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**Markowitz Risk Return Optimization
**

THE PORTFOLIO SELECTION

PROBLEM

2

INTRODUCTION

• THE BASIC PROBLEM:

– given uncertain outcomes, what risky securities

should an investor own?

3

INTRODUCTION

• THE BASIC PROBLEM:

– The Markowitz Approach

• assume an initial wealth

• a specific holding period (one period)

• a terminal wealth

• diversify

4

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

÷

=

5

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

÷

=

6

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

÷

=

7

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

+ =

8

THE MARKOWITZ APPROACH

• MARKOWITZ PORTFOLIO RETURN

– portfolio return (r

p

) is a random variable

9

THE MARKOWITZ APPROACH

• MARKOWITZ PORTFOLIO RETURN

– defined by the first and second moments of the

distribution

• expected return

• standard deviation

10

THE MARKOWITZ APPROACH

• MARKOWITZ PORTFOLIO RETURN

– First Assumption:

• nonsatiation: investor always prefers a higher rate

of portfolio return

11

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

12

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

13

THE MARKOWITZ APPROACH

• MARGINAL UTILITY

– each investor has a unique utility-of-wealth

function

– incremental or marginal utility differs by

individual investor

14

THE MARKOWITZ APPROACH

• MARGINAL UTILITY

– Assumes

• diminishing characteristic

• nonsatiation

• Concave utility-of-wealth function

15

THE MARKOWITZ APPROACH

UTILITY OF WEALTH FUNCTION

Wealth

Utility

Utility of Wealth

16

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

17

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

18

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

19

PORTFOLIO RETURN

• CALCULATING PORTFOLIO RETURN

– Expected returns:

• Method One:

r

P

= w

1

- w

0

/ w

0

20

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

21

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

22

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

23

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

24

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 / =

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