Question

The basic elements of modern portfolio theory were proposed by Dr. Harry M.Markowitz in 1952. He provided the theoretical framework for the systematic composition of optimum portfolio.

Inlight of the above , discuss Markowitzs Model and the Efficient Frontier as a finance theory

Answer 1

Efficient frontier is one of the building blocks of modern finance.

A rational investor is ideally assumed to be risk averse. Also in case there is a possibility to earn a higher return with the same risk, the investor will logically opt for the opportunity with the higher return.

Also in case there is a possibility where between two alternatives - same return is there in both options but one has a lower risk, the investor will logically opt for the opportunity with lower risk.

Now all such portfolios where the (i) return is maximized for lowest level of risk
or
(ii) return is maximized for lowest level of risk

can be referred to as combinations of efficient portfolios.

When risk ( X Axis) and return (Y Axis) is plotted on a X-Y Graph table, and the combination of all efficient portfolios are plotted, the graph is known as the efficient frontier.   

The Markowitz Model builds on this and says that a rational investor basis his risk- return framework will only invest in a portfolio which is part of the efficient frontier.

It further builds to state about a Capital Market Line which basically is upward sloping. The Capital market line shows the risk that the market is willing to take for each level of return. (Thus forming the risk appetite - return wanting line).

Markowitz model goes on to build that the location where the Capital Market line co-incides with the efficient frontier, is the market portfolio.

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