MODERN PORTFOLIO THEORY: IDENTIFICATION OF OPTIMAL PORTFOLIOS AND CAPITAL ASSET PRICING MODEL TEST
AbstractThe tool we employ in this work is the well-known Modern Portfolio Theory (MPT), which forms the basis of virtually all quantitative portfolio management and theory today. Since its formulation half a century ago it has been seized on by the investment industry as a workable tool for investment and risk management, in particular because of its simplicity and intuitive appeal, and it remains one of the cornerstones in the foundation on which todayâ€™s asset management industry rests. The MPT introduced the analysis of portfolios of investments by con- sidering the expected return and risk of individual assets and, crucially, their interrelationship as measured by correlation. In MPT diversification plays an important role. The Capital Asset Pricing Model (CAPM) relates the returns on individual assets or entire portfolios to the return on the market as a whole. In CAPM investors are compensated for taking systematic risk but not for taking spe- cific risk. This is because specific risk can be diversified away by holding many different assets. We illustrate this concepts in an application on real market data. We use an optimization in order to find the optimal portfolios and then we test the CAPM.
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