Introduction

The objective of any effective asset allocation strategy is

the generation of maximum desirable return with the acceptable level of risk.

However more often than not coming with up with a strategy

which proves to be successful in every conceivable scenario proves to be an

impossible riddle to solve. Various theories and models have been put forward

in the last few decades which have tried to answer that riddle.

Arguably Foremost amongst these theories were those

forwarded by Nobel Laureate Harry Markowitz in 1952. At a time when finance was

nothing more than ”rule of thumbs, accounting manipulations and analysis of

discounted value” (Merton, 1990), Markowitz developed what now known as modern

portfolio theory in which the desirability of maximizing portfolio return was

an important assumption along with the undesirability of taking risk by the

investor. He tried to explore the problem of maximizing the return of a

portfolio at a given level of risk (Varian, 1993). During this process

Markowitz came up with the concept of efficient frontier which according to him

was a set of portfolios, consisting of risky assets, offering the highest

possible returns for any level of risks or vice versa. This concept proved to

be his most important contribution and perhaps the genesis of the modern

portfolio theory.

In this report in order to satisfy the requirements put

forward by the assignment questions, an attempt has been made to develop (using

MS excel) efficient frontiers of a portfolio consisting of seven stocks namely Tesco Plc (TSCO) Barclays

Plc (BARC) British American Tobacco (BAT) British Petroleum (BP) Pfizer Inc. (PFE) Microsoft Inc. (MSFT) and Caterpillar Inc.

(CAT). The rationale behind the selection of these stocks was that each of

these stocks represents different industries with no apparent significant

relationship with each other. The stocks represent the convenience stores,

financial services, Tobacco, Oil and Gas, pharmaceuticals, IT and Industrial

goods industries. The reason behind choosing stocks from seven different

industries was to observe first-hand the diversification benefit that effective

asset allocation is said to provide to the investor.

Method

The efficient frontiers have been graphed for a total of

three scenarios. The presence of a risk less asset offering a risk free rate of

return has also been incorporated for one of the scenarios while short selling

has been allowed for the other two scenarios. The expected returns are

calculated by a capital asset pricing model (CAPM) and Market Model Approach.

Initially the mean annual returns, variance and standard

deviations of the chosen stocks and the index (FTSE 100) were calculated using the

monthly returns representing the period of five years from September 2012 to 2017.

The returns of the stocks were then regressed against the index to calculate

the beta of the chosen stocks. The beta was also calculate The alphas were

calculated using the INTERCEPT function in excel