Markowitz Model

¾ Introduction
¾ Assumptions of Markowitz Theory
¾ Markowitz Diversification
¾ Criteria of Dominance
¾ Markowitz Model
¾ Measurement of Risk
¾ Portfolio Risk
¾ Markowitz Vs Sharp Model
¾ Optimal Portfolio of Sharp
¾ Arbitrage Pricing Theory
¾ Asset Selection in APT
¾ Components of Expected Return
¾ Empirical Testing of APT
 Introduction
Harry M. Markowitz, introduced new concepts of
risk management and their application in selection of
portfolios. His model is theoretical framework for
analysis of risk and return and their inter relationship.
He generated number of portfolios within a given
amount of money and given preferences of investors for
risk and return.
Markowitz emphasised that quality of a portfolio
will be different from the quality of individual assets
within it.
 Assumptions of Markowitz Theory

Markowitz’s Modern Portfolio Theory is based

on following assumptions;
1. Investors are rational and wants to maximise their return
2. They have free access to fair and correct information
3. The markets are efficient and absorb the information
4. Investors are risk averse and try to minimise the risk
5. They prefer higher returns to lower returns for a given
level of risk.
 Markowitz Diversification

The diversification theory of portfolio by

Markowitz attaches importance to standard deviation, to
reduce it to zero, if possible, covariance to have as much
as possible negative interactive effect among the
securities within the portfolio. The theory also postulated
that diversification should not only aim at reducing the
risk of security by reducing its variability or standard
deviation, but by reducing the covariance of two or more
securities in portfolio.
 Parameters of Markowitz Diversification
For building up the efficient set of portfolio, we
need to look into following important parameters;
1. Expected return
2. Covariance of one asset return to other asset returns.
3. Variability of returns as measured by standard deviation
from the mean.
Whatever is the risk of the individual securities in
isolation, the total risk of the portfolio of all securities
may be lower, if the covariance of their return is negative
or negligible.
 Criteria of Dominance
The superiority of one portfolio over the other, if
with the same return, risk is lower or higher, is known as
dominance. This principle includes trade off between risk
and return. For two security portfolio, minimise the
portfolio risk by the equation
σp = Wa σa2 + Wb σb2 + 2(Wa Wb σa σb σab)
E (Rp) = WaE (Ra) + Wb E (Rb)
R refers to return, E (Rp) is the expected return, W refers to
the proportion invested in each security σa and σb are the std. dev.
of a and b securities and σab is the covariance of the security
returns.
 Markowitz Model
In Markowitz model risk is measured by standard
deviation of the return over the Mean for a number of
observations. There are two types of risks

Types of Risk

Systematic (Market Risk) Unsystematic (Company Risk)

