Question

Answer briefly the conceptual understanding question parts (a) and (b).

a) Using a diagram, draw and explain the efficient portfolio

b) Using examples, explain the difference between forward price and futures price of an asset (for example wheat)

Answer 1

QUESTION A

A portfolio consists of a number of different securities or other assets selected for investment gains. However, a portfolio also has investment risks. The primary objective of portfolio theory or management is to maximize gains while reducing diversifiable risk. Diversifiable risk is so named because the risk can be reduced by diversifying assets. Systemic risk, on the other hand, cannot be reduced through diversification, since it is a risk that affects the entire economy and most investments. So even the most optimized portfolio will still be subject to systemic risk.

Traditional portfolio management is a nonquantitative approach to balancing a portfolio with different assets, such as stocks and bonds, from different companies and different sectors as a way of reducing the overall risk of the portfolio. The main objective is to select assets that have little or negative correlation with each other, so that the overall diversifiable risk is reduced.

Modern portfolio theory (MPT) reduces portfolio risk by selecting and balancing assets based on statistical techniques that quantify the amount of diversification by calculating expected returns, standard deviations of individual securities to assess their risk, and by calculating the actual coefficients of correlation between assets, or by using a good proxy, such as the single-index model, allowing a better choice of assets that have negative or no correlation with other assets in the portfolio. Modern portfolio management differs from the traditional approach by the use of quantitative methods to reduce risk. The main objective of modern portfolio theory is to have an efficient portfolio, which is a portfolio that yields the highest return for a specific risk, or, stated in another way, the lowest risk for a given return. Profits can be maximized by selecting an efficient portfolio that is also an optimal portfolio, which is one that provides the most satisfaction — the greatest return — for an investor based on his tolerance for risk.

QUESTION B

Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset. A forward contract, though, is an arrangement made over-the-counter (OTC) between two counterparties that negotitate and arrive on the exact terms of the contract - such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis.

Both forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.

A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter.

A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.