Modern portfolio theory (MPT)or portfolio theorywas introduced by Harry Markowitz

with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance
Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual
securities in constructing their portfolios. Standard investment advice was to identify those
securities that offered the best opportunities for gain with the least risk and then construct a
portfolio from these. Following this advice, an investor might conclude that railroad stocks all
offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively,
this would be foolish. Markowitz formalized this intuition.
The efficient frontier was first defined by Harry Markowitz in his groundbreaking (1952) paper
that launched portfolio theory. That theory considers a universe of risky investments and
explores what might be an optimal portfolio based upon those possible investments.
The notion of "optimal" portfolio can be defined in one of two ways:
1. Given risk higher return
2. Given return lower risk
Each definition produces a set of optimal portfolios. Definition (1) produces an optimal portfolio
for each possible level of risk. Definition (2) produces an optimal portfolio for each expected
return. Actually, the two definitions are equivalent. The set of optimal portfolios obtained using
one definition is exactly the same set which is obtained from the other. That set of optimal
portfolios is called the efficient frontier.
(Table with risk and return nos and efficient frontier diagram and explain the diagram)
An efficient portfolio is one that lies on the efficient frontier.
An efficient portfolio provides the lowest level of risk possible for a given level of expected
return. If a portfolio is efficient, then it is not possible to construct a portfolio with the same, or a
better level, of expected return and a lower volatility.
An efficient portfolio also provides the best returns achievable for a given level of risk. If a
portfolio is efficient it is not possible to construct a portfolio with a higher expected return and
the same or a lower level of volatility with the securities available in the market, excluding risk
free assets.

Capital Market line
James Tobin (1958) added the notion of leverage to portfolio theory by incorporating into the
analysis an asset which pays a risk-free rate. By combining a risk-free asset with a portfolio on
the efficient frontier, it is possible to construct portfolios whose risk-return profiles are superior
to those of portfolios on the efficient frontier. The capital market lineis drawn to the efficient
frontier passing through the risk-free rate. The point of tangency corresponds to a portfolio on
the efficient frontier. That portfolio is called the super-efficient portfolio.
Using the risk-free asset, investors who hold the super-efficient portfolio may:
Leverage their position by shorting the risk-free asset and investing the proceeds in additional
holdings in the super-efficient portfolio, or
De-leverage their position by selling some of their holdings in the super-efficient portfolio
and investing the proceeds in the risk-free asset.
The resulting portfolios have risk-reward profiles which all fall on the capital market line.
Accordingly, portfolios which combine the risk free asset with the super-efficient portfolio are
superior from a risk-reward standpoint to the portfolios on the efficient frontier.
(Draw diagram and explain)
William Sharpe (1964) published the capital asset pricing model (CAPM). CAPM extended
Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk.
CAPM considers a simplified world where:
There are no taxes or transaction costs.
All investors have identical investment horizons.
All investors have identical opinions about expected returns, volatilities and correlations of
available investments.
CAPM decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk
of holding the market portfolio. As the market moves, each individual asset is more or less
affected. To the extent that any asset participates in such general market moves, that asset entails
systematic risk. Specific risk is the risk which is unique to an individual asset. It represents the
component of an asset's return which is uncorrelated with general market moves.
According to CAPM, the marketplace compensates investors for taking systematic risk but not
for taking specific risk. This is because specific risk can be diversified away. When an investor
holds the market portfolio, each individual asset in that portfolio entails specific risk, but through
diversification, the investor's net exposure is just the systematic risk of the market portfolio.
Systematic risk can be measured using beta. According to CAPM, the expected return of a stock
equals the risk-free rate plus the portfolio's beta multiplied by the expected excess return of the
market portfolio.
(Write formula and explain the formula)
SML is graphical presentation of CAPM (Draw the diagram and explain)
SHARPE RATIO
This ratio measures the return earned in excess of the risk free rate (normally Treasury
instruments) on a portfolio to the portfolio's total risk as measured by the standard
deviation in its returns over the measurement period. Or how much better did you do
for the risk assumed.

S = Return portfolio- Return of Risk free investment
Standard Deviation of Portfolio
The Sharpe ratio is an appropriate measure of performance for an overall portfolio
particularly when it is compared to another portfolio, or another index such as the
S&P 500, Small Cap index, etc.
TREYNOR RATIO
This ratio is similar to the above except it uses beta instead of standard deviation. It's
also known as the Reward to Volatility Ratio, it is the ratio of a fund's average excess
return to the fund's beta. It measures the returns earned in excess of those that could
have been earned on a riskless investment per unit of market risk assumed.

T = Return of Portfolio - Return of Risk Free Investment
Beta of Portfolio

The absolute risk adjusted return is the Treynor plus the risk free rate.
The Sharpe and Treynor measures are similar, but different:
S uses the standard deviation, T uses beta
S is more appropriate for well diversified portfolios, T for individual
assets
For perfectly diversified portfolios, S and T will give the same ranking,
but different numbers (the ranking, not the number itself, is what is most
important)

JENSEN'S ALPHA
This is the difference between a fund's actual return and those that could have been
made on a benchmark portfolio with the same risk- i.e. beta. It measures the ability of
active management to increase returns above those that are purely a reward for
bearing market risk. Caveats apply however since it will only produce meaningful
results if it is used to compare two portfolios which have similar betas.
Jensens alpha is a measure of the excess return on a portfolio over time
A portfolio with a consistently positive excess return (adjusted for risk) will
have a positive alpha
A portfolio with a consistently negative excess return (adjusted for risk) will
have a negative alpha