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.

CONCEPT-

It 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).

DEFINITION-
A 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 AREA
PVWP INCLUDES ALL THE
POSSIBLE SECURITIES AN INVESTOR
CAN INVEST IN. THE EFFICIENT
PORTFOLIOS ARE THE ONES THAT
LIE ON THE BOUNDARY OF PQVW.
FOR EXAMPLE, AT RISK LEVEL X
2
,
THERE ARE THREE PORTFOLIOS S,
T, U. BUT PORTFOLIO S IS CALLED
THE EFFICIENT PORTFOLIO AS IT
HAS THE HIGHEST RETURN, Y
2
,
COMPARED TO T AND U. ALL THE
PORTFOLIOS THAT LIE ON THE
BOUNDARY OF PQVW ARE
EFFICIENT PORTFOLIOS FOR A
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 RISK-RETURN
INDIFFERENCE CURVE. A PARTICULAR
INDIFFERENCE CURVE SHOWS A
DIFFERENT COMBINATION OF RISK AND
RETURN, WHICH PROVIDE THE SAME
SATISFACTION TO THE INVESTORS. EACH
CURVE TO THE LEFT REPRESENTS HIGHER
UTILITY OR SATISFACTION. THE GOAL OF
THE INVESTOR WOULD BE TO MAXIMIZE
HIS SATISFACTION BY MOVING TO A
CURVE THAT IS HIGHER. AN INVESTOR
MIGHT HAVE SATISFACTION REPRESENTED
BY C
2
, BUT IF HIS SATISFACTION/UTILITY
INCREASES, HE/SHE THEN MOVES TO
CURVE C
3
THUS, AT ANY POINT OF TIME,
AN INVESTOR WILL BE INDIFFERENT
BETWEEN COMBINATIONS S
1
AND S
2
, OR
S
5
AND S
6
.
THE INVESTOR'S OPTIMAL PORTFOLIO
IS FOUND AT THE POINT OF TANGENCY
OF THE EFFICIENT FRONTIER WITH THE
INDIFFERENCE CURVE. THIS POINT
MARKS THE HIGHEST LEVEL OF
SATISFACTION THE INVESTOR CAN
OBTAIN.
R IS THE POINT WHERE THE EFFICIENT
FRONTIER IS TANGENT TO
INDIFFERENCE CURVE C
3
, AND IS ALSO
AN EFFICIENT PORTFOLIO. WITH THIS
PORTFOLIO, THE INVESTOR WILL GET
HIGHEST SATISFACTION AS WELL AS
BEST RISK-RETURN COMBINATION.
R
1
IS THE RISK-FREE RETURN, OR THE
RETURN FROM GOVERNMENT SECURITIES, AS
GOVERNMENT SECURITIES HAVE NO RISK.
R
1
PX IS DRAWN SO THAT IT IS TANGENT TO
THE EFFICIENT FRONTIER. ANY POINT ON
THE LINE R
1
PX SHOWS A COMBINATION OF
DIFFERENT PROPORTIONS OF RISK-FREE
SECURITIES AND EFFICIENT PORTFOLIOS. THE
SATISFACTION AN INVESTOR OBTAINS FROM
PORTFOLIOS ON THE LINE R
1
PX IS MORE
THAN THE SATISFACTION OBTAINED FROM
THE PORTFOLIO 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