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ASSUMPTIONS
An investor is basically risk averse. The risk of a portfolio is estimated on the basis of variability of expected returns of the portfolio. The decision of the investor regarding selection of the portfolio is made on the basis of expected returns and risk of the portfolio. An investor attempts to get maximum return from the investment with minimum risk. That is for a given level of risk he attempts to earn a higher return.
Starts with the identification of the opportunity set of various portfolios in terms of risk and return of each portfolio. Say x number of securities available in which an investor can invest his funds. An infinite number of combinations of all or a few of these securities are possible. Each such combination has an expected average rate of return and a level of risk.
The shaded area AEHA includes all possible combinations of risk and return of portfolios. Combination R represents risk level of r1 and the return level of r2.
Also L is called the dominating portfolio. The boundary AGEH is called the Efficient Frontier.
All the points lying on a particular indifference curve represent different combinations of risk and return which provide same level of utility or satisfaction to the investor.
Now, the efficient frontier can be combined with the indifference curve to determine the investors optimal portfolio.
The investors optimal portfolio is found at the tangency point of efficient frontier with indifference curve.
This tangency point marks the highest level of satisfaction, the investor can attain.
As he moves along the efficient frontier to the left, new securities enter the portfolio mix and some securities may leave the portfolio and this is known as corner portfolio.
On Risk free lending or investment return is certain Standard deviation of the risk free asset is zero
Examples: treasury bills, government securities
Risk-Free Asset
Covariance between two sets of returns is
RF 0
Consequently, the covariance of the risk-free asset with any risky asset or portfolio will always equal zero. Similarly the correlation between any risky asset and the risk-free asset would be zero.
Since we know that the variance of the risk-free asset is zero and the correlation between the risk-free asset and any risky asset i is zero we can adjust the formula
2 E( port ) (1 w RF ) 2 i2
E( port ) (1 w RF ) 2 i2
(1 w RF ) i
Therefore, the standard deviation of a portfolio that combines the risk-free asset with risky assets is the linear proportion of the standard deviation of the risky asset portfolio.
Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier E(R port )
D M C B A
RFR
E( port )
Portfolio Possibilities Combining the Risk-Free Asset and Risky Portfolios on the Efficient Frontier
E(R port )
RFR
E( port )
The CML
Individual investors should differ in position on the CML depending on risk preferences (which leads to the Financing Decision)
Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio (points left of M) Aggressive investors would borrow funds at the RFR and invest everything in the market portfolio (points to the right of M)
Sharpes
Optimization Model
Uses a single number to decide whether a security should be a part of portfolio or not.
A security is preferred to another if it excess return to beta ratio is more than the other security
Ri RF
Sharpe computes a number which is compared to the above ratio for all the securities. Only those securities are selected which have excess return to beta ratio above this number.
1. Calculate the excess return to beta ratio for each stock and rank it in descending order.
2.Find out all the stocks for which the excess return to beta ratio is more than a cut-off rate.
3. Determine the weightages in which the investments have to be made in the stocks in the optimal portfolio
Risk-free Rate=5%
Security 1
Mean return 7
Excess return 2
Beta 0.8
Ratio 2.50
2
3 4 5 6 7 8 9 10
15
17 12 11 5.6 17 11 7 11
10
12 7 6 0.6 12 6 2 6
1
1.5 1 1.5 0.6 2 1 1 2
10.00
8.00 7.00 4.00 1.00 6.00 6.00 2.00 3.00
Now arrange the securities in the descending order of the excess return to beta ratio
Security 2
Mean return 15
Excess return 10
beta 1
ratio 10.00
3
4 7 8 5 10 1 9 6
17
12 17 11 11 11 7 7 5.6
12
7 12 6 6 6 2 2 0.6
1.5
1 2 1 1.5 2 0.8 1 0.6
8.00
7.00 6.00 6.00 4.00 3.00 2.50 2.00 1.00
Starting from the top, portfolios are constructed with the first portfolio including only the first security, the second portfolio including the first and second security and so on.
For each of these portfolios a number C(i) is computed where C(i) is given by the following equation:
Ci
2 m
2 i 1 e 2 i 2 i 1 m 2 i 1 e
i i
( Ri RF ) * i
Where:
2 m : market var iance
Security 2 3 4 7
Mean return 15 17 12 17
Excess return 10 12 7 12
beta 1 1.5 1 2
e2
i
50 40 20 10 40
8
5 10 1 9
11
11 11 7 7
6
6 6 2 2
1
1.5 2 0.8 1
6.00
4.00 3.00 2.50 2.00
30
40 16 20 6
5.6
0.6
0.6
1.00
Computing
Ci
i 1 i
2 for m 10
( Ri RF ) * i
Security
e2
i
i2 e2
i
( Ri RF ) * i
e2
i
i2 2 i 1 e
i
i
Ci
1.667
3.688 4.420 5.429 5.451 5.301 5.023 4.906 4.748 4.517
( Ri RF )
2
3 4 7 8 5 10 1 9 6
0.200
0.450 0.350 2.400 0.150 0.300 0.300 0.100 0.100 0.060
0.020
0.056 0.050 0.400 0.025 0.075 0.100 0.040 0.050 0.060
0.200
0.650 1.000 3.400 3.550 3.850 4.150 4.250 4.350 4.410
0.020
0.076 0.126 0.526 0.551 0.626 0.726 0.766 0.816 0.876
10.00
8.00 7.00 6.00 6.00 4.00 3.00 2.50 2.00 1.00
Now only those securities are selected for which the excess return to beta is more than the corresponding C(i) value. So the first 5 securities are selected
The cut-off ratio C* has to be such that all the securities above the lowest selected security are selected. In this case it turns out to be 5.45.
Xi
Zi
Z
i 1
Where:
i Ri RF Zi 2 ( C*) e i
i
Security 2 3 4 7 8
beta 1 1.5 1 2 1
e2
i
C 50 40 20 10 40
Z 1.667 0.090979
X 0.23477
3.688 0.095585 0.246657 4.420 0.077447 0.199851 5.429 0.109789 0.283309 5.451 0.013724 0.035414