Efficient Frontier and the Famous Portfolio Theory of Markowitz - Assignment Example

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The reporter underlines that the Efficient Frontier was derived originally from the famous portfolio theory of Markowitz. Moreover, an efficient frontier represents the curve which provides a maximum rate of return along with a particular level of risk…

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Download file to see previous pages If we assume that riskless borrowing and lending were allowed then the efficient portfolio would be a line passing from Risk-free rate and tangent to the efficient frontier as evident from the figure provided below
Only the first assumption seems to be viable while all the other assumptions are not practically valid. It is very difficult to forecast the expected rate of returns, therefore, forecasting comes into play which tries to provide a reliable value but not the actual that will be in the marketplace. Errors in estimating of mean returns can have a dramatic impact on the portfolio returns and risk and thus can lead to ineffective decision making. Furthermore, the number of estimates required for calculating portfolio risk can be huge depending on the number of assets. Regardless of the quantity, the quality of even some of the factors can deteriorate the calculation of the whole portfolio and makes the mean-variance theory inefficient and impractical.
Minimum Variance Portfolio is relevant with the concept of efficient frontier, as, in order to find the efficient portfolio, we must identify the portfolios that have the minimum variance for each level of expected rate of return. All such portfolios are called minimum variance portfolio.
XA and XB in the above formula represent the weight of each stock. The minimum variance is computed by assigning values to XA and XB in such a way that it gives us the minimum variance. For a two asset portfolio, the weight of assets in the minimum variance portfolio can be computed by
The efficient frontier curve would have changed if the assumption that borrowing or lending is not allowed at the same rate. Since in the practical world, borrowing has implied credit risk, therefore, financial institution charge a premium on the risk-free rate to cover for the credit risk. Thus borrowing would have becomes more costly.
This ratio might be different from the PE ratio based on the actual price of the share since this price which we have calculated through is a particular model.  ...Download file to see next pagesRead More
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