Utilising Modern Portfolio Theory in Corporate Treasury Functions for Optimal Risk Management
- sabbirrahman0
- Feb 28, 2023
- 3 min read
In the world of finance, risk management is a crucial aspect for any organization seeking to protect and grow their assets. One tool that has proven effective in this pursuit is Markowitz's Modern Portfolio Theory (MPT), which offers a framework for constructing portfolios with the aim of maximizing returns while minimizing risk.
MPT is based on the premise that an investor's primary objective is to maximize returns, given a certain level of risk. The theory suggests that an optimal portfolio is one that lies on the "efficient frontier," a graph that plots the relationship between risk and return for all possible portfolios. This frontier represents the highest level of return that can be achieved for a given level of risk, or conversely, the lowest level of risk that can be taken for a given level of return.
In order to construct an optimal portfolio, MPT utilizes the concept of diversification, which involves including a mix of assets with low correlations in order to mitigate the impact of any single asset's performance on the overall portfolio. By diversifying, an investor can achieve a higher level of return for a given level of risk, or conversely, a lower level of risk for a given level of return.
One key application of MPT in corporate treasury functions is in the development of financial risk management strategies. Treasury departments are responsible for managing an organization's financial assets and liabilities, and MPT can be used to help them make informed decisions about the allocation of these assets in order to minimize risk and maximize returns.
For example, a corporate treasury function may use MPT to determine the optimal mix of assets to include in a portfolio, based on the organization's risk tolerance and investment objectives. This may involve the use of portfolio optimization models, which use mathematical algorithms to calculate the optimal mix of assets based on various inputs such as expected returns and covariances.
Another way in which MPT is applied by corporate treasury functions is in the use of financial derivatives, such as FX forwards, FX options, FX options based lightly structured hedging instruments, interest rate swaps and lightly structured interest rate hedging instruments such as caps and collars. These instruments can be used to hedge against certain types of risk, such as interest rate risk or currency risk, by allowing an organization to transfer that risk to another party. By utilizing MPT and portfolio optimization techniques, corporate treasury functions can make informed decisions about which derivatives to use and which quantum of those derivatives to use in order to effectively manage risk of a portfolio of risk exposures, by optimising return for a given level of risk or minimising risk for a given level of return, defined by the company’s treasury policy.
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About the author
Sabbir Rahman is Managing Director of Langdon Capital and a Partner at Bridging Funding. He has held prior roles with Morgan Stanley, Lazard and Barclays Investment Bank. He has executed over £60 billion in notional value of transactions across financing, M&A and derivatives with global corporates, private equity funds and financial sponsor groups.
About Langdon Capital
Langdon Capital provides in-house transaction services to C-suites and Boards of publicly-listed and PE-backed businesses during the negotiation, execution and due diligence of corporate finance and capital markets transactions and senior interim resourcing solutions across finance, treasury, strategy and corporate development | contact info@langdoncap.com | visit www.langdoncap.com
About Bridging Funding
Bridging Funding is a private credit fund engaged in principal lending of commercial property bridging loans in the UK and select South-East Asian markets. We lend between £200k and £20m per transaction. As a private credit fund, our credit sanctioning process is leaner and more flexible than lenders funded by bank capital | contact sr@bridgingfunding.com | mention code “Langdon” for preferential rates | visit www.bridgingfunding.com
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