Mean-Variance Optimization

Risky portfolio construction decide how to distribute

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Unformatted text preview: eturn. It is a measure of the reward for holding the risky market portfolio rather than the risk-free asset. The denominator is the market risk of the market portfolio. Thus, the first factor, or the slope of the CML, measures the reward per unit of market risk. Since the CML represents the return offered to compensate for a perceived level of risk, each point on the CML is a balanced market condition, or equilibrium. The slope of the CML RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 28 determines the additional return needed to compensate for a unit change in risk, which is why it is also referred to as the equilibrium market price of risk. In other words, the CML says that the expected return on a portfolio is equal to the risk-free rate plus a risk premium, where the risk premium is equal to the market price of risk (as measured by the reward per unit of market risk) times the quantity of risk for the portfolio (as measured by the standard deviation of the portfolio) RISK AND PORTFOLIO MANAGEMENT WITH ECONOMETRICS, VER. 10/23/2012. © P. KOLM. 29 Practical implications Portfolio construction is normally broken down into at least the following two steps: 1. Asset allocation: decide how to allocate the investor’s wealth between the risk-free security and the set of risky securities...
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