The Quarterly Review of Economics and Finance

44 (2004) 337361
The mathematics of the portfolio frontier:
a geometry-based approach

Avi Bick

Faculty of Business Administration, Simon Fraser University, Burnaby, BC, Canada V5A 1S6
Received 24 April 2003; accepted 28 April 2003
Abstract
The mathematics of the portfolio frontier and the Capital Asset Pricing Model (CAPM) are derived
by using Analytical Geometry as the point of departure. The paper provides the Analytical Geometry
theorem which is the analog of the CAPM relationship between frontier portfolios.
2003 Board of Trustees of the University of Illinois. All rights reserved.
JEL classication: G11, G12
Keywords: Mean-variance; Portfolio frontier; Capital Asset Pricing Model
1. Introduction
Markowitzs (1952) and Tobins (1958) theory of portfolio selection is one of the most
important pillars of Financial Economics. Built on this theory is the celebrated Capital Asset
Pricing Model (CAPM), developed by Sharpe (1964), Lintner (1985), and Mossin (1966).
1
Roughly speaking, the model says that investors are compensated on the average for taking risk.
The CAPM equation relates the expected rate of return of a security to its risk, as measured
by its beta, which is the (normalized) covariance of two random variables: the return of the
given security and the return of the market portfolio.
This work is a self-contained expository paper on the basics of Portfolio Theory. At the
same time, this is also a research paper because it contributes at the foundational level by

Further details of the mathematics can be found at. http://www.bus.sfu.ca/homes/avi b/Bick papers.htm.

Tel.: +1-604-291-3748; fax: +1-604-291-4920.

E-mail address: bick@sfu.ca (A. Bick).
1062-9769/$ see front matter 2003 Board of Trustees of the University of Illinois. All rights reserved.
doi:10.1016/j.qref.2003.04.001
338 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
demonstrating that the celebrated CAPM equation is based on a result of Analytical Geometry.
Thus the Fundamental Theorem of Portfolio Theory (in our terminology), which entails the
CAPM equation, is just a translation of an Analytical Geometry theorem into the setting of
portfolio selection.
The geometric aspects of portfolio selection, developed in Merton (1972), Gonzales-Gaverra
(1973), Roll (1977) and in numerous other works, are well-known.
2
However, in this literature
the geometry is always interpreted as a representation of the portfolio selection problem. In
contrast, our exposition will be based on compartmentalization of the geometry and the
required matrix algebra. The paper is aimed at readers who appreciate an approach where the
underlying pure-mathematics structure is made transparent before any applications.
The paper is organized as follows: Section 2 presents Analytical Geometry results. Section 3
contains the matrix algebra tools that we need later. In Section 4 we discuss the mean-variance
portfolio selection problem, where the goal is to identify the portfolio frontier, namely those
portfolios with minimal variance among all portfolios with the same expected return. Properties
of the portfolio frontier are discussed in Section 5. This is just a repetition of the results from
Section 3 in the setting of Section 4. In Section 6, we combine these results with the Slope
Comparison Theorem from Section 2, and derive the Fundamental Theorem of Portfolio
Theory, which is (in relation to the historical development) the CAPM equation without as-
suming an equilibrium. Sections 79 discuss important special cases. Section 10 discusses the
connection between the previous results and market equilibrium. Section 11 is a short summary.
2. The geometric results
Consider the conic section in the -plane, given by

2
= k
2
[( )
2
+b
2
], (1)
where k > 0, b 0 and R are given parameters. If b > 0, the equation can be written in
standard form as

2
k
2
b
2

( )
2
b
2
= 1, (2)
and it represents a hyperbola. We also allow b = 0 in (1), in which case the equation
2
=
k
2
( )
2
represents two lines intersecting at (0, ). Later in the paper and denote standard
deviation of return and expected return, respectively, and therefore we restrict our attention to
the half-plane 0. Hence Eq. (1) denes a function : R [0, ). (We will use the same
notation for the -coordinate and the function () = (; k
2
, b
2
, ), but the meaning will be
clear from the context.) This function has a a minimum at = , and the minimal value is
( ) = kb. Thus () = 0 only if b = 0 and = , otherwise () > 0. It actually makes
more sense to represent the graph in the -plane, but in most of the nance literature on the
subject this is done in the -plane, and we will follow this custom here. This is not essential.
With the given parameters, dene C : R R R as follows:
C(, ) := C(, ; k
2
, b
2
, ) := k
2
[( )( ) +b
2
]. (3)
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 339
We note that C satises, for , ,
1
,
2
, R
C(, ) =
2
(), (4)
C(
1
+(1 )
2
, ) = C(
1
, ) +(1 )C(
2
, ), (5)
C(, ) = C(, ), [C(, )]
2

2
()
2
(), (6)
C(, ) = k
2
b
2
=
2
( ). (7)
The inequality in (6) is a matter of simple algebra, using (1) and (3). The rest is straightforward.
Property (5), which is satised in both variables, means, as a matter of terminology, that C is a
biafne map.
One can then dene : R R R as follows: (, ) = 0 if C(, ) = 0, otherwise
(, ) :=
C(, )
()()
. (8)
In light of (6), this is well-dened and 1 1. We add parenthetically, although it is not
used at the formal development at this stage, that later in the paper C(, ) will represent the
covariance between two frontier portfolios with expected returns and , respectively, and
will be the correlation coefcient.
Next, dene Z : R \ { } R via
C(, Z()) = 0. (9)
That is, for = ,
Z() := Z(; , b
2
) :=
b
2

. (10)
If b > 0 then clearly
Z(Z()) = . (11)
We note in this case that > if and only if Z() < , if and only if > Z(). We also
obtain, by simple algebra,

2
() = k
2
( )( Z()), (12)

2
(Z()) = k
2
(Z() )(Z() ), (13)
where (13) is obtained from (12) by replacing by Z(). In the case b = 0 we have that
Z() = for each = , and the two previous equations clearly remain correct.
Later in the paper C(, ) will be given in the form
C(, ) = (, 1)

, (14)
where is a given 2 2 symmetric nonnegative denite matrix with
11
> 0. Then
C(, ) =
11
+
12
( +) +
22
= k
2
[( )( ) +b
2
], (15)
340 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
where
:=

12

11
, k
2
:=
11
> 0, (16)
b
2
:=

11

22

2
12

2
11
=
det()

