Question

then discuss the theory of portfolio choice. Define and discuss the determinants that underlie the demand for an asset in two to three paragraphs.

Answer 1

Theory of portFolio choice is also referred to as theory of Asset to demand

• Financial system offers Array of Assets to choose from
• such Assets are storage of values
• Theory of Port Folio choice determines how a person distributes his or her savings in various investments
• An individual saver decides which Assets has to be included in Port Folio to form a collection of Assets.
• The theory of portfolio choice has the following factors:

1. The quality demanded of an asset is positively related to its wealth and also to its expected return.
2. While the quality demanded is negatively related to the risks of its return from the assets.
3. The quality demanded is also positively related to its liquidity.

The determinants of asset demand:

There are various determinants of an asset demand.

• wealth :

Refers to the savers wealth or the amount of savings that has to be allocated to the portfolio. As people become wealthier their size of portfolios containing the assets also increases as they have more savings. The wealth elasticity of demand does not depend on the value of our wealth rather it depends on the percentage increase in quantity of an asset divided by total wealth. As wealth increases savers hold more wealth in luxury assets and less in necessity assets.

• Expected returns on asset:

The expected retun refers to the return from the investment. If a saver has to choose between two similar assets a saver should pick the one with higher expected return. an increase in the risk of one asset leads to the decline in quantity of that asset.

• Liquidity:

Assets with greater liquidity will help saver during emergencies to draw their fund. For example cash that is held by people is a liquid asset.

• Cost of acquiring information about the asset:

The cost of acquiring information about the asset is more beneficial compared to gathering information about other assets. Infromation is readily available to the public with low cost.