EFFICIENT FRONTIER

-Ranpreet kaur

INTRODUCTION
The concept was popularized by Dr Harry Markowitz, who won a nobel prize for his work on Portfolio Management in relation to financial investments. The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Frontier will be portfolios of investments rather than individual securities.

CONCEPTIt can be said The set of optimal portfolios is called the efficient frontier
Portfolios on the efficient frontier are optimal in both the sense that they offer maximal expected return for some given level of risk and minimal risk for some given level of expected return.

OPTIMAL PORTFOLIO
The notion of "optimal" portfolio can be defined in one of two ways:

From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of return

The efficient frontier is the basis for modern portfolio theory(Risk & Return, Diversification).

DEFINITIONA graphical representation of the set of portfolios giving the highest level of expected return at different levels of risk. Or The graphical depiction of the Markowitz efficient set of portfolios representing the boundary of the set of feasible portfolios that have the maximum return for a given level of risk. Any portfolios above the frontier cannot be achieved. Any below the frontier are dominated by Markowitz efficient portfolios. Or A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.
Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.

EFFICIENT FRONTIER

IN FIGURE 1, THE SHADED PVWP INCLUDES ALL

CAN INVEST IN.

AREA

THE

POSSIBLE SECURITIES AN INVESTOR

THE

EFFICIENT

PORTFOLIOS ARE THE ONES THAT

PQVW. FOR EXAMPLE, AT RISK LEVEL X2, THERE ARE THREE PORTFOLIOS S, T, U. BUT PORTFOLIO S IS CALLED
LIE ON THE BOUNDARY OF THE EFFICIENT PORTFOLIO AS IT HAS THE HIGHEST RETURN, Y2, THE THE ARE A COMPARED TO PORTFOLIOS BOUNDARY EFFICIENT

AND

U. ALL
ON FOR

THAT OF

LIE

PQVW

PORTFOLIOS

GIVEN RISK LEVEL.

ASSUMPTION

Risk of a portfolio is based on the variability of returns from the said portfolio. An investor is risk averse. An investor prefers to increase consumption. The investor's utility function is concave and increasing, due to his risk aversion and consumption preference. Analysis is based on single period model of investment. An investor either maximizes his portfolio return for a given level of risk or maximum return for minimum risk. An investor is rational in nature

CLEAR DEMONSTRATION OF THE POWER OF

DIVERSIFICATION Since the efficient frontier is curved, rather than linear, a key finding of the concept was the benefit of diversification. Optimal portfolios that comprise the efficient frontier tend to have a higher degree of diversification than the sub-optimal ones, which are typically less diversified.

DEMERITS OF THE HM MODEL

It requires lots of data to be included. An investor must obtain variances of return, covariance of returns and estimates of return for all the securities in a portfolio. There are numerous calculations involved that are complicated because from a given set of securities, a very large number of portfolio combinations can be made. The expected return and variance will also have to computed for each securities

THE EFFICIENT FRONTIER AND INVESTOR UTILITY

An individual investors utility curve specifies the trade-offs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as move upward These two interactions will determine the particular portfolio selected by an individual investor

THE EFFICIENT FRONTIER AND INVESTOR UTILITY

The optimal portfolio has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility

FIGURE 2

SHOWS

THE A

RISK-RETURN PARTICULAR SHOWS A

INDIFFERENCE INDIFFERENCE

CURVE. CURVE

DIFFERENT COMBINATION OF RISK AND

RETURN,

WHICH

PROVIDE

THE

SAME

SATISFACTION TO THE INVESTORS. UTILITY OR SATISFACTION.

EACH

CURVE TO THE LEFT REPRESENTS HIGHER

THE

GOAL OF

THE INVESTOR WOULD BE TO MAXIMIZE HIS SATISFACTION BY MOVING TO A CURVE THAT IS HIGHER. BY

AN

INVESTOR

MIGHT HAVE SATISFACTION REPRESENTED

C2,

BUT IF HIS SATISFACTION/UTILITY HE/SHE WILL THEN BE MOVES TO

INCREASES, CURVE AN

C3 THUS,

AT ANY POINT OF TIME, INDIFFERENT AND

INVESTOR

BETWEEN COMBINATIONS

S1

S2,

OR

S5 AND S6.