2
11
0. (17)
Substituting (16) and (17) in Eq. (10) gives, for = ,
Z() =

12
+
22

11
+
12
. (18)
The geometric meaning of Z is as follows: If b = 0, Z() = for each , and Z() is the
intersection of the lines (1) with the -axis. If b = 0, this is true for the tangent line:
Proposition 2.1. Fix k > 0 and R.
(a) Suppose b > 0 and let = . Then the straight line through (0, Z()) and ((), ) is
tangent to the hyperbola (1) at ((), ).
(b) Equivalently, suppose b > 0 and let r = . Then the straight line through (0, r) and
((Z(r)), Z(r)) is tangent to the hyperbola (1) at ((Z(r)), Z(r)). In this case the tangency
point is on the upper arc of the hyperbola, namely Z(r) > , if and only if r < .
Proof (outline). In part (a), apply elementary Calculus. Part (b) follows from the fact that if
r = Z() then = Z(r). The second statement in (b) is clear.
The main result of this section is this:
3
Theorm 2.2 (Slope Comparison Theorem). Fix k > 0, b 0 and R. Then
(a) For each R and = ,
Z() =
C(, )

2
()
( Z()). (19)
(b) Suppose b > 0. Then (19) is equivalent to the property that for each R and r = ,
r =
C(, Z(r))

2
(Z(r))
(Z(r) r), (20)
which can also be written as
r
()
= (, Z(r))
Z(r) r
(Z(r))
. (21)
To state it in geometric terms: Consider the tangent line to the hyperbola (1) through (0, r) for
any r = . Then the tangency point is ((Z(r)), Z(r)), and Eq. (21) says:
Slope of line connecting (0, r) to an arbitrary hyperbola point ((), )
= (, Z(r)) Slope of line through (0, r) tangent to the hyperbola
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 341
(0,r )
0
0
((),)

((Z (r ),Z (r ))

Fig. 1.
Proof. Write = + (1 )Z() where = ( Z())/( Z()). Expand C(, )
as in (5) and use (7) and (9). This will give (19). Applying this equation with r = Z() and
= Z(r) gives Eqs. (20) and (21). The verbal equation at the end is just a restatement of
(21), combined with the geometric interpretation in Proposition 2.1 (see Fig. 1).
The next proposition, which is a slight generalization of Proposition 2.1, is needed only in
Section 9 and may be skipped for now:
Proposition 2.3. Fix k > 0, b > 0 and R. Let r R and let
2
:= k
2
b
2
/[( r)
2
+b
2
].
(a) For each R,

2
( r)
2
k
2
[( )
2
+b
2
]. (22)
This is a relationship between a hyperbola and a reected line, which can also be expressed
as

2
(;
2
, 0, r)
2
(; k
2
, b
2
, ). (23)
(b) If r = , equality holds in (22) only at = Z(r; b
2
, ). This is where the reected line is
tangent to the hyperbola.
(c) If r = , i.e.
2
= k
2
, then strict inequality holds in (22) for each , and the two half-lines
which constitute the graph of
2
(;
2
, 0, r) are asymptotic to the hyperbola corresponding
to
2
(; k
2
, b
2
, ).
342 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
Proof (outline). To prove (22), move everything in this inequality to the right-hand side and nd
the minimum of a quadratic function. If r = , this minimum is at the point = Z(r; b
2
, )
where the quadratic function is equal to zero. If r = , the above quadratic function reduces
to a positive constant. The formula for the asymptotes of a hyperbola is well known. In our
notation this is
2
= k
2
( r)
2
. This concludes the proof.
We should also mention, although this is not needed as a part of the formal argument, that

2
was found from

(Z(r) r)
(Z(r))

2
=
( r)
2
+b
2
k
2
b
2
, (24)
where the functions and Z are evaluated with parameters (k
2
, b
2
, ). (Use Eqs. (10) and
(13) to substitute Z(r) and
2
(Z(r)), respectively.) In light of Proposition 2.1, the left-hand
side is the squared slope of the tangent line to the hyperbola (1) through (0, r), provided that
r = .
3. Some matrix algebra preparations
In this section we will summarize some results on matrix inversion by partitioning. Material
on this topic can be found in Faddeev and Faddeeva (1963), Section 24 or Zhang (1999) Section
2.2.
4,5
In these texts it is assumed that the upper-left block (V below) is invertible, but we also
need the case when this is not necessarily satised.
Proposotion 3.1. Let Q and A be (n + m) (n + m) symmetric matrices such that Q has a
zero mm bottom-right submatrix. That is, they can be partitioned in the form
Q =

V Y
Y

, A =

, (25)
where V, R
nn
and Y, R
nm
. (The bottom-right mm submatrix of A is denoted
for convenience. Prime denotes transposition.) Then
(a) A = Q
1
if and only if

I
n
0
0 I
m

= QA =

V+Y

VY
Y

, (26)
where I
j
is the j j identity matrix. In particular:
V = Y, (27)

V = . (28)
(b) Suppose V is invertible, and so is := Y

V
1
Y. Then Q is invertible and
Q
1
=

V
1
(I
n
YY

V
1
) V
1
Y
Y

V
1

, (29)
where =
1
.
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 343
Proof. The second equality in (26) is a result of block multiplication. Eq. (27) is the upper-right
block equality in (26). To obtain (28), left-multiply (27) by

and use the bottom-right equality

in (26).
Under the additional assumptions of part (b), Eq. (27) becomes = V
1
Y. The next
step in specifying Q
1
is to use the upper-left block equality in (26) and conclude that =
V
1
(I
n
YY

V
1
). Nowall that is left to do is to nd . The equality in the bottom-left block
of (26) translates to
0 = Y

= Y

V
1
Y

V
1
YY

V
1
= Y

V
1
Y

V
1
. (30)
This is satised if =
1
.
Corollary 3.2. Suppose Q, V and Y are matrices as in (25). If V is positive denite and Y is of
rank m, then := Y

V
1
Y is positive denite. Therefore the conditions (and hence the result)
of part (b) of Proposition 3.1 are satised. That is, Q
1
exists and is given by (29).
Proof. If V is positive denite, it also has a positive denite inverse V
1
. Now it is an easy
exercise to show that is also positive denite. (Or see Theorem 4.2.1 in Golub and Van Loan
(1996).) Hence is invertible, and the conclusion follows.
Two other results, for the case m = 2, are needed later:
Corollary 3.3. With notation as in Proposition 3.1, assume that A = Q
1
and that V is
nonnegative denite. Then is also nonnegative denite. If is 2 2, this entails that either

11
> 0 or
11
=
12
= 0.
Proof. The fact that is nonnegative denite is immediate from(28). The rest is true in general
for a 2 2 symmetric nonnegative denite matrix . Indeed, for each R,
0 (, 1)(, 1)

=
11

2
+2
12
+
22
, (31)
which clearly entails the desired conclusion.
Proposition 3.4. Suppose Q is an (n +2) (n +2) symmetric matrix of the form
Q =

V (E, 1)
(E, 1)

, (32)
where V R
nn
and E, 1 R
n
. Assume that Q is invertible. As a matter of notation, assume
that Q
1
= A is partitioned as in (25). Dene, for each R,
w() :=

