Portfolio Theory with Application to Rolls Royce

von: Thorben Schenk

Table of Contents

1. Introduction 1

2. Portfolio Theory 1

3. Capital Asset Pricing Model 2

4. The Company – Rolls-Royce plc. 3

4.1. Rolls-Royce Business Segments 3

4.1.1. Civil Aerospace 3
4.1.2. Defence Aerospace 3
4.1.3. Marine 3
4.1.4. Energy 4

4.2. Corporate Objectives 4

5. The Application to Rolls-Rolls plc. 4

5.1. Financial Information 4
5.2. Diversification 5
5.3. Capital Asset Pricing Model 6

6. Critique 6

7. Conclusion 6

References 7

Word Count 7

1. Introduction

“Modern portfolio theory is the philosophical opposite of traditional stock picking.1“ It provides a tool with which it is possible to reduce the risks in business and private investments. At the same time it is the basis for the Capital Asset Pricing Model (CAPM).

This short assey introduces both the theoretical framework of Modern Portfolio Theory (MPT) and the CAPM which are then applied to Rolls-Royce plc. As this is just an overview the reader must be aware that this outline doesn´t go too deep.

2. Portfolio Theory

MPT – or portfolio theory – was introduced in 1952 by Harry Markowitz 2. It explores how risk averse investors construct portfolios in order to optimise expected returns for a given level of market risk . The theory quantifies the benefits of diversification. Out of a universe of risky assets, an efficient frontier of optimal portfolios can be constructed. Each portfolio on the efficient frontier offers the maximum possible expected return for a given level of risk. 3

To most investors, the logic of diversification is intuitively obvious: "Don′t put all your eggs in one basket." Diversification helps spread risk between countries, currencies or markets. It makes sure that the investor is able to benefit from opportunities from around the world. It provides him with a means of hedging bets against crises 4 and unexpected events (stock market crashes or natural disasters). 5

For this reason international diversification makes very good sense. A globally diversified portfolio represents less risk than a diversified domestic portfolio If you have shied away from investing abroad, you have actually been subjecting your portfolio to greater risk.

[...]

1 www.moneychimp.com/articles/risk

2 with his paper "Portfolio Selection" (1952)

3 www.moneychimp.com/articles/risk

4 such as war or oil shortages

5 taken from Markowitz: Portfolio Selection, page 19 f