e.g. Market Risk, Inflation Risk, e.g. Labour Problems, Liquidity Risk,
Interest Rate Risk etc. Financial Risk, Management Problems
 Measurement of Risk
Let’s take following example to calculate total risk.
Observations : 10%, -5%, 20%, 35%, -10%
10% will be the mean
Standard Deviation from the Square of
Deviation = ∑d ÷ 5
2
Mean Deviation
10 - 10 = 00 0
1350 ÷ 5
-5 - 10 = -15 225
20 - 10 = 10 100
270
35 - 10 = 25 625
-10 - 10 = -20 400
∑d2 = 1350
 Portfolio Risk
When two or more assets are combined in a portfolio,
their covariance or interactive risk is to be considered.
Mathematically covariance is defined as,
Cov x Y = (1 ÷ N) ∑ (Rx – Rx) (Ry – Ry)
Where,
Rx = return on security x, Ry = return on security Y
Rx and Ry are expected returns on them respectively
and N is the number of observations.
 Markowitz Vs Sharp Model
Markowitz Model Sharp Model
Utility of a portfolio is risk adjusted Optimal portfolio is set up by using the
return. It is equal to portfolio return minus single index model of sharp. The
risk penalty. desirability of any stock is directly related
Where, to its excess return to Beta ratio, namely
Risk penalty = (Risk Squared ÷ Risk Tolerance) Sharp Index = (RJ – RF) ÷ BJ
It is portfolio risk, relative to the Where, RJ is expected return on the
investor’s risk tolerance. The optimal stock, RF is the risk free return, and BJ is
portfolio is one on the efficient frontier the Beta relating the J stock to the market
that maximises utility. return.
To generate efficient portfolios the Then rank all the stocks in their order
Markowitz Model requires – (a) expected of the index value.
return on each assets (b) Standard In this model, the return on any stock
deviation of returns as a measure risk of depends on some constant (α) called alpha
each asset, and (c) the covariance or plus coefficient (β) called Beta, times the
correlation coefficient as a measure of value of a stock Index (I), plus random
inter-relationship between the returns on component. The equation in Sharp is
assets considered. R = α + β I +e
J J J J
 Sharp Model
Sharp model, having simplified process of compilation
of expected return, standard deviations, variance of each
security to every other security in the portfolio through
relating the return in a security to single market Index.
As against this Markowitz model had serious practical
limitations in compiling, due to rigours calculations.
The sharp model is useful because of following reasons,
i] This will theoretically reflect all well traded security
ii] It will reduce the work involve in compiling.
 Optimal Portfolio of Sharp
This portfolio of sharp also called Single Index
Model. It is directly related to Beta. If Ri is expected
return on stock I and Rf is risk free rate, then the excess
return is Ri – Rf. This has to be adjusted to βi. so the
equation for ranking Stocks in the order of their return
adjusted for risk is as below,
(Ri – Rf) ÷ (β1)
 Arbitrage Pricing Theory
APT
a) Investors do not look at expected returns and
standard deviations. Based on the law of one price, if
the price of an asset is different in different markets,
arbitrage brings them to the same price.
b) Investors prefer higher wealth/returns to lower
wealth.
c) APT is based on the return generated by factor
models.
CAPM
a) Investors look at the expected return and
accompanying risks measured by standard deviation.
b) Investors are risk averse and risk-return analysis is
necessary.
c) Investors maximise wealth for a given level of risk.

The APT is an equilibrium model of asset pricing

like CAPM. But this theory assumes that the returns are
generated by a factor model.
Factor Models in APT

Single Factor Model Multiple Factor Model

 Asset Selection in APT
In APT model, many types of investment strategies
can be selected. If there are many securities to be selected
and the amount is fixed for investment, the investor can
choose in a manner that he can aim at zero non-factor risk
(ei = 0). Although, theoretically it would be
possible to create “pure factor” portfolios that are
sensitive to only one factor and have insignificant non
factor risk. But in practice only impure factor portfolios
can be created.
 Components of Expected Return

There are two parts of expected return. i] risk free

rate of return ii] pure factor portfolio.
Although theory claims that the non-factor risk can
be reduced to zero, it is not possible in real life.
Therefore, in practical investment, it is better to combine
CAPM and APT model. The trade off between risk and
return is not considered by APT model. So synthesis
between CAPM and APT is more realistic.
 Empirical Testing of APT
The practical experience tell us that other things
being equal, securities with large ex-ante betas will have
relatively large expected returns. Investment is made on
expectation and hence investors use betas, despite the
fact that exact value of the beta is may not really give an
indication of actual returns in future.

In the graph, OM is risk

free return. Actual CAPM line
is shown in the Graph to vary
from the Zero Beta Line to a
Substantial extent.
 Problem on Arbitrage Pricing Theory
Question: From the below given figures, calculate the expected rate of return of the stock.
λ1 = 1.8 Risk free Rate λ0 = 7%
λ2 = 1.25 b1 = 1.1
λ3 = 0.50 b2 = 1.5
b3 = -0.75
Answer:
The equation for APT Model
Eri = λ0 + λ1 b1 + λ2 b2 + λ3 b3 …….
Eri = 7+1.8(1.2) + 1.25(1.5) + .50(-0.75)
= 7 + 2.16 + 1.875-0.375
= 10.66

The Expected Rate of Return is 10.66%.