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