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**THE EFFICIENT SET THEOREM
**

THE THEOREM

± An investor will choose his optimal portfolio from the set of portfolios that offer

maximum expected returns for varying levels of risk, and minimum risk for varying levels of returns

2

THE EFFICIENT SET THEOREM THE FEASIBLE SET ± DEFINITION: represents all portfolios that could be formed from a group of N securities 3 .

THE EFFICIENT SET THEOREM THE FEASIBLE SET rP 0 WP 4 .

THE EFFICIENT SET THEOREM EFFICIENT SET THEOREM APPLIED TO THE FEASIBLE SET ± Apply the efficient set theorem to the feasible set the set of portfolios that meet first conditions of efficient set theorem must be identified consider 2nd condition set offering minimum risk for varying levels of expected return lies on the ³western´ boundary remember both conditions: ³northwest´ set meets the requirements 5 .

THE EFFICIENT SET THEOREM THE EFFICIENT SET ± where the investor plots indifference curves and chooses the one that is furthest ³northwest´ ± the point of tangency at point E 6 .

THE EFFICIENT SET THEOREM THE OPTIMAL PORTFOLIO rP E 0 WP 7 .

CONCAVITY OF THE EFFICIENT SET WHY IS THE EFFICIENT SET CONCAVE? ± BOUNDS ON THE LOCATION OF PORFOLIOS ± EXAMPLE: Consider two securities ± Ark Shipping Company » E(r) = 5% W = 20% ± Gold Jewelry Company » E(r) = 15% W = 40% 8 .

CONCAVITY OF THE EFFICIENT SET rP rG=15 G rA = 5 A WA=20 WG=40 WP 9 .

CONCAVITY OF THE EFFICIENT SET ALL POSSIBLE COMBINATIONS RELIE ON THE WEIGHTS (X1 .X1 Consider 7 weighting combinations using the formula N rP ! § i !1 X i r i ! X 1 r1 X 2 r2 10 . X 2) X2= 1 .

7 13.CONCAVITY OF THE EFFICIENT SET Portfolio A B C D E F G return 5 6.7 8.3 10 11.3 15 11 .

CONCAVITY OF THE EFFICIENT SET USING THE FORMULA W « ! ¬§ i !1 N N § j !1 i » j W ij ¼ ½ 1/ 2 we can derive the following: 12 .

33 26.00 13 .33 36.67 30.3 10 11.67 40.7 13.3 15 WP=+1 20 10 0 10 20 30 40 WP=-1 20 23.00 33.7 8.CONCAVITY OF THE EFFICIENT SET rP A B C D E F G 5 6.

e.CONCAVITY OF THE EFFICIENT SET UPPER BOUNDS ± lie on a straight line connecting A and G i. all W must lie on or to the left of the straight line which implies that diversification generally leads to risk reduction 14 .

CONCAVITY OF THE EFFICIENT SET LOWER BOUNDS ± all lie on two line segments one connecting A to the vertical axis the other connecting the vertical axis to point G ± any portfolio of A and G cannot plot to the left of the two line segments ± which implies that any portfolio lies within the boundary of the triangle 15 .

CONCAVITY OF THE EFFICIENT SET rP lower bound G upper bound % WP 16 .

CONCAVITY OF THE EFFICIENT SET ACTUAL LOCATIONS OF THE PORTFOLIO ± What if correlation coefficient (Vij ) is zero? 17 .

60% 33.CONCAVITY OF THE EFFICIENT SET RESULTS: WB WB WB WB WB = = = = = 17.36% 27.37% 18 .81% 22.94% 18.

CONCAVITY OF THE EFFICIENT SET ACTUAL PORTFOLIO LOCATIONS D C & F ) 19 .

CONCAVITY OF THE EFFICIENT SET IMPLICATION: ± If Vij < 0 ± If Vij = 0 ± If Vij > 0 line curves more to left line curves to left line curves less to left 20 .

e.CONCAVITY OF THE EFFICIENT SET KEY POINT ± As long as -1 < V the portfolio line curves to the left and the northwest portion is concave ± i. the efficient set is concave 21 .

! random error term 22 .THE MARKET MODEL A RELATIONSHIP MAY EXIST BETWEEN A STOCK¶S RETURN AN THE MARKET INDEX RETURN ri ! E iI F i1rI I iI where EM-!intercept term ri = return on security rI = return on market index I FM.!slope term IM.

I 23 .THE MARKET MODEL THE RANDOM ERROR TERMS Ii. I ± shows that the market model cannot explain perfectly ± the difference between what the actual return value is and ± what the model expects it to be is attributable to Ii.

THE MARKET MODEL Ii. I CAN BE CONSIDERED A RANDOM VARIABLE ± DISTRIBUTION: MEAN = 0 VARIANCE = WIi 24 .

DIVERSIFICATION PORTFOLIO RISK TOTAL SECURITY RISK: Wi has two parts: W 2 i ! F W 2 iI 2 i W 2 Ii where F W 2 iI 2 = the market variance of index returns = the unique variance of security i returns 25 W 2 Ii .

DIVERSIFICATION TOTAL PORTFOLIO RISK ± also has two parts: market and unique Market Risk ± diversification leads to an averaging of market risk Unique Risk ± as a portfolio becomes more diversified. the smaller will be its unique risk 26 .

DIVERSIFICATION Unique Risk ± mathematically can be expressed as 2 W 2 I ! § i!1 N « 1 » ¬ N ¼ W ½ 2 I1 2 Ii 1 «W ! ¬ N W 2 I 2 ... W N 2 IN » ¼ ½ 27 .

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