Lecture: 20 and 21

TRACING THE EFFICIENT FRONTIER OF MARKOWITZ

These notes give answer to : What combination to buy? That was Question 2 raised in the very first class.
Investors have more or less funds to invest but feel baffled and disoriented and confused about deciding which
shares to buy and which shares not to buy. Those shares they decide to be buy, what percentage of the OE be
invested in each of those share? Or equal amounts be invested in all chosen shares? Should some shares be
short sold, if yes, which ones; and what percentage of OE be the amount by which a share be shorted such as
UBL shorted 3% of OE, resulting in - 0.03 X UBL . All these question are answered in a precise and quantitative
manner by the Markowtiz MPT (Modern Portfolio Theory). These notes are the heart of MPT, and you are
advised to pay great attention to this material and learn it 100%.

According to Markowitz theory an investor should chose one efficient portfolio as her optimal portfolio from the
efficient set of portfolios. The job of portfolio manager is to build that portfolio of client’s desired risk and return
combination. To do so portfolio manager has to find weights (Xi) of stocks included in that efficient portfolio, that
is, percentage of investors OE invested in those shares that are included in that portfolio which the customer has
selected as her optimal portfolio of desired level of total risk and expected return. The following procedure is one
method of finding weights of an efficient portfolio.
Suppose there are only 3 risky stocks in the country i.e. Lever, ICI, PTCL. Expected returns (Ri) of these risky stocks
and their respective total risk ( SDi) have been estimated by your staff of security analysts. Your staff has also
estimated correlations between the returns of these risky stocks using past data of returns. These estimates are
given below.

Expected
Stocks returns (Ri) SDi
Lever 14.0% 6.0%
ICI 8.0% 3.0%
PTCL 20.0% 15.0%

Correlation of RORs of 3 stocks

Lever ICI PTCL

Lever 1
ICI 0.5 1
PTCL 0.2 0.4 1