Markowitz Model

Introduction
Harry Markowitz is an American Economist
He is known for his pioneering work in modern
portfolio theory.
He developed this model in 1952.
Studied the effects of asset risk, return, correlation and
diversification on probable investment portfolio returns.
 Essence of Markowitz Model
An investor has a certain amount of capital he wants to invest
over a single time horizon.
He can choose between different investment instruments, like
stocks, bonds, options, currency, or portfolio. The investment
decision depends on the future risk and return.
The decision also depends on if he or she wants to either
maximize the yield or minimize the risk.
 Essence of Model
It assists in the selection of the most efficient portfolios, by
analyzing various possible portfolios of the given securities.
By choosing securities that do not move exactly together, the
model shows investors how to reduce their risk.
It is also called Mean Variance Model due to the fact that it is
based on expected returns and the standard deviation of the
various portfolios.
 Diversification

Risk
std. dev.

Unsystematic risk

Total risk

Systematic or
market risk

20 30 No of securities in a portfolio
 Assumptions
An investor has a certain amount of capital he wants to
invest over a single time horizon.
He can choose between different investment instruments,
like stocks, bonds, options, currency or portfolio.
The investment decision depends on the future risk and
return.
The decision also depends on if he or she wants to either
maximize the yield or minimize the risk.
The investor is only willing to accept a higher risk if he
or she gets a higher expected return.
 Tools for selection of Portfolio

Expected return (Mean)

Mean and average to refer to the sum of all values
divided by the total number of values.
Formula
Variance & Co-variance
The variance is a measure of how for a set of numbers is
spread out.
It is one of the several descriptors of a probability
distribution, describing how far the number life from the
mean.
Covariance
Covariance reflects the degree to which the return of the
two securities vary or change together
A positive covariance means that the returns of the two
securities move in the same direction.
 A negative covariance implies that the returns of the two
securities move in opposite direction
Formula
Co-relation Coefficient
Covariance & correlation are conceptually analogous in
the sense that of them reflect the degree of variation
between two variables.
The correlation coefficient is simply covariance divided
by the product of standard deviations.
The correlation coefficient can vary between -1 to +1
Effect of Perfectly Negatively Correlated Returns
Perfectly Positive Correlated Returns
 Grouping Individual Assets into Portfolio
The riskiness of a portfolio that is made of different assets
is a function of 3 different factors:
The riskiness of the individual assets that make up the
portfolio
The relative weights of the assets in the portfolio
The degree of variation of returns of the assets making
up the portfolio
Standard deviation formula
Risk of a three asset portfolio
 Implications of Portfolio Formation

Assets differ in terms of expected rates of return, s.d. and correlations

with one another.
While portfolios give average returns they give lower risk
Diversification works
Even for assets that are positively correlated, the portfolio s.d. tends
to fall as assets are added to the portfolio
Combining assets together with low correlations reduces portfolio
risk more.
The lower the correlation , the lower the portfolio s.d.
Negative correlation reduces portfolio risk greatly.
Combining two assets with perfect negative correlation reduces the portfolio
s.d. to nearly zero
 Rule of Dominance

Feasible set / Opportunity Set---- to Efficient Set

Same Return ---- Low Risk
Same Risk -------- High Return
 Utility Analysis with Indifference Curves
Utility of Investor

Risk Lover Risk Neutral Risk Averse

Description Property
Risk Seeker Accepts a Fair Gamble
Risk Neutral Indifferent to a Fair Gamble
Risk Averse Rejects a Fair Gamble
 Optimal Portfolio

The optimal portfolio concept falls under the modern

portfolio theory. The theory assumes that investors try
to minimize risk while striving for the highest possible
returns.
 Risk Free Lending and Borrowing

Risk free asset is the asset whose default risk and

standard deviation is zero; and a certain sum is assured,
at times in nominal terms, at the end of the holding
period.
Only the government securities, and that too when their
maturity period and the holding period of the investors
are identical, are considered risk free securities.
 Risk Free Lending

In risk free lending the one who issues the risk free
asset is not the lender, rather the one who buys the asset,
is.
Investment in a risk free asset is referred to as risk free
lending.
As an investor invests in such an asset the investor is
actually lending the fund to the government by
purchasing its security.
It is a kind of loan by the investor to the government
Constructing a Portfolio of Risk Free Asset and
Risky Asset
The covariance of a risk free security with any risky
security is always zero.
Capital Allocation Line is a graph created by investors
to measure the risk return profile of risky and risk free
asset.
The slope of the CAL indicates incremental return per
incremental risk.
Constructing a Portfolio of Risk Free Asset and
Risky Portfolio
Constructing the portfolio by borrowing at the risk
free rate
It is assumed that the investors can borrow at risk free
rate
This borrowed fund they invest, along with the seed
money.