R
n
, (33)
where is as in (25). Then
(a) w is an afne function. That is, if =
1
+(1 )
2
where
1
,
2
, R, then
w() = w(
1
) +(1 )w(
2
). (34)
344 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
(b) For , R
w()

E = , w()

1 = 1, (35)
Vw() = (E, 1)

= (
11
+
12
)E +(
12
+
22
)1, (36)
w()

Vw() = (, 1)

. (37)
(c) For R and x R
n
such that 1

x = 1,
x

Vw() = (x

E, 1)

= w(x

E)

Vw(), (38)
x

Vw(x

E) = w(x

E)

Vw(x

E). (39)
(d) If in addition, V is nonnegative denite, then
w(x

E)

Vw(x

E) x

Vx. (40)
Proof. Part (a) is straightforward. To prove part (b), we combine the denition (33) and the
bottom-right equality in (26) (with Y = (E, 1)), obtaining
w()

(E, 1) = (, 1)

(E, 1) = (, 1). (41)

Eq. (36) follows from (27) and (33). Eq. (37) follows from (35) and (36). Eq. (38) follows from
(36) and (37). Eq. (39) is a special case of (38) which we need. To prove part (d), open the
brackets in
(x w(x

E))

V(x w(x

E)) 0, (42)
and apply (39).
4. The minimum-variance frontier
We now turn to the problem of identifying the minimum-variance frontier. We are given
n 2 securities (investments), which are to be held over a given period, say between time
0 and time 1. A portfolio of these n securities is identied with a column vector w =
(w
1
, . . . , w
n
)

W
n
, where prime denotes transposition and W
n
:=

w R
n
;

i
w
i
= 1

.
The w
i
s represent the proportions of wealth invested in securities i = 1, . . . , n, and they are
allowed to be negative (representing a short position) or above 1. If w, x W
n
, R, then
clearly the afne combination w +(1 )x is also in W
n
. In words, a portfolio of portfolios
is a portfolio in the original securities.
The n securities are characterized by a column vector of expected returns (or mean returns)
over the period, E = (E
1
, . . . , E
n
)

R
n
and by an n n covariance matrix of the returns,
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 345
denoted V, which is symmetric and nonnegative denite. The expected return of a portfolio
w W
n
is w

E. The covariance between portfolios w, x W

n
is w

Vx, and the variance of

w is w

Vw. For our purpose, all this can be taken as a denition. We say that w and x are
uncorrelated (or orthogonal) if w

Vx = 0.
A more detailed background, which is mostly not needed in the sequel, is this: Ownership
of securities is represented by shares, which are traded at time 0 (without transaction costs,
in our setting). Let P
j,1
be the time-1 price of one share of security j {1, . . . , n}. We may
assume that securities do not pay dividends or other payouts, or alternatively, that P
j,1
already
includes dividends reinvested in security j. The rate of return (return, for short) of security
j is R
j
:= (P
j,1
P
j,0
)/P
j,0
, where P
j,0
is the time-0 price. Prices are specied in some units
of account, say dollars. Let R := (R
1
, . . . , R
n
)

. We regard time-0 prices as given, and we

model uncertainty at time 1 by assigning a joint probability distribution to (P
1,1
, . . . , P
n,1
).
(We allow the possibility that one of these securities is riskless, namely that its time-1 price is
deterministic.) Thus R becomes an R
n
-valued random variable, and by denition,
E := E[R] R
n
, V := E[(R E)(R E)

] R
nn
, (43)
where E denotes the expectation (mean) operator with the appropriate dimensionality. Thus
E
j
:= E[R
j
], j = 1,. . . ,n, is the expected return of security j. The (i, j) component of the
covariance matrix V is V
i,j
:= Cov(R
i
, R
j
) := E[(R
i
E
i
)(R
j
E
j
)], assuming that these are
nite numbers. In particular V
i,i
:= Var(R
i
) := Cov(R
i
, R
i
). For each portfolio w W
n
, its
return over the period is the random variable R
w
:= w

R which has mean E[R

w
] = w

E. The
covariance between the returns of portfolios w, x W
n
(the covariance between w and x, for
short) is
Cov(R
w
, R
x
) = E[(w

R w

E)(R

x E

x)] = w

Vx. (44)
The variance of portfolio w is Cov(R
w
, R
w
) = E[(w

Rw

E)
2
] = w

Vw, and this also proves

that the matrix V is nonnegative denite.
Our goal is to identify the minimum-variance portfolios. That is, for each R we wish to
nd the portfolio with minimal variance for that level of expected return. We may envision
a nancial advisor who has many clients, all of whom have the same beliefs and prefer higher
mean and lower variance of return. While the tradeoff between expected return and variance
may vary among these clients, the advisor wishes to present to all of them a reduced menu of
only those portfolios that make sense. This is the mean-variance frontier, or the portfolio
frontier, as this set, or its representation in the mean-standard deviation plane, is often called
in the literature. As we shall see below, only the upper portion of this set contains portfolios
which are candidates for optimal mean-variance selection.
Portfolio selection can be narrowed down further by solving for a single portfolio which is
optimal for a given individual. Mathematically, an individuals preferences can be represented
by a utility function of the form U(, ) which is maximized over a given set in R
2
. Typically
it assumed that U is suitably smooth and is decreasing in and increasing in . For example,
Best and Grauer (1990) take U(, ) = t
2
/2, where t is a risk tolerance parameter. The
minimum-variance frontier can then be found as a second step by varying the parameter t. See
also the Bodie, Kane, and Marcus (1999) textbook, which uses this utility function in some
346 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
simple cases (e.g., two stocks). However, in this paper we will not go into the individuals
optimization problem and the focus is solely on identifying the whole minimum-variance
frontier.
Mathematically, following Merton (1972),
6
we wish to solve, for any given R,
Problem(, E, V) : min
wR
n
1
2
w

Vw, (45)
s.t. w

E = , w

1 = 1, (46)
where 1 = (1, . . . , 1)

. To solve that, we use the Lagrangian

L =
1
2
w

Vw +
1
( w

E) +
2
(1 w

1). (47)
The standard procedure of differentiating Lwith respect to w
1
, . . . , w
n
,
1
and
2
and equating
these derivatives to zero gives n + 2 equations in n + 2 unknowns. In matrix notation, the
following system is obtained.

V E 1
E

0 0
1

0 0

, (48)
where on the right-hand side 0 R
n
. Denote the (n +2) (n +2) matrix on the left-hand side
by Q.
The assumptions that we need are as follows:
(A.1) The matrix V is symmetric and nonnegative denite.
(A.2) The matrix Q from (48) in invertible. As a matter of notation, assume that Q
1
= A is
partitioned as in (25).
(A.3)
11
from (25) is positive.
Condition (A.1) is our standing assumption. Conditions (A.2)(A.3) will be corollaries of
other conditions later in the paper, but at this point we regard them as assumptions. Note that
(A.2) implies that E is not a multiple of 1. If E is a multiple of 1, say E = 1, then all portfolios
have the same expected return , and Problem (, E, V) can be solved only for = . This
is the case of a one-point frontier. Also note that assumption (A.3) rules out the possibility
that (, 1)(, 1)

, interpreted below as variance, does not depend on . (See Corollary 3.3.)

