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Introduction to Finance

Case Study 1: Basics of Modern Portfolio Theory
Team members of Group 18:
Felix Starke

371747

[felix.starke@uni-muenster.de]

Tom Eggers

416931

[tom.eggers@uni-muenster.de]

Jonas Bungert

416749

[jonasbungert@gmx.de]

Tim Echterling

424032

[timechterling@web.de]

Index of abbreviations: CAL Capital allocation line SD Standard deviation SR Sharpe ratio T-Bills Treasury-Bills Index of symbols: X. Felix. Tom. investor's indifference curve and optimal risky or complete portfolio Group 18: Starke.g. A Weight of the random variables X and Y Risk aversion factor List of figures: Figure 1 Illustration of the efficient frontier. CAL. rate of return) Standard deviation of the random variables X and Y Standard deviation of the complete portfolio Standard deviation of the risky portfolio Standard deviation of the risk free asset Risk free interest rate Return of the risky portfolio P Correlation of the random variables X and Y . Eggers. Jonas.Y Random variables (e. Bungert. Echterling. Tim 1 .

 describes the magnitude of the linear relation of two random variables c. Tom. T-Bill Capital allocation line (CAL): represents all possible risk-return combinations of the optimal risky portfolio and the risk-free asset: Sharpe ratio = = = slope of the CAL  measures the risk-return combination of a portfolio  the higher the SR the better the portfolio performance f. Eggers. Bungert. Shorting/short sales: is the selling of borrowed financial assets which will be subsequently purchased in the future  enables the investor to make a profit from declining asset prices b.g. Set of risky assets: sum of all possible risk-return combinations for portfolios of risky assets Efficient frontier: dominant portfolios of risky assets that provide the best risk-return combinations. Tim 2 . e. upwards from the minimum variance portfolio d. Felix. Risk-free asset: security without risk ( . however it does not describe the magnitude of the relation Correlation: . Optimal portfolio and the related indifference curve/utility function: The combination of risky and risk-free assets that generates the highest feasible utility for an individual investor Optimization condition: slope of indifference curve = slope of the CAL Group 18: Starke. Echterling.  Left boundary of the opportunity set. Covariance: shows the linear relation of two random variables. Jonas.Exercise 1: a. given or . Global minimum variance portfolio: The efficient portfolio of risky assets that has the lowest variance  : e.

Echterling. Felix. Group 18: Starke. Bungert. investor's indifference curve and optimal risky or complete portfolio 20% Optimal risky portfolio 18% 16% 14% Minimum variance portfolio E (r) 12% Optimal complete portfolio 10% 8% 6% Optimal risky portfolio 4% 2% 0% 0% 5% 10% 15% σ 20% 25% 30% Inefficient frontier Efficient frontier Capital allocation line Investor's indifference curve Source: own illustration. Tim 3 . Jonas. CAL. Tom. Eggers.Exercise 2: Figure 1: Illustration of the efficient frontier.

Excel Solver ii. Excel Solver ii. Calculating the optimal weights of the risky portfolio P and the risk-free asset by using either i. Formula iii. Y and of the risk-free asset in the optimal complete portfolio: The portfolio is composed of . The efficient frontier:  Starts upwards from the Minimum-Variance-Portfolio (MVP) with b. Jonas. Felix. Weights of X. Echterling. Calculating the optimal composition of the risky portfolio by using either i. Estimation through a data table and maximizing the Sharpe ratio 2.0657 from the optimal complete portfolio d. Formula e. generating with Group 18: Starke. Eggers.4479 c. Bungert. The capital allocation line: The capital allocation line starts at with the slope 0. The optimal risky portfolio: The point of intersection of the investor´s indifference curve and the CAL represents the location of the optimal portfolio  Can be determined by 1. thus is leveraged by 69%. Tom. The investor´s indifference curve: Can be determined by converting the utility function to with Ū=0. Tim 4 .a.

Tim 5 . so the larger is the investment in the . Bungert. For with 3. else in  Diversification is sufficient with weights depending on  Optimal complete portfolio splits between resulting  For : The higher the less risky is risky portfolio. The risk aversion A:  The higher A the lower the utility of a given portfolio combination  Investor is more risk averse  The investor specific complete portfolio therefore allocates more in and less in . Group 18: Starke. Jonas. only the risky assets X and Y are available. so the smaller is the investment in the Exercise 4: Weights of X and Y if borrowing and lending at the risk-free rate is prohibited: If borrowing and lending at the risk-free rate is prohibited. 1. The risk-free rate : The higher the smaller the excess return  The CAL has a higher intercept and flatter slope. Felix. The : . For    Diversification not useful  Optimal risky portfolio via specialization into the asset with the higher Sharpe ratio  Investor specific portfolio is a mix of and that asset. thus representing the tangential portfolio with and . maximizing utility . the individual invests all in . . resulting in a riskier tangential portfolio  The investor allocates a higher proportion to the risk-free security  his indifference curve is tangent to the CAL further left.For a decreasing the contrary logic holds b. due to hedging possibilities  For 0 : The higher the riskier is risky portfolio combination and . For   If then  A perfect hedge is possible: . Tom.e. towards . Echterling. Eggers.Exercise 3: Influence of the following ceteris paribus input variations on the portfolio optimization:  Slope of the CAL = Sharpe ratio = a. with maximized utility 2.For a declining the opposite is true c. i.