MODERN PORTFOLIO THEORY: IDENTIFICATION OF OPTIMAL PORTFOLIOS AND CAPITAL ASSET PRICING MODEL TEST

  • Висар Малај
Keywords: Investments, portfolio performance, stock return, risk, volatility

Abstract

The 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 today’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.

References

Billio M., M. Getmansky, A. Lo and L. Pelizzon (2010), Econometric Measures of Systemic Risk in Finance

and Insurance sectors, MIT WP 4774-10, NBER WP 16223, Journal of Financial Economics. Campbell,

John Y., A.W. Lo, and A.C. MacKinlay. The Econometrics of Financial

Markets. Princeton University Press, Princeton, NJ, 1997.

Chavas, Jean-Paul, and M.T. Holt. ‘‘Economic Behavior under Uncertainty: A Joint Analysis of Risk Preferences and Technology’’ Review of Economics and Statistics. DeGroot, Morris H. Optimal Statistical Decisions. McGraw-Hill, New York, 1970.

Dixit, Avinash K., and Robert S. Pindyck. Investment under Uncertainty. Princeton University Press,

Dre`ze, Jacques. Essays on Economic Decisions under Uncertainty. Cambridge University Press, New York, 1987.

Epstein, L., and S. Zin. ‘‘Substitution, Risk Aversion, and Temporal Behavior of Consumption and Asset Returns: An Empirical Investigation’’ Journal of Political Economy. 99(1991): 263–286.

Hirshleifer, Jack, and John G. Riley. The Analytics of Uncertainty and Information. Cambridge University Press, Cambridge, 1992.

Hull, John. Options, Futures and Other Derivatives. Fifth Edition. Prentice Hall, 2002.

Kahneman, Daniel, and A. Tversky. ‘‘Prospect Theory: An Analysis of Decision under Risk’’ Econometrica 47(1979): 263–191.

Markowitz, H. ‘‘Portfolio Selection’’ Journal of Finance. 6(1952): 77–91. Menezes, C., and D. Hanson. ‘‘On the Theory of Risk Aversion’’ International Economic Review. 11(1970): 481–487.

Parigi B. and L. Pelizzon (2008), Diversification and Ownership Structure, CESifo Working Paper 1590. Journal of Banking and Finance, 32, 9, 1709-1722.

Pelizzon L and G. Weber (2008) Optimal portfolio composition when real assets and liabilities are taken into account, Trends in Saving and Wealth n.1/2008, Pioneer Investments.

Pelizzon L and G. Weber (2005) Efficient Portfolios Conditional on Housing: Evidence from the UCI survey, Trends in Saving and Wealth n.9/2005, Pioneer Investments. Pratt, John W. ‘‘Risk Aversion in the Small and in the Large’’ Econometrica 32(1964): 122–136. Savage, Leonard J. The Foundations of Statistics. Wiley, New York, 1954.

Published
2016-12-27