Python for Finance - Second Edition by Second Edition

Author:Second Edition [Edition, Second]
Language: eng
Format: epub
Published: 0101-01-01T00:00:00+00:00

Modigliani and Modigliani performance measure (M2 measure)

Introduction to portfolio theory

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The keyword for the portfolio theory is diversification, while the keyword for diversification is correlation. In other words, correlation is used to measure how closely two stocks or portfolios are moving together. The objective of portfolio theory is to allocate our assets optimally with respect to risk and return. Markowitz (1952) argues that we should consider only the first two moments of a security's return distribution: mean and variance. For financial markets, several important assumptions are made, such as stock markets are inefficient, a typical investor is rational, and an arbitrage opportunity would not last long. For the preferences between two stocks, for a given risk, a rational investor would prefer stock with a higher expected return; for a given return, a rational investor prefers stock with a lower risk level. Sometimes, a single period portfolio optimization is called Markowitz Portfolio Optimization. The input includes a return matrix, and a variance and covariance matrix, while the output is an efficient portfolio. By connecting numerous efficient portfolios, an efficient frontier is formed. Here, we start with the simplest scenario: a two-stock portfolio.

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