MARKOWITZ MODEL

Harry Markowitz
He developed a theory of portfolio choice for
dealing in household and firm investment.
He insisted on tradeoff between risk and
expected return.
Optimization in investment was his idea
The total risk is dependant on co variance of
assets and lower the covariance lower the risk.
This brings the concept of risk reduction
through diversification.
He showed that imperfect correlation between
securities in portfolio is the key reason why
diversification reduces portfolio risk.
Assumptions in the model.
All investors have the same expected single
period investment horizon.
Investors are rational and behave in a manner
so as to maximize their utility.
Investors are risk averse and try to minimize
risk and maximize return.
Investors have free access to fair and correct
information on the returns and risk.
Efficient frontier or set
It represents the trade off between risk and
return faced by investor at the time of
constructing portfolio.
The notion of efficient and optimal portfolios
For any level of volatility consider all the
portfolio which have that volatility .Select one
which has the highest return. (A set of port folio)
For any level of expected return consider all
portfolios which have that expected return .
Select one which has the lowest risk.(A set of
portfolio )
Since the two definitions are equivalent the set
of optimal portfolio obtained using the definition
is exactly same.


Efficient Frontier or Set
Portfolio E(R) Std. deviation
A 8 12
B 8 18
C 12 18
Efficient Frontier.
EF is the efficient frontier represents the most
preferable tradeoff between risk and expected return.
The theory considers a universe of risky investments
and explores what might be an optimal portfolio based
upon investments in these securities.
Portfolio lies above the EF are desirable but not
attainable.
Portfolio lies below the line of EF are called attainable
portfolios.
Efficient Frontier
From this attainable set of all possible portfolios we
locate the subset known as efficient set which is
composed of portfolios that offer the lowest risk for a
given level of return.
This is the curved line EF shown.
Thus the Markowitz Portfolio selection model generates
a frontier of efficient portfolios which are equally good .
And the investor can choose any one from it subject to
his suitability.
Efficient Frontier
1
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R E
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E(R)
Efficient Frontier (portfolios
lying between points E and F)
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R E
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R E
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R E
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A
B
C
D
E
F
SELECTION OF THE OPTIMAL PORTFOLIO
How will the investor go about selecting the optimal
portfolio?

Investors will have to consider their indifference
curves.

Put the investors indifference curves and the efficient
frontier and go for the portfolio on the farthest
northwest indifference curve, where the indifference
curve is tangent to the efficient frontier.
Indifference Curves for a Risk-Averse Investor
o
1
I
2
I
3
I
E(R)
4
I
Tangent Portfolio
Portfolio Selection for a Highly Risk-Averse Investor
o
1
I
2
I
3
I
E(R)
4
I
Tangent Portfolio
Indifference Curves for a Low Risk-Averse
Investor
o
1
I
2
I
3
I
E(R)
4
I
Tangent Portfolio
Risk free asst
A risky asset is one which gives uncertain
future returns .
This uncertainty can be measured by variance
or the std deviations of the expected future
return.
Risk free asset whose expected risk is fully
certain so the variance or std deviation of
expected return will be zero.
Covariance between a risky asset and a risk
free asset.
Two sets of return are A and B. A is risk free
asset return.
Uncertainty of a risk free asset is known. So
std deviation will be zero .which means
expected return and the actual return will be
same .so Covariance of A to B will be
Equal to zero.
Combining a risk free asset with a risky
portfolio.
What happens to risky asset that exist on EF
Expected return of the portfolio is
E(r)=W*(r) + (1-W)*E(Ra)
W= proportion of the portfolio in the risk free
asset.
r is expected return on risk free asset.
E(Ra) is expected return of risky portfolio A.
Combining a risk free asset with a risky
portfolio.
Expected variance of the two portfolios will be

