Investment Enhancement Modern Portfolio Theory Research Paper

These types of investments are often illiquid, so the investor needs to view them as long-term investments. However, the lack of liquidity also means that for the most part they have low levels of correlation with the broad market.

Derivatives are another possibility, and their potential impact on the portfolio will be discussed in the next question. They can either increase risk or decrease risk, depending on the type of derivative and how it is used.

Overall, the impact of alternative investments is to reduce the degree to which the portfolio is subject to the equity and fixed income markets. Alternative investments are often used as an ancillary component of the portfolio, to reduce the portfolio's overall volatility but with the hopes that returns will not suffer as a result.

3. Derivatives can be used for a couple of different purposes in a portfolio. The first is to increase leverage (risk), thereby delivering greater returns or losses than otherwise would be acquired for the money. The second use of derivatives is to limit the downside risk of a portfolio. They can also be used for asset allocation and diversification purposes.

The latter two purposes are simple -- derivatives are a different asset class and therefore represent a means by which an investor can increase his or her holdings not only of the derivatives class but eventually the underlying asset class as well.

An uncovered derivative increases the risk associated with the portfolio significantly. The investor is able to purchase or sell more of a security than would otherwise be possible, which increases the leverage and volatility of the portfolio. This tactic can be used sparingly in a portfolio to come effect but is largely gambling.

The covered derivative can be used to limit the downside risk to the security owner. Such a derivative strategy requires the portfolio to pay for the privilege of limiting downside risk -- essentially selling that downside risk to another party for a profit. The counterparty may use the same strategy to gain extra income from his or her portfolio.

According to the efficient market hypothesis, enhancing returns through derivatives should not be possible if the derivatives are fairly priced. However, in practice this is not the case (Lhabitant, 2000). One possible explanation is that derivative markets are less liquid than equity markets, which results in arbitrage opportunities. There are also biases built into derivatives markets that can be exploited as well, as these biases bring the price of the derivatives away from equilibrium.

Lhabitant (2000) shows that the Sharpe ratio for a covered call is higher when the exercise price is just out of the money, especially in long options. The author does not indicate why this is the case, but it could be speculated that the market is slightly irrational at this point, with buyers seeing a slightly out-of-the-money call as being a good value buy relative to other option positions. For the portfolio, the implications are clear -- that there are superior returns to be had by writing covered calls just out of the money.

What Lhabitant's work shows is the value of using derivatives to enhance income. The covered call strategy is essentially a tactic to increase income in the portfolio. This bias on the part of call buyers is an arbitrage opportunity, on that the portfolio holder can only take advantage through the use of options. This demonstrates the value of options in the portfolio. As versatile financial instruments, they can perform a number of different roles in used right, taking advantage of arbitrate opportunities that arise as the result of lower liquidity levels in options markets.

Works Cited:

De Santis, R. & Sarno, L. (2008). Assessing the benefits of international portfolio diversification in bonds and stocks. European Central Bank working paper. Retrieved May 6, 2010 from http://www.ecb.int/pub/pdf/scpwps/ecbwp883.pdf

Driessen, J. & Laeven, L. (no date). International portfolio diversification benefits: Cross-country evidence from a local perspective. International Monetary Fund. Retrieved May 6, 2010 from http://www.luclaeven.com/papers_files/Diversification_JBF_final.pdf

Lhabitant, F. (2000). Derivatives in portfolio management: Why beating the market is easy. EDHEC. Retrieved May 6, 2010 from http://www.edhec-risk.com/edhec_publications/RISKReview1055927251987929638/attachments/EDHEC_WhyBeatingTheMarketIsEasy.pdf

Schweizer, D. (2008). Portfolio optimization with alternative investments. European Business School. Retrieved May 6, 2010 from http://www.wbiconpro.com/339-Schweizer, D.pdfYavas, B. (2007). Findings indicate that co-movements among the U.S., Germany and Japan markets are significant. Pepperdine University. Retrieved May 6, 2010 from http://gbr.pepperdine.edu/072/diversification.html