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Markowitz Risk Return Optimization
THE PORTFOLIO SELECTION
PROBLEM
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INTRODUCTION
• THE BASIC PROBLEM:
– given uncertain outcomes, what risky securities
should an investor own?

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INTRODUCTION
• THE BASIC PROBLEM:
– The Markowitz Approach
• assume an initial wealth
• a specific holding period (one period)
• a terminal wealth
• diversify
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INTRODUCTION
• Initial and Terminal Wealth
• recall one period rate of return



where r
t
= the one period rate of return
w
b
= the beginning of period wealth
w
e
= the end of period wealth

b
b e
t
w
w w
r
÷
=
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INITIAL AND TERMINAL WEALTH
• DETERMINING THE PORTFOLIO RATE
OF RETURN
– similar to calculating the return on a security
– FORMULA


0
0 1
w
w w
r
p
÷
=
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INITIAL AND TERMINAL WEALTH
• DETERMINING THE PORTFOLIO RATE
OF RETURN
Formula:

where w
0
= the aggregate purchase
price at time t=0
w
1
= aggregate market value at
time t=1

0
0 1
w
w w
r
p
÷
=
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INITIAL AND TERMINAL WEALTH
• OR USING INITIAL AND TERMINAL
WEALTH


where
w
0
=the initial wealth
w
1
=the terminal wealth



( )
0 1
1 w r w
p
+ =
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– portfolio return (r
p
) is a random variable
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– defined by the first and second moments of the
distribution
• expected return
• standard deviation
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– First Assumption:
• nonsatiation: investor always prefers a higher rate
of portfolio return
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– Second Assumption
• assume a risk-averse investor will choose a portfolio
with a smaller standard deviation
• in other words, these investors when given a fair bet
(odds 50:50) will not take the bet
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– INVESTOR UTILITY
• DEFINITION: is the relative satisfaction derived by
the investor from the economic activity.
• It depends upon individual tastes and preferences
• It assumes rationality, i.e. people will seek to
maximize their utility
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THE MARKOWITZ APPROACH
• MARGINAL UTILITY
– each investor has a unique utility-of-wealth
function
– incremental or marginal utility differs by
individual investor
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THE MARKOWITZ APPROACH
• MARGINAL UTILITY
– Assumes
• diminishing characteristic
• nonsatiation
• Concave utility-of-wealth function
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THE MARKOWITZ APPROACH
UTILITY OF WEALTH FUNCTION
Wealth
Utility
Utility of Wealth
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INDIFFERENCE CURVE ANALYSIS
• INDIFFERENCE CURVE ANALYSIS
– DEFINITION OF INDIFFERENCE CURVES:
• a graphical representation of a set of various risk
and expected return combinations that provide the
same level of utility
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INDIFFERENCE CURVE ANALYSIS
• INDIFFERENCE CURVE ANALYSIS
– Features of Indifference Curves:
• no intersection by another curve
• “further northwest” is more desirable giving greater
utility
• investors possess infinite numbers of indifference
curves
• the slope of the curve is the marginal rate of
substitution which represents the nonsatiation and
risk averse Markowitz assumptions
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PORTFOLIO RETURN
• CALCULATING PORTFOLIO RETURN
– Expected returns
• Markowitz Approach focuses on terminal wealth
(W
1
), that is, the effect various portfolios have on
W
1


• measured by expected returns and standard
deviation

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PORTFOLIO RETURN
• CALCULATING PORTFOLIO RETURN
– Expected returns:
• Method One:

r
P
= w
1
- w
0
/ w
0

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PORTFOLIO RETURN
– Expected returns:
• Method Two:


where r
P
= the expected return of the portfolio
X
i
= the proportion of the portfolio’s initial
value invested in security i
r
i
= the expected return of security i
N = the number of securities in the
portfolio

¿
=
=
N
t
i i p
r X r
1
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PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK
– Portfolio Risk:
• DEFINITION: a measure that estimates the extent
to which the actual outcome is likely to diverge
from the expected outcome

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PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK
– Portfolio Risk:



where o
ij
= the covariance of returns
between security i and security j
2 / 1
1 1
(
¸
(

¸

=
¿¿
= =
N
i
N
j
ij j i P
X X o o
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PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK
– Portfolio Risk:
• COVARIANCE
– DEFINITION: a measure of the relationship between two
random variables
– possible values:
» positive: variables move together
» zero: no relationship
» negative: variables move in opposite directions
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PORTFOLIO RISK
CORRELATION COEFFICIENT
– rescales covariance to a range of +1 to -1



where





j i ij ij
o o µ o =
j i ij ij
o o o µ / =