FFE Ntes 5 Diversification and the mean Variance Model.docVIP

Financial Economics: Notes 5 A Diagrammatic Overview of the Mean- Variance Model Portfolio Mean and Variance Assume that investors care only about the mean and variance of their expected wealth (asset returns). This means that asset returns can be defined in mean-variance space. Investors will hold portfolios, with the portfolio return defined by the weights, of assets in the portfolio: The expected return (mean) is The individual asset returns are the same in any portfolio. A portfolio is defined by a set of asset weights denoted by . Individual assets in mean-variance space are The portfolio frontier in mean-variance space is Portfolio variance A portfolio return is a random variable with variance . Substitute for to find The covariation between the returns to different assets is very important. Covariation allows portfolio diversification and a reduction in variance. For a 2-asset portfolio: More generally, to derive the portfolio variance using matrix notation, define then Multiplying out the term gives the variance-covariance matrix V so that or where . Na?ve diversification Assume that asset weights are equal implying that for every asset and Define as the average variance. The sum of the variances can be written as Define as the average covariance. There are covariance terms. The sum of these terms is Therefore The value of cannot fall below , even when n is very large (there are many assets in the portfolio). In na?ve diversification, covariance information is not used efficiently. The Portfolio Frontier and the Efficient Set The portfolio frontier is found by making use of covariance information. The frontier is a central part of the mean-variance model that separates feasible portfolios from infeasible portfolios. It defines the limits of diversification and is defined by the minimum value of for every value of expected return, . E marks the minimum variance point of the portfolio frontier. The segm