RSM332H1 Lecture Notes - Lecture 7: Efficient Frontier, Capital Market, Sharpe Ratio
Document Summary
Investors only care about first and second moments. Correlations between returns of different assets are predictable. E(rp) = wae(ra) + wbe(rb) wb = 1 - wa. Can vary weights of a and b and plot expected return against standard deviation of returns. Exists a combination with positive return but zero risk. Curve traced by all possible combinations of a and b is variance opportunity set. Minimum variance portfolio is portfolio with lowest level of risk. Find minimum variance portfolio by finding optimal amount of stock a to invest so that portfolio variance is minimized. Take derivative with respect to wa and set to 0. Holding multiple stocks that are imperfectly correlated can reduce risk without reducing returns. Rather, consider how returns of every asset correlate with return of other assets in portfolio. Portfolio with less expected return than minimum variance portfolio. Can graph all possible combinations with existing assets.
