5. What are the 4 basic premises for Traditional Finance? Name the 4 and explain each.

Expert Solution

The four fundamental premises of traditional finance are:-
1) Rational investors- This implies that all investors would act logically in wanting to increase their returns. And also rational investors would want greater returns for higher risks

2) Efficient market - This implies that markets price the securities traded on the market efficiently and all information is reflected on the price of the product

3) Mean variance theory is the underlying governing feature - As per mean variance theory, a higher variance of the portfolio should correspond to a higher mean return. And efficient portfolios are those which have the highest mean corresponding to a given variance

4) Returns depend on risk (beta of a portfolio) - The beta of a portfolio shows that how accentuated the returns of a stock is with the market. Higher risk means that a higher beta which is because the returns exhibit more volatility as compared with general market. So a portfolio with higher volatility should have higher returns as well.

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