Mean-Variance Asset Allocation

Explain in detail the concept of the mean-variance optimal portfolio approach of Markowitz. Use graphs and simple formulas to support your qualitative arguments.

ALT: The optimal complete portfolio $w_{cp}$ is

$w_{cp}=y*w_{TP}$ and $w_{rf} = 1-y$

$w_{cp}$ is on the Capital Allocation Line

if $y < 1$: $w_{cp}$ between $r_f$ and $w_{TP}$

$y= 1: w_{cp} = w_{TP}$

$y>1: w_{cp}$ above $w_{TP}$. The investor borrows money

https://s3-us-west-2.amazonaws.com/secure.notion-static.com/ab08bd41-91c5-4609-b6ad-09b551a86ee8/Untitled.png

Markowitz: Revealed Risk-Aversion

Assume a risk-averse investor invests as suggested by Markowitz. The investor reveals that his complete portfolio is a 200/100 portfolio, meaning, the investor invests 200% of his wealth into the tangency portfolio and borrows the additional 100% at the risk-free rate. If the Sharpe ratio of the Tangency portfolio is 1.0 and its volatility is 30%, how large is the revealed degree of risk aversion of the investor? How large needs risk aversion to be so that the investor invests only 50% into the Tangency portfolio?

Assumption: volatility = standard deviation ????

The optimal fraction of wealth employee i invests into the TP portfolio is: $y_i^* = \frac{SR_{TP}}{\gamma_i *\sigma_{TP}}$

Hence, $\gamma_i=\frac{SR_{TP}}{y_i^**\sigma_{TP}}$

In the first case:

$y_i^* = 2, Var = 0.3, SR = 1$

risk aversion is: $\frac{1}{2 \times 0.3} = 1.6667$