E(Var) = (1-W)(Var A )
So we can say for any portfolio that combines
a risk free asset with any risky asset, the std
deviation is the linear proportion of the
standard deviation of the risky asset portfolio.
Risk return possibilities with leverage.
An investor will always want to increase his
expected returns.
Although he is situated on the EF still he will
try to go beyond and obtain more expected
return by accepting higher risk.
He can borrow the money at a risk free rate
and use the proceeds to invest in a risky asset
portfolio at a point on EF.
Achieving the Highest Reward-to-Variability Ratio
o
Capital Allocation
Line (CAL)
E(R)
f
R
Efficient Frontier with
risky assets only
A
Minimum Variance Portfolio
Capital Allocation Line
o
P
o
( )
f
R
P
R E
( )
P
R E
Capital Allocation
Line (CAL)
E(R)
f
R
Capital Allocation Line and the Efficient Frontier
o
Capital Allocation
Line (CAL)
E(R)
f
R
Efficient Frontier with
risky assets only
A
B
Portfolio A maximizes the
reward-to-variability ratio
Risk return possibilities with leverage.
A person has borrowed an amount which is 50% of his
original wealth .The effect of this on the expected return
for the portfolio will be
E(r) = -.5* r + [ 1-(-.5)]*E(R)
Solve the following : If Mr. A borrows @ risk free rate of 10
% . He borrows to add leverage to his portfolio by 30% if
the expected return on risky asset is 15 % find out the
total expected return of his portfolio.
Solve the following
Suppose the risk free rate is 8% and expected return of
risky portfolio is 20% with a std deviation of 25% . If an
investor would like to invest 20% of his portfolio in the
risk free asset and the balance in risky portfolio what will
be the return and risk of the combine portfolio.
If he leverages his portfolio by 50% by borrowing at a
risk free rate calculate the expected return and the risk
of the leveraged portfolio in that situation.
SEPARATION PROPERTY
The portfolio choice problem is separated into two
independent tasks:

First task: Determining the optimal risky portfolio (the
portfolio made up of risky assets);
Second task: The allocation between the risk-free asset
(T-bills) versus the risky portfolio depends on the
investors personal preferences for risk-taking (his
utility function).
Separation Theorem
First determine the risky portion of their portfolio.- the
tangency portfolio on the EF.
Second to achieve desired level of risk by leverage
(borrow at the risk free rate and invest in tangency
portfolio)
Or De-leverage (sell part of the tangency portfolio and
lend the proceeds at the risk free rate) .
Two decisions are to be taken i) choosing the
composition of the risky portion of the investors portfolio
ii) deciding on the amount of leverage to use
These two decisions are entirely independent of one
another and does not affect the each other .This is
called Tobins Separation Theorem.
MINIMUM-VARIANCE
FRONTIER
The outcome of risk-return combinations generated by
portfolios of risky assets that gives you the minimum
variance for a given rate of return.

[Intuitively, any set of combinations formed by two
risky assets with less than perfect correlation will lie
inside the triangle XYZ and will be convex.]
Minimum-Variance Frontier
E(R)
Minimum-Variance
Portfolio
o
Individual Assets
Individual Assets
Minimum-Variance Frontier
X
Y
Z
Markowitz models criticism.
The quality of research is lying with the
availability of quality of historical data.
If we increase the number of securities we will
increase the number of correlation to estimate.
Sharpes Single Index Model
Markowitz portfolio selection model has two
shortcomings.
The first is the problem of computational complexity.
The second problem with the Markowitz model is that it
assumes that all the risk and return characteristics can
be explained by the covariance of the securities returns
with the returns of other securities.
Thus, changes in factors, such as the growth rate of the
economy or the inflation rate, are not accounted for
directly.
These considerations have led to various simplifications
and extensions of the model.
Assumptions
All the covariances of security returns can be explained
by a single factor.
This factor is called the Index.
This model has substantially reduced the number of
required inputs when estimating portfolio risk.
The single index model requires that each securitys
correlation with an index be evaluated.
This means that for n securities we require n statistical
inputs.
So instead of 499,500 correlation coefficients required
for 1000 securities, we need just 1000 values.
How it works?
The Single Index Model (Market Model) states
that the return on an individual stock over a
given time period is related to the return on the
same period that is earned on a market index
such as the Sensex or the Nifty.
Thus, if the market goes up, then the stock
goes up and if the market goes down, then the
stock goes down.
The single index model equation has the form
of a regression equation:

Securities Characteristics Line
where, r i = return on stock, r M = return on the market index,
i= intercept term, i= slope term and i= random error term.