This is the case of a vertical-line frontier. In this paper we will not elaborate on these two
cases.
Assuming (A.1)(A.3), we obtain

= Q
1

, (49)
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 347
where the secondequalityis a matter of notation. The minimum-variance portfoliowithexpected
return is:
w() = w(; E, V) =

. (50)
Proposition 3.4 lists properties of this function. In particular, the covariance between two
minimum-variance portfolios is
C(, ) := w()

Vw() = (, 1)

= k
2
[( )( ) +b
2
], (51)
where in the last equality we used the fact that C(, ) is of the form (14), hence it can be
represented as in (15)(17). We can then dene Z as in (10) or (18) relative to the above C. We
can also use (18) and (36) to write, provided that = :
Vw() = (
11
+
12
)(E Z()1). (52)
For the global-minimum portfolio w( ) we have, based on (36), (16) and (17):
Vw( ) =

11

12

2
12

11
1 = k
2
b
2
1. (53)
The variance of a frontier portfolio is
2
()= C(, ). If b = 0, namely det() = 0, then
(51) gives
2
( ) = C( , ) = 0. That is, the portfolio w( ) has zero variance, so that its mean
return is in fact a riskfree rate. In this case Eq. (10) says that, for each = , Z() = ,
and thus Z() is the riskfree rate.
The notation (E, V), k
2
(E, V) and b
2
(E, V) will be used later when we wish to emphasize
the dependence on (E, V) (via ), and likewise we will allow ourselves to switch notation
and write C(, ; E, V),
2
(; E, V) and Z(; E, V) (instead of C(, ; k
2
, b
2
, ) etc., as in
Section 2).
5. Properties of the minimum-variance frontier
We remain in the setting of Section 4. In this section we restate known results, mainly from
Szeg (1980) and Huang and Litzenberger (1998), henceforth H-L.
7
The difference is that our
treatment does not require the explicit solution for the weights vector w, and as a result we do
not need to distinguish between two cases, with or without the riskfree rate. We only assume
that (A.1)(A.3) are satised. In fact, the results were already presented as matrix algebra
propositions, and all that is left to do here is to give the Portfolio Theory interpretation.
The (E, V)-minimum-variance frontier or (E, V)-portfolio frontier is dened as
F
n
(E, V) := {w(; E, V); R} R
n
. (54)
We will also refer to the (E, V)-minimum-variance frontier in the -plane, which is the set
{((; E, V), ); R}. We will abbreviate the terminology or notation when no ambiguity
arises.
348 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
The point (( ), ) represents the global minimum portfolio. (Recall that , k
2
and b
2
are
as in (16) and (17).) We note that for a > 0,
2
( +a) =
2
( a) while +a > a. This
means that w( a) is dominated by w( +a) in the mean-variance sense. In the language of
portfolio theory, it is inefcient. The efcient portfolios are those in {w( + a; a 0)},
represented by the upper portion of the conic section (hyperbola or reected line).
Going back to the matrix algebra work in Section 3, we interpret Proposition 3.4 in the
portfolio selection context:
F
n
is closed under afne combinations. Furthermore, any two arbitrary different elements
span the whole set. This is because, for xed
1
,
2
R,
2
=
1
, any Rcan be written
as =
1
+(1 )
2
where = (
2
)/(
2

1
), and (34) holds.
Eq. (38) gives the covariance between an arbitrary portfolio and an arbitrary frontier portfolio.
It says that if a frontier portfolio w() is xed, then its covariance with any portfolio x is the
same as its covariance with the frontier portfolio with the same mean return as x. This is a
key observation which will enable us (below) to extend the Slope Comparison Theorem to
non-frontier portfolios.
Eq. (39) says that the covariance of any portfolio with the frontier portfolio which has the
same mean return is equal to the variance of the latter.
The inequality in (40) conrms that any frontier portfolio w() has minimal variance com-
pared to all portfolios x with mean return x

E = .
It also follows by right-multiplying (53) by x

that all portfolios x W

n
have the same
covariance with the global-minimum portfolio, and this covariance is necessarily equal to
the variance of the latter portfolio:
x

Vw( ) = k
2
b
2
= w( )

Vw( ). (55)
6. The Fundamental Theorem of Portfolio Theory
We remain in the setting of Section 4, assuming that (A.1)(A.3) hold. Recall that Z is as in
(10) or (18) relative to C from (51).
Proposition 6.1. For every frontier portfolio w() with = there exists a unique frontier
portfolio w() which is uncorrelated with it, namely such that w()

Vw() = 0. This is given

by = Z().
Proof. This is just a restatement of Section 2 results in the portfolio selection setting.
Note. This includes the case b = 0 (that is, det() = 0,
2
( )= 0), where Z() = .
The concept of beta plays a major role in Portfolio Theory and asset pricing models. In
our framework we dene, for x R
n
and y W
n
such that y

Vy > 0,
(x, y) =
x

Vy
y

Vy
. (56)
We obtain:
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 349
Theorm 6.2
8,9
(The Fundamental Theorem of Portfolio Theory).
(a) For any = and x W
n
,
x

E = Z() +(x, w())( Z()). (57)

Equivalently, if x W
n
and y, z F
n
such that y

E = and y

Vz = 0, then
x

E = z

E +(x, y)(y

E z

E). (58)
(b) This is true, in particular, if a riskless portfolio exists (the case b = 0, that is, det() = 0),
whereZ() = z

E = is the riskfree rate.

Proof. Eq. (57) is obtained from Eq. (19), applied to C from (51), with = x

E, and incor-
porating (38). In light of the previous proposition, the equivalence between (57) and (58) is
straightforward, via y = w(), z = w(Z()).
One interpretation (or a sketch of an alternative proof) of Eq. (57) is this: Consider the conic
section {( (), ); R} (a hyperbola or a reected line) corresponding to all the portfolios
generated by x W
n
and w() F
n
. It is inside the n-asset frontier {((), ); R} and it
is tangent to it at the point = . Since they have the same tangent line at this point, it does not
matter if Z() is computed with respect to {( (), ); R} or {((), ); R}. Eq. (57)
is then obtained by applying Eq. (19) (the slope comparison theorem) to {( (), ); R}
at the point = . This will be elaborated upon in Appendix A.
Another interpretation: Recall that we regarded E and V as given and we used them to com-
pute the portfolio frontier. Eq. (58) says that we can go backward and infer E from frontier
portfolios in the following sense: The expected return of each portfolio (equivalently, the ex-
pected return E
j
of each security j {1, . . . , n}) can be calculated from (i) its beta relative
to a reference frontier portfolio, and (ii) the expected returns of this frontier portfolio and its
uncorrelated twin. This is important later in Section 10 when we regard expected returns as
being determined by equilibrium.
7. Special case: n risky securities, V is positive denite
The previous section contains the main results of the paper. The only purpose of this section
is to show how an important special case ts in the previous setting. For better integration with
the next section, we switch notation and write instead of V. (In both special cases is a
positive denite matrix. In this section is equal to V from Section 4, whereas in the next
section is a submatrix of V.)
The assumptions used here are as follows:
(B.1) E is not a multiple of 1. That is, rank (E, 1) = 2.
(B.2) The matrix (denoted V in (45)) is symmetric and positive denite.
This entails that the matrix Q from Section 4 is invertible, as we shall see below, and thus
conditions (A.1)(A.3) from our previous analysis will be satised.
10
350 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
In what follows we will need the notation:
:= (E, 1)

