PORTFOLIO AND INVESTMENT AYY / APRIL 28TH 2021

ANALYSIS
 CHAPTER 4: MEAN-VARIANCE PORTFOLIO THEORY
(WEEK 5-6)

TOPIC 1: INTRODUCTION
TOPIC 2 : PORTFOLIO THEORY
TOPIC 3 : BENEFITS OF DIVERSIFICATION
TOPIC 2 : PORTFOLIO THEORY

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TOPIC 2 : PORTFOLIO THEORY

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TOPIC 2 : PORTFOLIO THEORY

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TOPIC 2 : PORTFOLIO THEORY

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TOPIC 2 : PORTFOLIO THEORY
SPECIFICATION OF OPPORTUNITY SET

3. Lagrangian Multipliers
We now generalize to any E and V.
This is instead of considering specific values of Ep and Vp . In other words, we now look at (E, V) as E is
allowed to vary.
The solution to the problem shows that the minimum variance V is a quadratic in E and each Xi is linear in E.
The usual way of representing the results of the above calculations is by plotting the minimum standard
deviation for each value of Ep as a curve in expected return-standard deviation (E – σ ) space.
Recall that this is what we did for the two-security case in Figures 6.1 and 6.2 earlier in the chapter. As V is
quadratic in E, the resulting minimum-variance curve is a parabola in E- V space, and the minimum-
standard deviation curve is a hyperbola in E – σ. Hereafter we always consider space unless stated
otherwise.
In this space, with expected return on the vertical axis, the efficient frontier is the part of the curve lying
above the point of the global minimum of standard deviation. All other possible portfolios are inefficient.
According to MPT, inefficient portfolios should never be chosen by a rational, non-satiated, risk-averse
investor.

Exercise 4:
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TOPIC 2 : PORTFOLIO THEORY
CHOOSING AN EFFICIENT PORTFOLIO

A series of indifference curves (curves which join all outcomes of equal expected utility) can
be plotted in expected return-standard deviation space. Portfolios lying along a single curve
all give the same value of expected utility and so the investor would be indifferent between
them.

The following diagram shows typical indifference curves in E-σ space.

expected return

standard deviation
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TOPIC 2 : PORTFOLIO THEORY
CHOOSING AN EFFICIENT PORTFOLIO

Q: Why an investor's indifference curves slope upwards, and what determines their gradient?

An investor's indifference curves slope upwards because we are assuming that the investor is risk-averse
and prefers more to less. Consequently, additional expected return yields extra utility, whereas additional
risk reduces utility. Thus, any increase (decrease) in risk/standard deviation must be offset by an increase
(decrease) in expected return in order to maintain a constant level of expected utility.
The gradient of the indifference curves is determined by the degree of the investor's risk aversion. The
more risk-averse the investor, the steeper the indifference curves — as the investor will require a greater
increase in expected return in order to offset any extra risk.

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TOPIC 2 : PORTFOLIO THEORY
CHOOSING AN EFFICIENT PORTFOLIO

By combining the investor's indifference curves with the efficient frontier of portfolios, we can
determine the investor's optimal portfolio, i.e the portfolio that maximizes the investor's
expected
Utility is maximised by choosing the portfolio on the efficient frontier at the point where the
frontier is at a tangent to an indifference curve.

standard deviation of return (%)

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TOPIC 2 : PORTFOLIO THEORY
CHOOSING AN EFFICIENT PORTFOLIO

Q: Why the optimal portfolio on the efficient frontier is at the point where the frontier is at a
tangent to an indifference curve.

The optimal portfolio occurs at the point where the indifference curve is tangential to the efficient frontier
for the following two reasons:
1. The indifference curves that correspond to a higher level of expected utility are unattainable as they
lie strictly above the efficient frontier
2. Conversely, lower indifference curves that cut the efficient frontier are attainable, but correspond to a
lower level of expected utility.
The highest attainable indifference curve, and corresponding highest level of expected utility, is therefore
the one that is tangential to the efficient frontier. The optimal portfolio occurs at the tangency point, which is
in fact the only attainable point on this indifference curve, which is why it is optimal

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 CHAPTER 4: MEAN-VARIANCE PORTFOLIO THEORY
(WEEK 5-6)

TOPIC 1: INTRODUCTION
TOPIC 2 : PORTFOLIO THEORY
TOPIC 3 : BENEFITS OF DIVERSIFICATION
THE END…THANK YOU AYY / APRIL 28TH 2021