This defines a line with intercept i and slope i , with i being
the deviations from the line for the individual returns.

This line is called the Security Characteristic Line (SCL).

Assuming that the slope term is positive, the equation indicates
that the higher the return on the market index, the higher is the
return on the individual stock likely to be.

The expected value of random error term is zero.

Example
Example: Consider a stock which has r M =
return on the market index = 12%, i= 3% and
i= 1.5, then find the expected return on the
stock.
Stock A has Beta of 1.2 and stock B has a beta
of 1.5 and stock C has a beta of 1. They are in
a proportion in a portfolio by 30% , 30% and
40% respectively. Return on Sensex is 12%
and risk free rate in the economy is 6%. With
the help of sharpe model find out the return of
Portfolio . Assume random error term is zero.

Measurement of Individual Stock
Risk.
In the single index model, total risk of an individual stock, measured by its
variance, , has two components: market risk and unique (stock specific) risk:

where denotes the variance of return on the market index. Thus
denotes the market risk of stock and denotes the unique risk of stock as
measured by the variance of return of random error term i as appearing in
the equation for the return on an individual stock.



Measurement of Portfolio
Return

If the proportion of funds invested in stock i is denoted by Xi, then the return on
the portfolio is:

Substituting the value of ri, this results in the following equation for the portfolio:



Measuring Portfolio Risk
The total risk of the portfolio, measured by the variance of the portfolios returns, ,
is:

Assuming that the random error components of security returns are uncorrelated,
Thus the total risk of the portfolio can be viewed as having two components, similar
to the two components of the total risk of an individual stock.
These are the market risk and unique risk
EXAMPLE.
Find the variance and the standard deviation
of returns of the three stocks, A, B and C .
The standard deviation of market return is 8%.
Consider 3 securities A, B and C with the
following betas and standard deviation of
random error terms:

Let us combine the stocks A and B in a portfolio where each has a proportion of 0.5
and C has a proportion of 0 (i.e. C is not present in the portfolio).
Find the variance and standard deviation of this portfolio .

CAPM
The Capital Asset Pricing Model (CAPM) is a model to
explain why capital assets are priced the way they are.
William Sharpe, Treynor and Lintner contributed to the
development of this model.
CAPM extended Harry Markowitzs portfolio theory to
introduce the notions of systematic and unsystematic (or
unique) risk.
CAPM demonstrated that the tangency portfolio was
nothing but the Market Portfolio consisting of all risky
assets in proportion to their market capitalization.
Since the Market Portfolio includes all the risky assets in
the world in their relative proportions, it is a fully
diversified portfolio.
Capital Asset Pricing Model
Assumptions..
All investors will follow the mean variance approach.
There is a risk free rate at which investor can lend and
borrow.
Taxes and transaction costs are irrelevant.
All investors have the same holding period.
Information is freely and instantly available.
Investors have homogeneous expectation
Markets are assumed to be perfectly competitive.
Capital Asset Pricing Model
The CAPM is a model for risky asset pricing defining an
appropriate risk-adjusted required return for any risky
asset.
The systematic risk of a risky asset matters; it exists in
the Market Portfolio and cannot be eliminated by further
diversification .
And since investors will want to hold the Market
Portfolio, this is the risk that must be and is rewarded.
Thus the major conclusion of CAPM is that expected
return on an asset is related to its systematic and not to
its total risk or standard deviation.
Its systematic risk is given by its beta coefficient (). An
assets beta is a measure of its co-movement with the
market index.