1
(E, 1) =

1
E 1

1
E
1

1
E 1

1
1

, (59)
:= (E, ) := det() = (E

1
E)(1

1
1) (1

1
E)
2
, (60)
r R E
r
:= E r1. (61)
Lemma 7.1. For all r R,
(E, ) = (E
r
, ) := (E

1
E
r
)(1

1
1) (1

1
E
r
)
2
. (62)
Proof (outline). Apply straightforward algebra. Another way to see it: Use matrix Calculus to
show that (d/dr)(E
r
, ) = 0. This implies that (E
r
, ) = (E
0
, ).
After these preparations, let us now compute Q
1
explicitly. In light of Corollary 3.2, is
positive denite and its determinant is positive. This corollary also says that Q is invertible,
and
11
Q
1
=

1
(I
n
(E, 1)(E, 1)

1
)
1
(E, 1)
(E, 1)

, (63)
where
=
1
=
1

1
1 1

1
E
1

1
E E

1
E

. (64)
This means, in particular, that is positive denite. Later we will use the straightforward
relationships

11
+
12
=
1
1

1
E

,
12
+
22
=
1
E

1
E

. (65)
Now that we have , this species the minimum-variance frontier in the -plane as the
hyperbola (1) with the parameters (see (16) and (17))
(E, ) :=
1

1
E
1

1
1
, k
2
(E, ) :=
1

1
1
(E, )
, (66)
b
2
(E, ) :=
(E, )
(1

1
1)
2
. (67)
We also record a relation between these parameters which will be needed later in Section 9. (It
may be skipped for now.)
Lemma 7.2. For each r R,
( r)
2
+b
2
k
2
b
2
= E

1
E
r
. (68)
Proof (outline). from(66) satises r = 1

1
E
r
/1

1
1. Substitute this in the left-hand
side of (68), and also b
2
and k
2
as above, where = (E
r
, ) is now taken from (62).
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 351
We can now rewrite the expressions for C(, ), Z() and w() in this setting. Let us start
with Eq. (51), which gives the covariance between frontier portfolios. Substituting the geometric
parameters from (66) and (67), we can write the last equality in (51) as:
12
C(, ) =
1

1
1

1
E
1

1
1

1
E
1

1
1

+
1
1

1
1
=
1
(1

1
1)
1
{(1

1
E

)(1

1
E

) +}. (69)
The variance of a frontier portfolio is then
2
()= C(, ).
Next, we obtain, for = ,
13
Z(; E, ) =
(1

1
E) E

1
E
(1

1
1) 1

1
E
= +
E

1
E

1
E

, (70)
where the rst equality is a straightforward conversion of (18). The second equality requires
some algebraic manipulation. (Start from the right-hand side.) Another connection between
and Z() is as follows:
(1

1
E

)(1

1
E
Z()
) + = 0. (71)
This is obtained by combining (69) with C(, Z()) = 0.
Finally, we wish to write the expression for the minimum-variance portfolio with expected
return . Left-multiplying Eq. (36) (with V = ) by
1
and combining with (65) gives:
14
w() =
1

1
{(1

1
E

)E +(E

1
E

)1} (72)
Alternatively, if = , we can use (52) and (65) to express w() as
w() =
1
(1

1
E

)
1
E
Z()
=
1
1

1
E
Z()

1
E
Z()
, (73)
where in the second equality we applied (71).
One interpretation of (73) is as follows: For a given r = , substitute = Z(r) and r = Z()
in the equation, so that the formula is
r = w(Z(r)) =
1
1

1
E
r

1
E
r
. (74)
Recall that ((Z(r)), Z(r)) is the intersection point of the hyperbola and the tangent line through
(0, r). The formula identies w(Z(r)), the tangency portfolio relative to (0, r) and thus it
species the minimum-variance frontier as the set of tangency portfolios generated by varying
(0, r) on the -axis.
15
The global-minimum portfolio w( ) is obtained from (74) by taking
r , Z(r) , which gives w( ) =
1
1/(1

1
1) = k
2
b
2

1
1. It can be shown
that this in agreement with (53) and (72).
8. Special case: a riskfree rate exists
Another special case of interest is when one of the securities is riskless, while the other
securities have a positive denite covariance matrix. Here it is convenient to switch notation
352 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
and denote the number of securities by n+1, where n 1. We will write the (n+1)-dimensional
vector of expected returns as
E = (E
1
, . . . , E
n
, E
n+1
)

= (E

S
, R
F
)

, (75)
where E
S
includes only the expected returns of the rst n securities (stocks), and the return of
security n +1, which is riskless (to be formalized in assumption (C.2) below), is denoted R
F
.
Likewise, we will write a portfolio w W
n+1
as w = (w

S
, w
n+1
)

, where w
S
is the column
vector of investments in the stocks, and w
n+1
= 1 1

w
S
is the investment in the riskfree rate.
The assumptions used in this section are as follows:
(C.1) E is not a multiple of 1. (Here 1 R
n+1
.) Equivalently, E
S
= R
F
1. (Here and below,
1 R
n
.)
(C.2) The (n +1) (n +1) covariance matrix V from (45) has an n n upper-left submatrix
which is symmetric and positive denite. The (n + 1)-th row and (n + 1)-th column
of V are zero.
Again, as we shall see below, this entails that the matrixQfrom(48) (an(n+3)(n+3) matrix
in our case) is invertible and that
11
(from (25)) is positive, and thus conditions (A.1)(A.3)
from our previous analysis will be satised.
16
Note that we can express the covariance between
two portfolios x, w W
n+1
as x

Vw = x

S
w
S
.
We denote E := E
S
R
F
1. (In the notation of the previous section, this is E
R
F
relative to
E
S
.) In addition,
:= E

