Corporate Finance
Analysis and conclusionWhether one portfolio delivers best outcome to the client depends on several elements. The expected return and risk of such an portfolio are required to consider, however, the risk preference of the client also significantly affects the choice of the stock combination, according to Nosic and Weber (2010). Therefore, expected return, risk that is described by standard deviation and the willingness that the investor tends to take risk are discussed as below. Expected return and riskThe new portfolio, which combines 250% of the stock combination and -150% of the risk free bond, yields a return of 1.6958% monthly and a standard deviation of 18.5946%. This new portfolio lays on the line determined by the risk-free asset and the minimum variance portfolio, as shown in figure. It is on the right side of the minimum standard variance is because the portion of the risk free asset is negative, which means the client will short sell the risk free asset and bring the money to invest in the stock combination. [pic 1]
However, it is demonstrated obviously in figure that the new portfolio point is below the efficient frontier. This implies that there will be a point on the efficient frontier and has the same return as the new portfolio point does. Because efficient frontier is a set of portfolios that have the highest expected return with a specific standard deviation, according to Markowitz(1952). Thus, we draw a horizontal line between the new portfolio point and the efficient frontier, then find out the point (figure )that yields the same expected return as the new portfolio does, but has lower standard deviation. Hence, there is a point on the efficient frontier that has lower risk but gives out same expected return, compared to the new portfolio point. [pic 2]Substantially, there is a capital allocation line (CAL) that points out the optimal portfolio, as shown in figure. CAL is similar to the capital market line (CML), which is a line drawn from the risk free asset point and is tangent to the efficient frontier. The tangent point is the optimal portfolio that contains the optimal combination of the expected return and the risk(Myers and Read, 2001,p. 545-580). Compared to the new portfolio point, the tangent point covers a higher expected return and a lower risk (standard deviation). Additionally, the equation of CML under capital asset pricing model (CAMP) is a prevalent method to analysis the stock combination (Grauer and Janmaat, 2004). However, Frino et al. (2013) state that CAMP is used to examine the market risk that attributes to the asset and should contains the whole market asset data. In our case, we only cover three stocks and the 10-year bonds. Therefore, CAMP is not considered as a proper method to assess the portfolio here. [pic 3]