Systematic Risk and Unsystematic risk.
Systematic risk is Market Risk which can not
be diversified.
Unsystematic risk is firm specific risk or unique
risk which can be reduced by diversification.
Market risk is the variability in all risky assets
caused by macroeconomic variables.
Standard Deviation and Beta
A rational risk-averse investor views variance
as the appropriate risk measure if he holds
only one security.
But if he hold multiple assets the contribution
of any one of the assets to the riskiness of the
portfolio is its systematic or non diversifiable
risk. In that case his appropriate risk
measurement will be Beta.
The Capital Market Line CML
Ef is the efficient frontier. M is the market portfolio on EF and rf is
the risk free rate.
The line tangent to the EF and connecting the rf and M and going
beyond is the Capital Market Line.
CML says that the expected return on a portfolio is equal to the risk
free rate plus a risk premium.


The slope of CML (Rm-rf)/sdm is called the market price of the risk
. and this component is same for all portfolios lying along the CML.

Capital market line
CML .
The term (rm rf) is the expected return of the market beyond the risk-free return.

It is a measure of the reward for holding the risky market portfolio rather than the
risk-free asset.

Thus, the slope of the CML measures the reward per unit of market risk.

It determines the additional return needed to compensate for a unit change in risk.

It is also called the market price of risk.

The Capital Market Line (CML) leads all investors to invest in the tangency
portfolio (M portfolio) which is the investment decision.

The Individual investors differ in position on the CML depending on risk
preferences (which leads to the financing decision)
The Capital Market Line CML
The expected return on market portfolio is 20%
with a std deviation of 25%. If the risk free rate
is 8% find out the slope .If the risk of the
portfolio is 5 then find out the expected return
of the portfolio.

Solve the following
Suppose there are two investors A and B
.Objective of investor A is to earn 25% and
assume the relevant risk . on the other hand
the objective of B is to limit his risk to a
variance of 400%.What will be the expected
return of B. Assume 8% risk free return and
E(Rm) be 20% and std deviation of m is 25%.
How the financing decision will be taken by A
and B.
Solve the following
Suppose there are two investors C and D
.Objective of investor C is to earn 30% and
assume the relevant risk .On the other hand
the objective of D is to limit his risk to a
variance of 625%. Assume 10% risk free
return and E(Rm) is 20% and std deviation of
risky asset m is 20 . How the financing
decision will be taken by C and D.

Security Market Line
For an individual risky asset the relevant risk is measured through
the covariance of its return with the return of market portfolio.
An alternative measure is Beta = covariance of return on
asset/variance of return on market portfolio.

SML is a linear relationship between risk and return for an individual
asset where risk is Beta.
The required rate of return for a particular asset in a market
depends on its sensitivity towards the movement of the market
portfolio which is beta reflecting systematic risk.
Two instant interpretation
1.Each asset may be viewed as a combination of risk free asset and
market portfolio.
2.Under equilibrium all the assets plotted on SML are priced
correctly.
SML.
Security Market Line

Beta of the Market portfolio is 1 by definition.
The required return on any security or portfolio is equal
to the risk free rate plus a risk premium.

Thus the SML shows that the expected return on a security
(ri) depends on the risk free rate, rf, which is the pure
time value of money,
rM rf, the reward for bearing systematic risk and i, the
amount of systematic risk.
If the expected market risk premium is 8% and the risk
free rate is 3% calculate the expected return on an asset
whose beta is 1.25. If the beta decreases to 0.6 find the
return also.
Issues in Beta estimation.
Following factors are important in calculating
the Beta.
The length of time over which the return is
calculated.
The number of observations used.
The specific time period used.
The market index selected.
CML and SML
CML shows the relation between portfolio expected
return and portfolio standard deviation and help
investors in their capital allocation problems.
SML shows the relationship between expected return
and Beta and helps investors in security selection and
asset pricing.
A rightly priced security will lie exactly on SML.