1
E > 0, K :=
1

1
E, (76)
J :=
1
(I
n
EK

) =
1

1
EE

1
, (77)
(E
S
, ) :=
1

1
E
S
1

1
1
, (78)
and we note that
1

K = 0 1

1
E = 0 R
F
= (E
S
, ). (79)
In this sections setting the matrix from (48) becomes
Q =

0 E +R
F
1 1
0

0 R
F
1
E

+R
F
1

R
F
0 0
1

1 0 0

. (80)
The inverse is
Q
1
=

J J1 K R
F
K
1

J 1

J1 1

K 1 +R
F
1

K
K

1
1

1
R
F
R
F
K

1 +R
F
K

1
1
R
F

1
(R
F
)
2

. (81)
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 353
The matrix Q
1
was computed by following the method of Section 3, where blocks are
identied recursively, except that here 4 4 partitions were used. We will not give the details,
but the assertion that the above matrix is the inverse can be veried by multiplying it by Q.
(The reader may need to use the facts that J is symmetric, JE = 0 and K

E = 1.) Admittedly,
inverting Q is not the most economical way of solving the problem, but the intention here is to
present the solution as a special case of (49).
17
Recall that is the bottom-right 2 2 submatrix of Q
1
, and thus (16) and (17), together
with (81), translate to
(E, V) = R
F
, b
2
(E, V) = 0, k
2
(E, V) =
1
=
1
E

1
E
. (82)
The (E, V)-minimum-variance frontier in the -plane is composed of the two half-lines orig-
inating from (0, R
F
) (associated with the portfolio (0, . . . , 0, 1)

), as specied in (1).
Proposition 8.1. For each R, the frontier portfolio which has expected return , namely
the portfolio (w

S
(), w
n+1
())

W
n+1
, is given by
18
w
S
() = ( R
F
)K, w
n+1
() = 1 ( R
F
)1

K. (83)
If = R
F
and x = (x

S
, x
n+1
)

W
n+1
is an arbitrary portfolio, then (restating the Funda-
mental Theorem of Portfolio Theory)
x

S
E = x

E R
F
=
x

S
w
S
()
w
S
()

w
S
()
( R
F
). (84)
Proof. The rst part follows from (50):
w() =

w
S
()
w
n+1
()

K R
F
K
1

K 1 +R
F
1

. (85)
The second part is just a restatement of Theorem 6.2 part (b).
In the Finance literature, Eq. (84) is typically written in the form
E[R
x
] R
F
=
Cov(R
x
, R
p
)
Var(R
p
)
(E[R
p
] R
F
), (86)
where the notation R
x
is as in Section 4, and p := w().
We already sawin the general case in Section 5 that any two different frontier portfolios from
the minimum-variance frontier span the frontier. This applies in this sections setting, with the
frontier F
n+1
(E, V). As it was pointed out by Feldman and Reisman (2003), a computationally
convenient choice is the riskfree rate and the portfolio (in our notation) y = (y

S
, 1 1

y
S
)

,
where y
S
=
1
E. They noted that this is always an efcient portfolio. This corresponds to the
portfolio specied in (83) with the choice = R
F
+. Note that the case 1

y
S
= 0 is not ruled
out. (More on this condition below.)
354 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
9. Comparing portfolio frontiers
We remain in the setting of the previous section, where security n+1 provides a riskless rate
of return R
F
. If n 2, it is interesting to relate the minimum-variance frontier F
n+1
(E, V) to
the set F
n
(E
S
, ) obtained by investing only in the stocks. This is the topic of this section. For
F
n
(E
S
, ) to be non-degenerate, we need to assume now that E
S
is not a multiple of 1. (This
assumption is stronger than (C.1).)
If R
F
= (E
S
, ) (or see (79) for equivalent conditions), we denote

T
:= Z(R
F
; E
S
, ) = R
F
+
E

1
E
1

1
E
= R
F
+
1
1

K
, (87)
where the second equality follows from (70). We call w(
T
; E, V) F
n+1
(E, V) Portfolio T.
The following result is just a translation of Proposition 2.3 from the geometry section:
Proposition 9.1. The parameters of the (E, V)-frontier and the (E
S
, )-frontier are related via
k
2
(E, V) =
1
E

1
E
=
k
2
(E
S
, )b
2
(E
S
, )
( (E
S
, ) R
F
)
2
+b
2
(E
S
, )
, (88)
and hence, for each R,

2
(; E, V)
2
(; E
S
, ). (89)
In addition,
19
(i) If R
F
= (E
S
, ), equality holds only at =
T
. That is, the (E, V)-frontier (a reected
line) is tangent to the(E
S
, )-frontier (a hyperbola) at ((
T
),
T
).
(ii) If R
F
= (E
S
, ), there is strict inequality in (89) for each , and the (E, V)-frontier
is asymptotic to the (E
S
, )-frontier. In this case k
2
:= k
2
(E, V) = k
2
(E
S
, ) and the
(E, V)-frontier is the reected line
2
= k
2
( R
F
)
2
.
Proof. Eq. (88) is a result of (68) and (82), applied to r = R
F
. The rest is just a translation of
Proposition 2.3 to this sections setting. Of course, Eq. (89) can also be explained by comparing
the feasible sets of portfolios of the two optimization problems.
The same result can be rephrased as a statement on portfolio weights:
Proposition 9.2.
(a) If R
F
= (E
S
, ) then w
n+1
() = 1 for all , hence the investments in the stocks in every
(E, V)-frontier portfolio satisfy w

S
1 = 0.
(b) If R
F
= (E
S
, ) then there is a unique solution to w
n+1
(; E, V) = 0, and this is
T
from (87). That is, portfolio T is a pure-stock (E, V)-frontier portfolio. The corresponding
stock investments are
w
S
(
T
; E, V) = (
T
R
F
)K = (1

1
E)
1

1
E. (90)
(c) Assuming that R
F
= (E
S
, ),
w
S
(
T
; E, V) = w(
T
; E
S
, ). (91)
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 355
In words: The n-vector w
T
:= w
S
(
T
; E, V) which describes the stock components of
portfolio T is equal to the solution of the n-security portfolio problem (
T
, E
S
, ). That
is, in the -plane, ((w

T
w
T
)
1/2
,
T
) belongs both to the (E, V)-frontier and to the
(E
S
, )-frontier.
Proof. Again, note the conditions equivalent to R
F
= (E
S
, ), specied in (79). Parts (a)
and (b) of the proposition follow from (83). In Part (c), to see (91), write
w(
T
; E
S
, ) =w(Z(R
F
; E
S
, ); E
S
, )
=
1
1

