Question

How does the OLI paradigm affect Harry Markowitz portfolio theory?

Answer 1

OLI Paradigm : The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.

–O Ownership advantages specific advantages refer to the competitive advantages of the enterprises seeking to engage in Foreign direct investment (FDI). The greater the competitive advantages of the investing firms, the more they are likely to engage in their foreign production.

–L Location advantages attractions refer to the alternative countries or regions, for undertaking the value adding activities of MNEs. The more the immobile, natural or created resources, which firms need to use jointly with their own competitive advantages, favor a presence in a foreign location, the more firms will choose to augment or exploit their O specific advantages by engaging in FDI.

–I Internalization advantages Firms may organize the creation and exploitation of their core competencies. The greater the net benefits of internalizing cross-border intermediate product markets, the more likely a firm will prefer to engage in foreign production itself rather than license the right to do so.

Home bias is the tendency for investors to invest in a large amount of domestic equities, despite the purported benefits of diversifying into foreign equities. This bias is believed to have arisen as a result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs.

MPT looks for correlation between expected returns and expected volatility of different investments. This expected risk-reward relationship was titled the efficient frontier by Chicago-school economist Harry Markowitz. The efficient frontier is the optimal correlation between risk and return in MPT.

Correlation is measured on a scale of -1.0 to +1.0. If two assets have an expected return correlation of 1.0, that means that they are perfectly correlated. When one gains 5%, the other gains 5%; when one drops 10%, so does the other. A perfectly negative correlation (-1.0) implies that one asset's gain is proportionally matched by the other asset's loss. A zero correlation has no predictive relationship. MPT stresses that investors should look for a consistently uncorrelated (near zero) pool of assets to limit risk.

Modern Portfolio Theory's Use of Correlation : One of the major critiques of Markowitz's initial MPT was the assumption that the correlation between assets are fixed and predictable. The systematic relationships between different assets doesn't remain constant in the real world, which means that MPT becomes less and less useful during times of uncertainty– exactly when investors need the most protection from volatility.

Others say that the variables used to measure correlation coefficients are themselves faulty, and that the actual risk level of an asset can be mispriced. Expected values are really mathematical expressions about the implied covariance of future returns and not actually historical measurements of real return.

The Markowitz portfolio selection model laid the foundation for modern portfolio theory but it is not used in practice.The main reason for this is that it requires a huge amount of data. More useful models have however been developed from the Markowitz model by use of approximation. The first model that reduced the data requirements was the model of Sharpe which only need 3n + 2 parameters. This model does not require estimations of the pairwise correlation between the assets but only estimations of how the asset depend on the behavior of the market. The model of Sharpe led to Markowitz and Sharpe winning.

You can divide the history of investing in the United States into two periods: before and after 1952. That was the year that an economics student at the University of Chicago named Harry Markowitz published his doctoral thesis. His work was the beginning of what is now known as Modern Portfolio Theory. He received a Nobel Prize in economics in 1990 because of his research and its long-lasting effect on how investors approach investing today.

Markowitz starts out with the assumption that all investors would like to avoid risk whenever possible. He defines risk as a standard deviation of expected returns. Rather than look at risk on an individual security level, Markowitz proposes that you measure the risk of an entire portfolio. When considering a security for your portfolio, don't base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.

Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called "correlation," and it measures how much you can expect different securities or asset classes to change in price relative to each other.

For instance, high fuel prices might be good for oil companies, but bad for airlines who need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You'll get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies.

When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return.