an introduction to portfolio theory.pdfVIP

An Introduction to Portfolio Theory Paul J. Atzberger Comments should be sent to: atzberg@math.ucsb.edu Introduction Portfolio theory deals with the problem of constructing for a given collection of assets an investment with desirable features. A variety of different asset characteristics can be taken into consideration, such as the amount of value, on average, an asset returns on over a period of time and the riskiness of reaping returns comparable to the average. The financial objectives of the investor and tolerance of risk determine what types of portfolios are to be considered desirable. In these notes we shall discuss a quantitative approach to constructing portfolios. In particular, we shall use the methods of constrained optimization to construct portfolios for a given collection of assets with desirable features as quantitated by an appropriate utility function and constraints. The materials presented here are taken from the following sources: Theory of Finance - Mean Variance Analysis by Simon Hubbert, and Investments by Bodie, Kane, and Marcus. Characterizing the Rates of Return of Assets and Portfolios We shall concern ourselves with primarily two basic features of an asset. The first is the average return of an asset over a period of time. The second characteristic is how risky it is to obtain similar returns comparable to the average over the investment period. For an asset with value S(0) at time 0 and value S(T ) at time T , the rate of return ρ is defined by: S(T ) = (1 + ρ)S(0). (1) The rate of return can be thought of as an “effective interest rate” which would be required for a deposit of S(0) into a savings account at a bank to obtain the same change in value as the asset over the period [0,T]. For example, if S(0) = $4 and after one yea