1
E

1
E = w
S
(
T
; E, V), (92)
where in the second equality we applied (74) (recalling that E = E
R
F
) and in the third equality
we used (90).
10. The connection to equilibrium
The above results were derived from the point of view of one individual who computes the
portfolio frontier. They do not require any assumptions on the beliefs or risk preferences of
other market participants. In addition, securities 1, . . . , n (in the notation of Section 4) may
potentially constitute a subset of all securities which are available. We simply need to interpret
W
n
as all portfolios of securities 1, . . . , n instead of all possible portfolios, and likewise
for F
n
. This was evident in the previous section where two different portfolio frontiers were
compared.
The distinction between Portfolio Theory and asset pricing theories, like the celebrated Cap-
ital Asset Pricing Model, is that the latter are concerned with aggregate demand by all investors
and infer equilibrium relationships (to be elaborated upon below) between expected returns
and risk characteristics. Such theories typically require assumptions on all market participants
or on a representative individual.
Let us start by assuming a general setting as in Section 4, with n securities which may or may
not include a riskfree security. Assume, in addition, that these are all the securities in the market.
For each security j, let M
j
:=

N
j
P
j,0
, where

N
j
is the number of outstanding shares and P
j,0
is the time-0 price. This is the aggregate value of security j in units of account (dollars). Let

M :=

j
M
j
and m
j
:= M
j
/

M. Then m := (m
1
, . . . , m
n
)

is called the market portfolio.

This was the supply side. Let us now look at the demand for securities. We assume that
there are I individuals, denoted i = 1, . . . , I, who invest for the same time horizon and have
the same beliefs. (That is, they believe in the same (E, V).) Note that in the portfolio problem
(, E, V), formulated in Section 4, the goal is to identify the minimum-variance frontier, but
this does not specify how each individual makes his specic choice. We will not elaborate on
this here. For further details on individual portfolio choice and its connection to mean-variance
portfolio selection, see Levy and Markowitz (1979), Ingersoll (1987), Meyer and Rasche (1992),
Constantinides and Malliaris (1995), Berk (1997) and references therein. For our purposes we
will simply regard it as an assumption that the optimal portfolio of each individual i is a frontier
portfolio w(
i
) which is strictly efcient, i.e.,
i
> (E, V).
356 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
Let W
i
> 0 be the time-0 value (wealth, measured in dollars) of individual is portfo-
lio, and let

W :=

i
W
i
. Individual i wishes to hold w
j
(
i
)W
i
dollars worth of security j,
and the sum over all individuals (the aggregate demand) is D
j
:=

I
i=1
w
j
(
i
)W
i
dollars.
Clearly

j
D
j
=

W. The aggregate demand portfolio d W
n
is dened by d
j
:= D
j
/

W.
Then
d =
I

i=1

W
i

w(
i
) = w

i=1

W
i

. (93)
(For the second equality, see Proposition 6.1). As a convex combination,

i
(W
i
/

W)
i
is also
larger than (E, V), and we conclude that d is also a strictly-efcient frontier portfolio.
We now turn to the concept of equilibrium. For our purposes, this market is at equilibrium if
M
j
= D
j
for each j. (For a more detailed denition of equilibrium, which is beyond what we
need here, see Appendix B.) This implies that

M =

W, and that m = d. Thus an equilibrium
assumption boils down to the fact that the market portfolio is equal to the aggregate demand
portfolio. The latter is a strictly-efcient frontier portfolio, and thus the Fundamental Theorem
of Portfolio Theory is valid when the market portfolio is used as the reference frontier port-
folio. Mathematically, this means that we can write the market portfolio as a frontier portfolio
of the form m = w(
m
), where
m
is its expected return, and then we can restate Theo-
rem 6.2 with =
m
. (At the same time, the theorem remains correct for any other frontier
portfolios !)
More specically, in the setting of Section 7, without a riskfree rate, Eq. (57) implies that,
in equilibrium,
x

E = Z(
m
) +
x

Vm
m

Vm
(
m
Z(
m
)). (94)
This is the main result of Blacks (1972) zero-beta model.
20
It says that for an arbitrary
portfolio x,
Expected return of portfolio x
= Expected return of the frontier portfolio z uncorrelated with the market portfolio m
+(x, m) Difference between expected returns of z and m
(See (56) for the denition of .)
In the setting of Section 8, let us introduce the additional assumption that the riskfree rate
(security n +1) has zero net supply. That is, M
n+1
= 0, which means that individuals lend and
borrow between themselves. Thus equilibrium in this setting boils down to the assertion that
the market portfolio is an efcient frontier portfolio which is a pure-stock portfolio. If n 2,
it means that the tangency portfolio T from Section 9 is equal to the market portfolio, and it
is efcient. The latter property is possible only if R
F
< (E
S
, ). Eq. (57) implies that, in
equilibrium,
x

E = R
F
+
x

Vm
m

Vm
(
m
R
F
). (95)
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 357
This is the main result of the Sharpe-Lintner-Mossin Capital Asset Pricing Model.
21
It says that
for an arbitrary portfolio x,
Expected return of x
= R
F
+(x, m) Difference between expected return of the
market portfolio and the riskfree rate.
11. Summary
We have developed a geometry-rst approach to derive the mathematics of the portfolio
frontier and the CAPM.
Notes
1. See also Sharpes (1991) summary.
2. See also Szeg (1980), Ingersoll (1987), Huang and Litzenberger (1998) and
Constantinides and Malliaris (1995).
3. The theorems title is suggested by the author.
4. Note a typographical error in the F&F text, middle of p. 162: a negative sign should
come before A
1
BN.
5. In the Portfolio Theory literature, Szeg (1980) uses this method, but with a different
matrix. See his Appendix E.
6. Textbook coverage is available in Szeg (1980), Ingersoll (1987), Huang and
Litzenberger (1998) and Cochrane (2001). See also Sections 1.1 and 1.2 in Steinbach
(2001). Our matrix representation below is similar (albeit not in the same order of
rows) to the one in Steinbachs paper. For alternative approaches, see Elton, Gruber,
and Padberg (1976), Best and Grauer (1990) and Ttnc (2001). Benninga and
Czaczkes (2000) provide spreadsheet calculation methods in addition to theory.
7. Our w, V (or ), E, 1,
1
,
2
, , Z(), E

1
E, 1

1
E, 1

1
1, , R
F
, E and
correspond to Szegs x, V, r, e,
1
,
2
, ,
0
, , , ,
2
, , d and d

