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CONTENT
1.Markowitz efficient market hypothesis mean variance optimization. 2.Single index market model 3.Multi index market model 4.Capital asset pricing model 5.Arbitrage pricing model
In single period MVO portfolio allocation is done for a single upcoming period, and the goal is to maximize expected return subject to a selected level of risk it was developed by Markowitz the efficient frontier is conventionally plotted on a graph with the standard deviation (risk) on the horizontal axis, and the expected return on the vertical axis. A useful feature of the single period MVO problem is that it is soluble by the quadratic programming algorithm
Inputs:
The expected return for each asset The standard deviation of each asset (a measure of risk) The correlation matrix between these assets
Output:
The efficient frontier, i.e. the set of portfolios with expected return greater than any other with the same or lesser risk, and lesser risk than any other with the same or greater return.
The goal of the mean variance analysis is to determine the efficient set and to reveal the portfolio structure of optimal portfolios within the framework of risk versus return. Therefore, the technique employed in this analysis is the quadratic programming approach.
Assumptions
all investors are risk averse so that they prefer less risk to more for the same level of expected return; investors have the information regarding the expected returns, variances and co variances of all assets; investors need only to know the expected the returns, variances and the co variances of returns to determine optimal portfolios; and there exist no transaction costs or taxes limitation.
Assumption
there is one macroeconomic factor that causes the systematic risk affecting all stock returns and this factor can be represented by the rate of return on a market index, such as S&P 500 Beyond this common effect all remaining uncertainty in stock return is firm specific i.e. there is no other source of correlation between securities Stocks covary together only because of their common relationship to the market index
Model representation
Single index model can be expressed as-
rit is return to stock i in period t rf is the risk free rate (i.e. the interest rate on treasury bills) rmt is the return to the market portfolio in period t stock's alpha or abnormal return stocks's beta or responsiveness to the market return e are the residual (random) returns, which are assumed independent normally distributed with mean zero
To summarize it is a relationship between a security's performance and the performance of a portfolio containing it. Model states that the security's performance is related to its portfolio's performance, according to its beta. Return on security = alpha+ beta * return on portfolio + residual return
General Multi-Index Models- Return on stock is a function of return on the market, changes in the level of interest rates, and a set of industry indexes.
Industry index model -This methodology assumes that the correlation between securities is caused by a market effect and industry effect
* * * Ri ai* bi* I1 bi*2 I2 bi*3 I3 ci 1
Assumptions
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 All assets have a definite value, and remains fixed in a certain period of time. All assets are completely divided, and pricing in a fully competitive market environment. Implied: human capital does not exist, because it is indivisible and can not be used as assets owned. Asset markets, there is no friction, the information at the same time for every investor, and free use. Implied: the borrowing rate equal to the loan interest rate.
Model representation
CAPM model is represented as-
Model holds that the expected return of a financial asset can be modelled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient. The model-derived rate of return will then be used to price the asset correctly the asset price is equal to the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage would bring it back into line.
The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities-
= risk premium of the factor, f is the risk-free rate thus the expected return of an asset j is a linear function of the assets sensitivities to the n factors.
Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap.