# Lyceum of the Philippines University

Batangas City

A Report on the

PORTFOLIO THEORY

C/Y/S: Doctor of Philosophy in International Hospitality Management
S/T/R/D: PHD IHM 606 / EAC / Saturday
Professor: Dr. Sevillia Felicen

The Markowitz Portfolio Theory

hence if short sale should be included in the model this condition should be omitted[3].e. The return Rt of a portfolio at time t can be de_ned to be the total value Tt of the portfolio divided by the total value at an earlier time t 1. Markowitz portfolio theory provides a method to analyse how good a given portfolio is based on only the means and the variance of the returns of the assets contained in the portfolio. Consider a portfolio with n di_erent assets where asset number i will give the return Ri. :::. PORTFOLIO THEORY Which portfolio is the best? This question is probably as old as the stock-market itself. _) with minimum _2 for a given _ or more and maximum _ for a given _2 or less are called the e_cient set (or e_cient frontier). 2 Special case: Portfolio with tree assets Lyceum of the Philippines University PHD IHM 602 with Dr. xn the investor will get di_erent combinations of _ and _2. Suppose the the relative amount of the value of the portfolio invested in asset i is xi. a small risk) and a high expected return[3]. (1) Tt. Those (_2. Since an investor wants a high pro_t and a small risk he/she wants to maximize _ and minimize _2 and therefore he/she should choose a portfolio which gives a (_2. Rt = Tt . However when Markowitz published his paper on portfolio selection in 1952 he provided the foundation for modern portfolio theory as a mathematical problem [2]. The set of all possible (_2.1 hence its simply the percentally change in the value from one time to another. _) combination in the e_cient set.j be the covariance between Ri and Rj . For di_erent choices of x1. i. If R is the return of the whole portfolio then: Condition (5) is the same as saying that only long positions are allowed. An investor is supposed to be risk-averse. In _gure 1 the attainable set is the interior of the ellipse and the e_cient set is the upper left part of its boundary [1]. Let _i and _2i be the corresponding mean and variance and let _i. Sevillia 2 Felicen . hence he/she wants a small variance of the return (i.1.e. _) combinations is called the attainable set.

i = 1. x2 and x3 the problem has a clear geometrical interpretation [1]. Sevillia 3 Felicen .x2 _ ≥. thevariance of the return ∑2 =P3i=1P3j=1 _i. One way to handle this is to consider the optimization problem Lyceum of the Philippines University PHD IHM 602 with Dr. This set forms a straight line. It may be shown that the isoclines of _ are parallel straight lines and the isoclines of _ are concentric ellipses in the x1x2 plane [1]. In _gure 2 (gure borrowed from [1]) the graphical representation of the problem can be seen. 2. 1-x1-x2. for portfolios with more than four assets this can not be done. The set of e_cient portfolios starts at the point x and then goes in the direction of increasing expected return until it hits the border of the attainable set. Now varying _ gives rise to a set of e_cient portfolios i. At any moment x1 and x2 can easily be obtained from the picture (and hence x3). 3.e. However. PORTFOLIO THEORY Given a portfolio containing only three assets. We get the expected return to be ∑= P3i=1 _ixi. Hence _ and _ are now functions of x1 and x2. 3 Portfolio selection as optimization problem As mentioned in section 1 the Markowitz portfolio theory states that an investor should choose a portfolio from the e_cient set. Using the relations given above we can express x3 as x3 = Figure 1: The e_cient set in the __2 plane. the e_cient set. Inthe case of a portfolio containing four assets we might analogously give a three dimensional graphical representation.What is the e_cient set in this case? Fixing a _ and minimizing the variance.x1 .jxixj with the constraints that 1 =P3 i=1 xi and xi _ ∑. depending on how risk averse he/she is. yielding a two-dimensional problem with the constraints x1 _ ≥. called the critical line denoted by l [1]. then continuing along the border in the direction of growing expectation. x2 _ ≥ and 1 . is where the isomean line is parallel to the isovariance ellipses. The point in this plane giving the least variance is denoted by x. x1. we easily observe that the point yielding the minimal variance and hence the most e_cient portfolio.