V
1
d,
respectively, and to H-Ls w, V, e, 1, , , E[ r
p
], E[ r
zc(p)
], B, A, C, D, r
f
, e r
f
1 and
H, respectively.
8. The theorems title is suggested by the author and is not a universally-used name.
9. The result is parallel to Eqs. (3.16.2) and (3.19.1) in H-L and to Propositions 3 and 4
in the appendix to Chapter 9 in Benninga and Czaczkes (2000). A short proof for part
(b) also appears in Feldman and Reisman (2003).
10. See also Szeg (1980), Appendix C, on the connection between assumptions (B.1) and
(B.2) and invertibility of Q.
11. This is consistent with the solution in H-L, Section 3.9 and with Theorem 1.5 in
Steinbach (2001).
12. This is parallel to Eq. (4.4) in Szeg (1980) and Eq. (3.11.1) in H-L.
13. The rst equality corresponds to Eq. (4.24) in Szeg (1980) and Eq. (3.14.2) in H-L.
The second equality is parallel to Eq. (4.30) in Szegs book.
358 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
14. This is parallel to Szegs Eq. (2.9). To compare to H-Ls results, pp. 6465: w(0) is
their g and w(1) is their g +h.
15. This corresponds to Proposition 1 in the appendix to Chapter 9 in Benninga and
Czaczkes (2000).
16. See also Szeg (1980), Appendix F, on the connection between assumptions (C.1) and
(C.2) and invertibility of Q.
17. See Szeg (1980), H-Lor Steinbach (2001) for a direct approach of solving the Problem
(, E, V) in the presence of a riskfree rate. Our Q
1
is consistent with the solution in
Theorem 1.8 in Steinbachs paper.
18. Eq. (83) coincides, after some algebra, with Eqs. (6.10) and (6.11) in Szeg (1980).
19. This part is parallel to Theorem (6.54) in Szegs book (where his

corresponds to
our
T
) and to discussion in H-L, Section 3.18. For the graphs, see Szegs Figure 6.4
or H-L Figures. 3.18.13.18.3.
20. See also Ingersoll (1987) pp. 9295, H-L Section 4.11.
21. See also Ingersoll (1987) pp. 9295, H-L Section 4.13.
Appendix A
In this appendix we briey outline an alternative proof of Eq. (57) (the fundamental theorem
of portfolio theory), which provides additional insights regarding the connection to the slope
comparison theorem.
Fix x W
n
and w(
0
) F
n
for some
0
= . We will prove (57) for this x and for =
0
,
limiting ourselves to the case x

E =
0
. Dene a biafne map

C : R R R via

C(
0
,
0
) := w(
0
)

Vw(
0
) = C(
0
,
0
), (A.1)

C(x

E, x

E) := x

Vx,

C(x

E,
0
) := x

Vw(
0
), (A.2)
which is then extended as in (5) in both variables. Dene
2
() :=

C(, ) for any R.
This is the variance of the portfolio with mean which is spanned by x and w(
0
). That is, one
can verify that
x

E +(1 )
0
= {x +(1 )w(
0
)}

V{x +(1 )w(

0
)} =
2
().
Thus the portfolios spanned by afne combinations of x and w(
0
) generate the conic section
() (a hyperbola or a reected line) in the -plane, and the corresponding biafne map is

C(, ).
Applying Eq. (19) (the slope comparison theorem) to

C(, ), evaluated at = x

E and
=
0
, we obtain
x

E

Z(
0
) =

C(x

E,
0
)

C(
0
,
0
)
(
0


Z(
0
)). (A.3)
where

Z is dened as in Section 2 with respect to

C. In light of (A.1) and (A.2), this translates
to Eq. (57), provided that we show that

Z(
0
) = Z(
0
).
A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361 359
Indeed, because of the optimality of the n-security frontier, we must have () () for all
. Eq. (A.1) also says that (
0
) = (
0
). Thus at =
0
, the two curves () and () must
have the same tangent line. (This idea appears in the CAPM proof in Jensen (1972).) Recalling
the interpretation of Z as the intercept of a tangent line, we conclude that

Z(
0
) = Z(
0
).
It should be mentioned that this includes the cases that (i) and are hyperbolas, possibly
identical, (ii) and are reected lines, necessarily identical, and (iii) is a reected line and
in a hyperbola.
Appendix B
This appendix, which complements Section 10, will elaborate on the denition of equili-
brium in a mean-variance setting, following Nielsen (1988) with slight modications. Suppose
there are n securities which are traded at time 0 in a frictionless market by I individuals. Assume
that there are

N
j
0 outstanding shares of security j. Individual i is endowed with e
i,j
shares
of security j, and thus

i
e
i,j
=

N
j
for each j.
The uncertainty is modeled by assigning a joint probability distribution to (P
1,1
, . . . , P
n,1
),
the time-1 prices of the n securities. (This includes the possibility that one of the securities is
riskless.) This probability distribution, regarded below as xed, represents the common beliefs
of all individuals. For every possible vector of time-0 prices P
0
= (P
1,0
, . . . , P
n,0
) (announced
by a Walrasian auctioneer), an individual can compute the joint probability distribution of
the R
n
-valued random variable R = R(P
0
), where R
j
= P
j,1
/P
j,0
1 is the return of security
j. This distribution denes the mean-variance parameters as in (43), where now we can regard
the expected returns vector E = E(P
0
) and the covariance matrix V = V(P
0
) as functions
of P
0
.
We assume that individual is portfolio selection problem can be represented as
max
xW
n
U
i
((x

Vx)
1/2
, x

E; W
i
), (B.1)
where U
i
(, ; W
i
) is a suitably smooth function which is decreasing in and increasing in
, and may depend as a parameter on the individuals time-0 wealth W
i
. (This representation
can actually be obtained as a result from more primitive assumptions on risk preferences. See
Section 10 for references on this issue.) For a given P
0
, individual i computes his time-0 wealth
W
i
(P
0
) =

j
e
i,j
P
j,0
and solves for his optimal portfolio, using E = E(P
0
) and V = V(P
0
).
Suppose the solution is x
i
(P
0
) = (x
i,1
(P
0
), . . . , x
i,n
(P
0
))

W
n
, and let
i
(P
0
) = x
i
(P
0
)

E.
Such a solution is necessarily of the form
x
i
(P
0
) = w(
i
(P
0
); E(P
0
), V(P
0
)), (B.2)
where the right-hand side is the solution of Problem (
i
(P
0
); E(P
0
), V(P
0
)) as in Section 4. In
other words, this is the minimum variance portfolio among all portfolios with expected return

i
(P
0
). The portfolio can also be expressed in terms of the number of shares in each security.
For security j, this number (including the individuals initial endowment) is
N
i,j
(P
0
) =
x
i,j
(P
0
)W
i
(P
0
)
P
j,0
. (B.3)
360 A. Bick / The Quarterly Review of Economics and Finance 44 (2004) 337361
We can envision each individual i responding to the declared price vector P
0
by submitting
his optimal holdings (N
i,1
(P
0
), . . . , N
i,n
(P
0
)) to the auctioneer. This procedure can be repeated
for every time-0 price vector P
0
. Then P
0
is an equilibrium price vector if the market clears,
that is, if for j = 1, . . . , n
I

i=1
N
ij
(P
0
) =

N
j
. (B.4)
In the notation of Section 10, this translates to D
j
= M
j
for each j. (Multiply the two sides of
(B.4) by P
j,0
and use (B.2) and (B.3).)
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