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Dr. Himanshu Joshi FORE School of Management

An Exercise

• Choose A or B • A. $240000 with probability 100% • B : $0 with probability 75% and $1000000 with probability 25% • Choose C or D • C. −$750000 with probability 100% • D. −$1000000 with probability 75% and $0 with probability 25%

• Equivalent Choices: • A + D : −$760000 with probability 75% & $240000 with probability 25% • B + C : −$750000 with probability 75% & $250000 with probability 25% .An Exercise..

will always choose the one with the higher level of expected return. • Thus. given two portfolios with the same standard deviation. • Investors are assumed to always prefer higher levels of terminal wealth to lower levels of terminal wealth. the investor will choose the portfolio with higher expected return.Non Satiation and Risk Aversion • Investors. • The reason is that higher level of terminal wealth allow the investors to spend more on consumption at time t=1 (or in more distant future). when given the choice between two otherwise identical portfolios. .

.. • Where a fair gamble is defined to be one that has an expected payoff of zero. will not take a fair gamble. which means that the investor will choose the portfolio with smaller standard deviation. • What does it mean to say that an investor is risk averse? • It means that the investor.Risk Aversion • It is assumed that all investors are risk averse. when given the choice. Or fair bets.

• As wealth increases. • The assumption of non-satiation requires that the utility of wealth function is always positively sloped no matter what the level of wealth. • However. • A common assumption is that investors experience diminishing marginal utility of wealth. this utility of wealth function is concave (bowed downward). • Each extra dollar of wealth always provides positive additional utility. the corresponding increase in utility becomes smaller. . but the added utility produced by each extra dollar becomes successively smaller.Marginal Utility • Each investor has a unique utility of wealth function.

Marginal Utility • Certainty Equivalent • Risk Premium .

• Indifference curves for a risk neutral investor. .Indifference Curves • Indifference curves for a risk averse investor.

• Calculation of two security portfolio return and Risk. • Calculation of three Security Portfolio Return and Risk using double sum and VarianceCovariance Matrix.Calculation of SD and Expected Return of Portfolio • Markowitz Approach using indifference curves. .

• A risk averse investor would select for investment the portfolio with the indifference curve that is farthest north west. .Portfolio Analysis • According to Markowitz Approach an investor should evaluate alternative portfolios on the basis of their expected returns and standard deviations by using indifference curves.

What happens when an investor consider investing in a set of securities. What happens when investor is allowed to invest in securities using margin. 3. one of which is risk free. 2. How can Markowitz approach to be used once it is recognized that there are infinite number of portfolios available for investment.Questions Markowitz left Unanswered? 1. .

Question 1. . where N= 3 • Without even considering Charlie. an infinite number of portfolios can be formed from a set of N securities. there is already an infinite number of possible portfolios that could be purchased.. • Consider Securities Able. Baker and Charlie. • As mentioned earlier.

Does the investor need to evaluate all these portfolios? .The Efficient Set Theorem • Q.

Offer Maximum Expected Returns for Varying levels of Risk. Offer Minimum Risk for Varying level of Expected Returns. The set of portfolios meeting these two conditions is known as the efficient set or Efficient Frontier. An investor will choose his or her optimal portfolio from the set of portfolios that: 1.The Efficient Set Theorem • According to Efficient Set Theorem. . 2.

• In general. • GESH illustrate the location of the feasible set (also known as the opportunity set) from which efficient set can be identified. • That is all possible portfolios that could be formed from the N Securities lie on or within the boundary of feasible set. . • The feasible set simply represents all portfolios that could be formed from a group of N securities. this set will have an umbrella-type shape.The Efficient Frontieroptimal..gif • The Feasible Set and The Efficient Set.

there would be no point in the feasible set to the right of H. • There is no portfolio offering less risk than portfolio E.The Efficient Set Theorem Applied to the Feasible Set • First Condition: Maximum Return for varying level of risk. • Thus the set of portfolios offering maximum expected return for varying levels of risk is the set of portfolio lying on the northern boundary of the feasible set between point E and H. there is no portfolio offering risk higher than H. because if a vertical line were drawn through H. there would be no point in the feasible set that was to the left of the line. • Also. . because if a vertical line were drawn E.

• Thus set of portfolios offering minimum risk for varying levels of expected return is the set of portfolio on the western boundary of the feasible set between point G and point S. .The Efficient Set Theorem Applied to the Feasible Set • Second Condition: Minimum Risk for Varying Levels of Return. • There is no point offering lower expected return than Point G. • there is no portfolio offering higher expected return than Point S.

. • Accordingly these portfolios form the efficient set. It can be seen that only those portfolios lying on the North-West Boundary between Points E and S do so. • All other feasible portfolios are inefficient and can be ignored.The Efficient Set Theorem Applied to the Feasible Set • Remember that both the conditions have to be met in order to identify the efficient set. and it is from this set of efficient portfolios that the risk averse investor will find his or optimal one.

Selection of Optimal Portfolio • Using Efficient Set and Indifference Curves. .

• If X1 is the proportion of the investor’s funds invested in Ark Shipping and X2 (=1-X1) the proportion invested into Gold Jewelry.xlsx • Why Efficient Set is Concave? • Consider an example of two securities 1 Ark Shipping Co. σ2 = 40%). (ER2= 15%. (ER1 = 5%. .Concavity of Efficient Set.Concavity of the Efficient Set. σ1= 20%) and Security 2 Gold Jewelry Co.

• This means that any portfolio consisting of these two securities can not have standard deviation that plots to the right of a straight line connecting the two securities.. . the standard deviation of a portfolio will generally be less than a weighted average of the SD of securities on a portfolio. • Diversification leads to risk reduction of portfolio. • Instead. the upper bounds all lie on a straight line connecting point A and G. SD must lie on or left of the straight line.Concavity of Efficient Set. • This observation suggests a motivation for diversifying a portfolio. • Interestingly. because.

any portfolio consisting of securities A and G will lie within or on the boundary of the triangle shown in figure.Concavity of Efficient Set. • In sum. with its actual location depending upon magnitude of correlation coefficient between the two securities. ...

Actual Location of the Portfolios • What would happen if the correlation were zero? • As can be seen in the figure that these portfolios as well as all other possible portfolios consisting of Ark Shipping and Gold Jewelry. • If the correlation were greater than zero but less than zero it would not curve quite as much to the left. . the line would curve more to the left. • If the correlation were less than zero. lie on a line that is curved. or bowed to the left.

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