Harry Markowitz Model

Harry Markowitz put forward this model in 1952. It assists in the selection of the most efficient portfolios of the given securities. By choosing securities that do not 'move' exactly together, the HM model shows investors how to reduce their risk. The HM model is also called Mean-Variance Model due to the fact that it is based on expected returns (mean) and the standard deviation (variance) of the various portfolios

Assumptions
Harry Markowitz made the following assumptions while developing the HM model: Risk of a portfolio is based on the variability of returns from the said portfolio. An investor is risk averse. An investor prefers to increase consumption. The investor's utility function is concave and increasing, due to his risk aversion and consumption preference.

Assumptions Contd.

Analysis is based on single period model of investment. An investor either maximizes his portfolio return for a given level of risk or minimizes risk for a given return. An investor is rational in nature.

Selection Process
To choose the best portfolio from a number of possible portfolios, each with different return and risk, two separate decisions are to be made:
1. Determination of a set of efficient portfolios. 2. Selection of the best portfolio out of the efficient set.

Determining the Efficient Set

A portfolio that gives maximum return for a given risk, or minimum risk for a given return is an efficient portfolio. Thus, portfolios are selected as follows:
a. From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and b. From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of return.

Effecient Frontier
The shaded area ,PVWP includes all the possible securities an investor can invest in. The efficient portfolios are the ones that lie on the boundary of PQVW All the portfolios that lie on the boundary of PQVW are efficient portfolios for a given risk level At Risk level x2, S is called the effecient protfolio , as it has the highest return y2 compared to T and U .

Risk-Return of Possible Portfolios

Selecting Optimal Portfolio

All portfolios that lie below the Efficient Frontier the return would be lower for the given risk. Portfolios that lie to the right of the Efficient Frontier contain higher risk for a given rate of return. An investor who is highly risk averse will hold a portfolio on the lower left hand of the frontier, an investor who isnt too risk averse will choose a portfolio on the upper portion of the frontier

Risk-return of possible portfolio

Investors Indifference Curves

Each points on a particular indifference curve shows a different combination of risk and return, which provide the same satisfaction to the investors.

Each curve to the left represents higher utility or satisfaction The goal of the investor is to maximize his satisfaction by moving to a curve that is higher at any point of time, an investor will be indifferent between combinations S1 and S2, or S5 and S6 . Risk-Return Indifference Curves

Optimul Portfolio
The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the indifference curve This point marks the highest level of satisfaction the investor can obtain. R is the point where the efficient frontier is tangent to indifference curve C3, With this portfolio, the investor will get highest satisfaction as well as best risk-return combination X is out of effecient frontier Y is not on the highest IC

Combination of Risk-free Securities

R1 is the risk-free return, R1PX is drawn so that it is tangent to the efficient frontier Any point on the line R1PX shows a combination of different proportions of risk-free securities and efficient portfolios The satisfaction an investor obtains from portfolios on the line R1PX is more than the satisfaction obtained from the portfolio P. All portfolio combinations to the left of P show combinations of risky and risk-free assets, and all those to the right of P represent purchases of risky assets made with funds borrowed at the risk-free rate. R1PX is known as the Capital Market Line (CML).

The Combination of Risk-Free Securities with the Efficient Frontier and CML

Capital Market Line

The CML represents the risk-return trade off in the capital market. The CML is an upward sloping curve, which means that the investor will take higher risk if the return of the portfolio is also higher. The portfolio P is the most efficient portfolio, as it lies on both the CML and Efficient Frontier, and every investor would prefer to attain this portfolio, P. The P portfolio is known as the Market Portfolio and is also the most diversified portfolio. It consists of all shares and other securities in the capital market.

Capital Market Line Ch.

In the market for portfolios that consists of risky and risk-free securities, the CML represents the equilibrium condition. The Capital Market Line says that the return from a portfolio is the risk-free rate plus risk premium. Risk premium is the product of the market price of risk and the quantity of risk, and the risk is the standard deviation of the portfolio. The CML equation is : RP = IRF + (RM - IRF)P/M Where, RP = Expected Return of Portfolio RM = Return on the Market Portfolio IRF = Risk-Free rate of interest M = Standard Deviation of the market portfolio P = Standard Deviation of portfolio

The Characteristic Features of CML

1. At the tangent point, i.e. Portfolio P, is the optimum combination of risky investments and the market portfolio. 2. Only efficient portfolios that consist of risk free investments and the market portfolio P lie on the CML. 3. CML is always upward sloping as the price of risk has to be positive. A rational investor will not invest unless he knows he will be compensated for that risk.

Capital Market Line (CML)

CML Vs. SML

Shows the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio standard deviation is the measure of risk in CML Graphs define efficient portfolios Market portfolio and risk free assets are determined by the CML

Security Market Line (SML)

a graphical representation of the markets risk and return at a given time Beta coefficient determines the risk factors of the SML. Graphs define both efficient and non-efficient portfolios. all security factors are determined by the SML.