PORTFOLIO THEORY

ASSUMPTIONS OF NIV PT

and variances
Expected Returns Yavanas co -
-

are known
-

Investor decisions are based on mean and

variance
only to less
Investors
-

prefer more

Investors are risk averse

Fixed
single step time horizon
transaction costs (unrealistic)
Ignore taxes and
-

Each asset amount

be
purchased in
any
-

can

MVP -1 IGNORES INVESTORS LIABILITY ie ACTUARIAL RISK

.

|
OPPORTUNITY SET EFFICIENT FRONTIERS
-
set
of
all
possible -

set
of all
efficient
portfolio in the Er
space portfolios
_^
→ efficient frontier
•É Helmig set

¥§ * std der

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 any portfolio opportunity
HACK in the
: From set if
you
can move
⑤ ⑧ then on that portfolio is

inefficient .

¥ ¥
More return same return
for same risk for less risk

NUMBER OF PARAMETERS

-
N expected returns
NCN + 3)
-

H variances = parameters
-2
covariances
NCN2
-

OPTIMAL PORTFOLIO Point

utility and
:
of tangency of curve

efficient frontier

¥-4
" → Indifference curve

•É
efficient frontier
¥§
>

☒ std der

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 FOR TWO ASSETS A, B :

Rp =
RA RA t N
BRB ; NA t
HB = 1

Up =
NEVA t RB VB t 2N
A RB 6A 613 TAB
MINIMUM VARIANCE PORTFOLIO :

✗A =
VB-CAB_
VA -
2 CAB 1- V13

condition for non

negative holding for A and B
-

(÷z II ]
NAB min
=P ± '

correlation Frontier
Impact of
^
on
Efficient
•

B
T
EE
= -
I

p =
I

Ige
•

> std der

when P= the cost elimination risk is to short sell B

i. of of
and invest 100% wealth in A and still a return
>
earning
lesser than A
when p= -1
,
to eliminate risk we hold positive amounts of
both assets and somewhat
earn
weighted returns

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when assets
minimization greater
we have than 2 we solve

problems by LAGRANGIAN MULTIPLIERS

OBJECTIVE :

rain up =

Fg nixjcij
subject to Ep =
§ Ni Ei

subject to I =
4. ni
DEFINING THE LAGRANGIAN FUNCTION FOR A CASE OF 3 ASSETS

assuming Up = 10k£ + 11
Rpf + 20 Not

Ep =
5nA t 10K Bt 20sec

I =
NA th Bt Nc

L ( NA ,
N B
.
N c ,
X ,
M ) = 10kg2 t 11N pit 20%2 -

✗ ( 5N At 10K Bt 20sec
-

Ep ) -

N (NA t RB + Nc -

1)

partial derivatives to zero

obtain and set all

;d÷ ;J÷ J÷ ;d÷

ie :
Ina
0 = 0 = 0 : = 0 = 0
=

to these
through the solution equations we can

minimum
obtain the variance
portfolio for 3 assets

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BENEFITS OF DIVERSIFICATION

eliminate the
By diversifying we can
unsystematic
risk in the portfolio .

V =

In N÷I,
+

where T and I variance and

average
are
average
covariance

that individual
,Iy indicating
As N → so
→ o
,

risk of securities can be diversified and portfolio

variance to covariance
converges average
In case all assets are coidepandant then

N -
I
c-
also becomes zero hence it is possible
a-
eliminate risk from the
portfolio
to
completely .

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