FINANCE Corporate financial policy and R and D Management

The monthly standard deviation of the three-asset, risk-minimizing portfo-
lio is 5.48 percent, which represents an 18.98 percent annualized standard
deviation. There is a reduction in risk for the same (approximate) level of
return when one uses the risk-minimizing versus the equally weighted port-
folio deviation.
Markowitz analysis sought to minimize risk for a given level of return.
Thus, one could construct an infinite number of portfolios, by varying se-
curity weights, but the efficient frontier would contain securities with
weights that would maximize return for a given level of risk.
The Capital Market Line (CML) was developed to describe the return-
risk trade-off assuming that investors could borrow and lend at the risk-
free rate (RF) and that investors must be compensated for bearing risk.
Investors seek to hold mean-variance efficient portfolios, invest for a one-
period horizon, pay no taxes or transactions costs (we wish), and have ho-
mogeneous beliefs. All investors have identical probabilities of the
distribution of future returns of securities.

(8.6)

where E(Rp) = expected return on the portfolio
E(RM) = expected return on the market portfolio, where all
securities are held relative to their market value
σM= standard deviation of the market portfolio
σρ= standard deviation of the portfolio

The reader notes that as the standard deviation of the portfolio rises,
its expected return must rise.

Introduction to Modern Portfolio Theory

Markowitz created a portfolio construction theory in which investors
should be compensated with higher returns for bearing higher risk. The
Markowitz framework measured risk as the portfolio standard devia-
tion, its measure of dispersion, or total risk. The Sharpe (1964), Lintner
(1965b), and Mossin (1966) development of the capital asset pricing
model (CAPM) held that investors are compensated for bearing not total
risk, but rather market risk, or systematic risk, as measured by the stock
beta. Sharpe wrote his dissertation at UCLA and worked under
Markowitz. Sharpe, Markowitz, and M. Miller shared the 1991 Nobel

ER R

ER R

pF

MF

M

()

()

=+

 −









σ σρ

Introduction to Modern Portfolio Theory 209