Section 3: Mean-Variance Portfolio Theory

Efficient Frontier

The set of portfolios offering the maximum expected return at each level of risk (or minimum risk at each return level);

• The boundary of the opportunity set, used to identify the optimal portfolio given an investor’s risk appetite

Efficient Portfolio

A portfolio on the efficient frontier

Indifference Curve

The locus of (σ_p,R_p) combinations that give equal expected utility

• investor is indifferent between all points on one curve

Global minimum-variance portfolio

R_mv = a/c, σ² = 1/c

Two-fund (mutual fund) separation theorem

Any two efficient portfolios can be combined to replicate any other efficient portfolio

Zero-covariance portfolio

For an efficient portfolio (other than the global min-variance portfolio), the unique portfolio whose return has zero covariance with it, is inefficient

Non-systematic (idiosyncratic) risk

The portion of an asset’s risk unique to it, not explained by market performance; diversifiable

Systematic Risk

The portion of risk due to market-wide movements; not diversifiable the only risk priced under CAPM

Tangency Portfolio

The unique risky portfolio where a line from R_f is tangent to the efficient frontier

Capital Allocation Line (CAL)

The line from the risk-free asset through a chosen risky portfolio

Capital Market Line (CML)

The CAL using the tangency (market) portfolio as the risky component