Asset pricing theories
According to these theories the expected
return on security is related to risk free rate
and risk premium rate which includes the
return on the market portfolio.
All the variables are ex ante expectation which
an investor believes for the coming relevant
investment horizon.

Market Efficiency.
When the market is efficient question of
Abnormal return does not arise.
So return on all securities will be
commensurate with the underlying risk.
All assets will be correctly priced and will
provide a normal return for their level of risk
.And in that case variance of the return will be
insignificant.
Why APT?
A market model is a single factor model which relates
a securitys return to a single factor, the return on a
market index.
However, the return on a security may depend on
more than a single factor, necessitating the use of
multiple factor models.
Multiple factor models relate the return on a security
to different factors in the economy, like the expected
inflation, GDP growth rate, interest rate, tax rate
changes etc.
Arbitrage Pricing Theory (APT) is a factor model that
was developed by Stephen Ross.
It starts with the assumption that security returns are
related to an unknown number of unknown factors.
Factor Model
The market model assumes that there is one factor- the return
on a market index.
But actual security returns are sensitive to more than
movements in a market index.
A factor model attempts to capture the major economic forces
that systematically move the prices of all securities.
The assumption of a factor model is that the returns on
securities move through common reaction to one or more
factors specified in the model.
Arbitrage Pricing Theory does not rely on measuring the
performance of the market.
Instead, APT directly relates the price of the security to the
fundamental factors driving it.
The problem with this is that the theory in itself provides no
indication of what these factors are, so they need to be
empirically determined.
Assumptions of Arbitrage Pricing
Theory
Capital markets are perfectly competitive
Investors always prefer more wealth to less
wealth with certainty
The stochastic process generating asset
returns can be presented as a k-factor model
Arbitrage Pricing Theory
Multiple factors expected to have an impact on all
assets:
Inflation
Growth in GNP
Major political upheavals
Changes in interest rates
And many more.
Contrast with CAPM assumption that only beta is
relevant
Arbitrage Pricing Theory (APT)
b
ik
measure how each asset (i) reacts to a
common factor (k)
Each asset may be affected by a factor, but the
effects will differ
In application of the theory, the factors are not
identified
Similar to the CAPM, the unique effects are
independent and will be diversified away in a
large portfolio
Arbitrage Pricing Theory (APT)
APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic-risk
portfolio is zero when the unique effects are
diversified away
The expected return on any asset i (E
i
) can
be expressed as
Arbitrage Pricing Theory (APT)
where:
= the expected return on an asset with zero
systematic risk where
ik k i i i
b b b E + + + + = ...
2 2 1 1 0
0

0 1
E E
i
= =
0 0
E =
1

= the risk premium related to each of the common factors - for

example the risk premium related to interest rate risk
b
ik
= the pricing relationship between the risk premium and asset i - that is how
responsive asset i is to this common factor K
Two Factor Model
In Case of a two factor model the following formula is quoted for the return
Ri = Rf +1F1 + 2 F2 + i
Where F1 and F2 are the two factors, Ri is the expected return on the
security i ,
1 is the sensitivity of security i to factor F1, 2 is the sensitivity of
security i to factor F2 and i is the random error term which is assumed
to be uncorrelated across different stocks.
We call it the idiosyncratic return component for stock i.
An important property of the idiosyncratic component is that it is
assumed to be uncorrelated with F, the common factor in stock returns.
So the expected value of random error term is zero.

Example: If GDP grows by 2.9 %, inflation is 3%, and factor sensitivities
of the security to GDP and inflation rate are 2.2 and -0.7 respectively,
and Rf = 5.8%, the securitys expected return is equal to ?





Empirical Tests of the APT
Studies by Roll and Ross and by Chen support
APT by explaining different rates of return with
some better results than CAPM
Reinganums study indicated that the APT does
not explain small-firm results
Dhrymes and Shanken question the usefulness
of APT because it was not possible to identify
the factors and therefore may not be testable