of future short-term
rates. For example, an increasing sloping term structure implies increasing short-term interest rates. Related:
biased expectations theories

Replicating portfolio

A portfolio constructed to match an index or benchmark.

Static theory of capital structure

theory that the firm's capital structure is determined by a trade-off of the
value of tax shields against the costs of bankruptcy.

Structured portfolio strategy

A strategy in which a portfolio is designed to achieve the performance of some
predetermined liabilities that must be paid out in the future.

Tilted portfolio

An indexing strategy that is linked to active management through the emphasis of a
particular industry sector, selected performance factors such as earnings momentum, dividend yield, priceearnings
ratio, or selected economic factors such as interest rates and inflation.

Weighted average portfolio yield

The weighted average of the yield of all the bonds in a portfolio.

Well diversified portfolio

A portfolio spread out over many securities in such a way that the weight in any
security is small. The risk of a well-diversified portfolio closely approximates the systemic risk of the overall
market, the unsystematic risk of each security having been diversified out of the portfolio.

Zero-beta portfolio

A portfolio constructed to represent the risk-free asset, that is, having a beta of zero.

Zero-investment portfolio

A portfolio of zero net value established by buying and shorting component
securities, usually in the context of an arbitrage strategy.


A collection of securities and investments held by an investor

Portfolio Diversification

See diversification

Portfolio Weight

The percentage of a total portfolio represented by a single specific
security. It is calculated by dividing the value of the investment in a
specific security by the value of the investment in the total portfolio.

theory of constraints (TOC)

a method of analyzing the bottlenecks
(constraints) that keep a system from achieving
higher performance; it states that production cannot take
place at a rate faster than the slowest machine or person
in the process

expectations theory of exchange rates

theory that expected spot exchange rate equals the forward rate.

market portfolio

portfolio of all assets in the economy. In practice a broad stock market index, such as the Standard & Poor's Composite, is used to represent the market.

pecking order theory

Firms prefer to issue debt rather than equity if internal finance is insufficient.

random walk theory

Security prices change randomly, with no predictable trends or patterns.

trade-off theory

Debt levels are chosen to balance interest tax shields against the costs of financial distress.

Quantity Theory of Money

theory that velocity is constant, and so a change in money supply will change nominal income by the same percentage. Formalized by the equation Mv = PQ.

Real Business Cycle Theory

Belief that business cycles arise from real shocks to the economy, such as technology advances and natural resource discoveries, and have little to do with monetary policy.

Market Portfolio

The total of all investment opportunities available to the investor.

Index Portfolio Rebalancing Service (IPRS)

Index portfolio Rebalancing Service (IPRS) is a comprehensive investment service that can help increase potential returns while reducing volatility. Several portfolios are available, each with its own strategic balance of Index Funds. IPRS maintains your personal asset allocation by monitoring and rebalancing your portfolio semi-annually.







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