4 Risk free lending and borrowing Consider the case where it is possible to lend out money without risk. where A ( ≤ A ≤1) is the so called risk aversion index. A = ≤ will result in the portfolio with the smallest variance. Let x be the proportion of the portfolio invested in risky assets with the mean _p and the variance α2 p and let 1 .x be the proportion put in the risk free asset (i. A increasing A corresponds to the investor becoming more willing to take a bigger risk to get a higher expected return and A = 1 corresponds to the investor only caring about getting a large expected return no matter what the risk is [2]. PORTFOLIO THEORY Figure 2: Graphical representation of the problem. lending or borrowing). Sevillia 4 Felicen . Then. This can be seen as another asset with _2 = 0 and return r and if it is possible to borrow money to the same interest rate than it means µ that this asset may be hold in short position.e. for the whole portfolio: Lyceum of the Philippines University PHD IHM 602 with Dr.

r) and the slope _p. This model does not require estimations of the pairwise correlation between the assets but only estimations of how the asset depend on the behavior of the market [3]. PORTFOLIO THEORY which is a straight line going through the point (0.The main reason for this is that it requires a huge amount of data (if n assets are considered then the model needs 2n + � n2_parameters). 5 Impact on portfolio theory The Markowitz portfolio selection model laid the foundation for modern portfolio theory but it is not used in practice[2]. Figure 3: Two examples of the cml and the OPRA given an interest rate r. The _rst model that reduced the data requirements was the model of Sharpe which only need 3n+2 parameters._p. r) (See _gure 3). (With _ onthe x-axis and _ on the y-axis) Since the investor wants maximum return for a _xed level of risk he/she wants this line to be as steep as possible[3]. The model of Sharpe led Lyceum of the Philippines University PHD IHM 602 with Dr. Hence the OPRA is the solution to the maximization problem: The OPRA will generate a line that has the steepest gradient of all lines going through the attainable set and the point (0. This line is called the capital market line. Investors can place themselves anywhere on this line through lending/borrowing an appropriate amount and buying OPRA for the rest [3]. Sevillia 5 Felicen . cml. The portfolio giving the _p and _p that maximizes _p-r_p is called the Optimal Portfolio of Risky Assets (OPRA).More useful models have however been developed from the Markowitz model by use of approximation.

_nmod. No.org http://www. Its _rst parts cover elementary probability theory and can be skipped if wanted. Vol. 7.1108/eb013433 [3] West G.2307/2975974?origin=api (2012-10- 30) [2] Stephen F.za/MPT.se/stable/10. cient Portfolio Frontier (http://www. Sevillia 6 Felicen .lib. The Journal of Finance.Markowitz by the name Portfolio Selection: E_cient diversi_cation of investments [1]. (1952) Portfolio Selection.com/watch? v=3ntwyjXZdS0&feature=related). (1979) The Markowitz Contribution to Port- folio Theory. _ In [3] the Markowitz portfolio theory. 1952. DOI: 10.proxy. March. CAP-M. (2012- 11-07) [4] All Prizes in Economic Sciences.org/nobel prizes/economics/laureates/ (2012-11-25) Lyceum of the Philippines University PHD IHM 602 with Dr. If an investor wants to use the Markowitz model to choose a suitable portfolio then it is probably a good idea to do some complementary calculations of the risk of extreme events using extreme value statistics (like PoT modelling for the tails).jstor. Hence the Markowitz model do not tell an investor which portfolio he/she can a_ord to buy if he/she is willing to take a certain risk to get bankrupted. 6 Our thoughts One drawback with the Markowitz model is that the variance of a portfolio is not a complete measure of the risk taken by the investor.pdf. _ The interested reader can also _nd a complete book in the subject by Harry. http://www. together with more involved models (the model of Sharpe. PORTFOLIO THEORY to Markowitz and Sharpe winning The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 1990 [4].chalmers. M. Managerial Finance. APT and the Black-Litterman model) arising from the MPT are briey discussed. 77-91. 7 Reading guide Here follows a short reading guide for those who want to know more about portfolio optimization theory:_ An easy introduction to the concept E_cient Portfolio is given in the video E_.org. What is the Value at Risk for a given portfolio? That is impossible to answer if only the variance and mean and not the distribution is known. 1.ory. (2006) An Introduction to Modern Portfolio Theory: Markowitz. Richard Dobbins. the Arbitrage Pricing The.17. 5 Iss: 1 pp. Financial Modelling Agency.youtube. pp.nobelprize. Vol. However this is not really an issue since nobody uses the model in practice. Nobelprize. H. the Sharpe-Lintner-Mossin CAP-M. References [1] Markowitz. Witt. 3 . www. APT and Black-Litterman.co.

PhD IHM Professor Lyceum of the Philippines University PHD IHM 602 with Dr. Sevillia Felicen Student. PORTFOLIO THEORY Evaluation Mastery 40 % _________________ Content 30 % _________________ Visual Aid 20 % _________________ Personality 10 % _________________ Final Grade Submitted by: Submitted to: Ian Quadra Guillermo Dr. Sevillia 7 Felicen .