Non-satiation and risk aversion

There are two assumptions implicit in the portfolio selection problem. First, investors want to select a portfolio, which provides the highest possible return. An assumption of non-satiation is made n the Markowitz portfolio, in which investors are assumed to always prefer higher levels of terminal wealth to lower levels of terminal wealth. Therefore, given two portfolios with the same standard deviations, the investor will choose the portfolio with the higher expected return.

The portfolio theory presumes that individual investors attempt to maximize the utility of their portfolios. However, since individuals differ in their attitude toward risk, differences in their risk aversion factor will lead to different investment policies. The portfolio theory defines three types of investors:

Risk averse: Investors who have positive risk aversion factors. They view the true return that is earned on an investment as being its expected return, less an amount that compensates for its risk.

Risk neural: Investors who have a risk aversion factor equal to zero. Their utility functions only consist of an investments expected return. Such investors tend to ignore risk when making an investment decision.

Risk loving: Investors who have negative risk aversion factors. This means that, for them, the greater the risk, the more they like an investment. They view the true compensation that an investment offers as consisting of both its expected return and the thrill of the game.

Concept of portfolio

Portfolio theory was originally proposed by Harry M. Markowitz in 1952. The theory is concerned with the selection of an optimal portfolio by a risk-averse investor. A risk –averse investor is an investor who select a portfolio that maximizes the expected return for any given level of risk or minimizes the risk for any given level of expected return. Thus a risk-averse investor will select only efficient portfolios.

The selection of the optimal portfolio depends on the investors preferences for risk and returns. The investors risk-return preferences can be represented by indifference curves. By combining the efficient portfolios with the investor’s indifference curves. By combining the efficient portfolios with the investor’s indifferences curves, the optimal portfolio can be determined.

Portfolio theory assumptions

The portfolio model developed by Markowitz is based on the reasonable assumption:

• The expected return from asset is the mean value of a probability distribution of future returns over some holding period.
• The risk of an individual asset or portfolio is based on the variability of returns.
• Investors depend solely on their estimates of return and risk in making their investment decisions. This means that an investors utility is only a function of the expected return and risk.
• Investors adhere to the dominance principle. That is for any given level with a lower expected return; for assets with the same expected return, investors prefer lower to higher risk.

Function of security market

Price discovery

Price discovery is the first function of the security market. Price discovery is a determination of a fair price of the securities it trades. The interactions of buyers and sellers in a security market determine the price of the security.

The provision of liquidity

Liquidity refers to how an asset can be converted into cash. Security markets provide a mechanism for an investor to sell a financial security. Due to this feature, it is said that a security market offers liquidity. If you takes a long time to sell the shares or if you can sell them immediately only at a sacrifice, it does not meant liquidity. If you sell 20 shares of standard chartered immediately for a fair price, then the market provides you a good liquidity.

The minimization of trading costs or transaction costs

The third function of the security market is that it reduces the cost of transaction. There are two costs associated with transacting i.e. search costs and information costs.

Search costs represent explicit costs, such as the money spent to advertise ones intention to sell or purchase a financial security, and implicit costs, such as the value of time spent in locating a counter party. The present of some form of organized security market reduces search costs. Information costs are costs associated with assessing the investment merits of a financial security.

Organized securities markets lower the trading costs in a variety of ways. By restricting access and setting rules, by standardizing trades, by providing a framework for conflict resolution, and by guaranteeing execution.