Portfolio Theory

Question 1

Modern Portfolio Theory

Answer 1

• Specifies a method for an investor to construct a portfolio that gives the maximum return for a specified risk or the minimum risk for a specified return
• Assumes investment decisions are solely based on risk and return
• Also known as mean-variance portfolio theory

Question 2

Assumptions of Modern Portfolio Theory

Answer 2

• All expected returns, variance and covariances of pairs of assets are unknown
• Investors make their decisions purely on the basis of expected return and variance
• Investors are non-satiated
• Investors are risk-averse
• There is a fixed single-step time period
• There are no taxes and transaction costs
• Assets may be held in any amounts ie short-selling is possible, we can have infinitely divisible holdings and there are no maximum investment limits

Question 3

Inefficient Portfolio

Answer 3

A portfolio is inefficient if the investor can find another portfolio with the same (or higher) expected return and lower variance, or the same (or lower) variance and higher expected return. Otherwise, the portfolio is efficient

Question 4

Efficient Portfolio

Answer 4

A portfolio is efficient if the investor cannot find another portfolio with the same (or higher) expected return and lower variance, or the same (or lower) variance and higher expected return

Question 5

Efficient Frontier

Answer 5

The efficient frontier is the set of all efficient portfolios, usually represented graphically
by a curve in E-sigma space.