THE

INVESTOR'S OPTIMAL PORTFOLIO

IS FOUND AT THE POINT OF TANGENCY

OF THE EFFICIENT FRONTIER WITH THE INDIFFERENCE MARKS THE SATISFACTION CURVE. HIGHEST THE

THIS

POINT OF CAN

LEVEL

INVESTOR

OBTAIN.

IS THE POINT WHERE THE EFFICIENT IS TANGENT TO THIS

FRONTIER

INDIFFERENCE CURVE

C3,

AND IS ALSO

AN EFFICIENT PORTFOLIO.

WITH

PORTFOLIO, THE INVESTOR WILL GET HIGHEST SATISFACTION AS WELL AS BEST RISK-RETURN COMBINATION.

R1

IS THE RISK-FREE RETURN, OR THE

RETURN FROM GOVERNMENT SECURITIES, AS GOVERNMENT SECURITIES HAVE NO RISK.

R1PX

IS DRAWN SO THAT IT IS TANGENT TO

THE EFFICIENT FRONTIER. THE LINE

ANY
OF

POINT ON RISK-FREE

R1PX

SHOWS A COMBINATION OF

DIFFERENT

PROPORTIONS

SECURITIES AND EFFICIENT PORTFOLIOS. THE SATISFACTION AN INVESTOR OBTAINS FROM PORTFOLIOS ON THE LINE THE PORTFOLIO

R1PX

IS MORE

THAN THE SATISFACTION OBTAINED FROM

P.

SINGLE INDEX MODEL

The single-index model (SIM) was first suggested by William Sharpe, and is a simple asset pricing model commonly used in the finance industry to measure risk and return of a stock. or
The relationship between a security's performance and the performance of a portfolio containing it. The market model states that the security's performance is related to its portfolio's performance, according to its beta. or A model of stock returns that decomposes influences on returns into a systematic factor, as measured by the return on the broad market index, and firm specific factors.

SINGLE INDEX MODEL-ASSUMPTIONS

Known economist William Sharpe developed the single index model. According to this model following assumptions are there :

Most stocks have a positive covariance because they all respond similarly to macroeconomic factors. However, some firms are more sensitive to these factors than others, and this firm-specific variance is typically denoted by its beta (), which measures its variance compared to the market for one or more economic factors. Covariance's among securities result from differing responses to macroeconomic factors. Hence, the covariance of each stock can be found by multiplying their betas and the market variance: All relevant economic factors by one macro-economic indicator and assume that it moves the security market as a whole.

CONTI..

Beyond this common effect, all remaining uncertainty in stock return is firm specific; i.e. there is no other source of correlation between securities. Stocks co vary together only because of their common relationship to the market index. This model relates returns on each security to the returns on a common index. A broad index of common stock is generally used for this purpose. The common index can be BSE 100 stocks, Nifty 50 stocks so on and so forth.

THE SINGLE INDEX MODEL

Expressed by the following equation

Ri=ai+i.RM+ ei
Ri= the return on security i RM=the return on the market index ai=that part of security is return independent of market performance i= a constant measuring the expected change in the dependent variable, Ri, given a change in the independent variable RM ei= random residual error.

INTERPRETATION / APPLICATIONS

These equations show that the stock return is influenced by the market (beta), has a firm specific expected value (alpha) and firm-specific unexpected component (residual). Each stock's performance is in relation to the performance of a market index (such as the All Ordinaries). Security analysts often use the SIM for such functions as computing stock betas, evaluating stock selection skills, and conducting event studies
To simplify the Markowitz model

Model says only the common factor (the market) matters; there is no relationship otherwise