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The Pros And Cons Of Modern Portfolio Theory

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Fundamental principle of investment is the relationship between the risk and return tradeoff, where if there is high risk it will compensate with high return as well as the low risk with lower return. The risk can be classified into two types which are systematic (uncontrollable) risk and unsystematic (controllable) risk. The examples of systematic risk are the interest rate risk, inflation risk, foreign exchange risk, country risk, political risk and market risk. Meanwhile, the example of unsystematic risk is business risk, liquidity risk and credit risk. However, all this risk can be diversified which by creating a well-diversified portfolio. This diversified portfolio and mostly aimed by investors in order to reduce their risk towards their investment and to diversify the unsystematic risk.

According to Shaji (2012), he stated that Modern Portfolio Theory only consists of systematic or uncontrollable risks. The reason was because not all the investment having the same degree of risk. Therefore, Modern Portfolio Theory was consisted of two theories which are Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). CAPM was created …show more content…
Arbitrage were done when investor selling his securities during price increment and using the proceed money to buy cheaper securities, and then from the activity investor can generate positive return. The return that those investors generate was earned from the risk they are incurred with. Therefore, APT being used in this thesis in order to analyze the risk factor of LSAP announcement, exchange rate, treasuries yield, and volatility index toward Gold return. The model that will be used under APT was the multi factor model as below where the return of gold were linear combination with those factors and risk free rate of return. The random error term in the equation were not related with the risk

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