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    Meanvariance Efficiency Proof

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    Alberto Wilkins
    This document provides a proof that mean-variance efficiency and the capital asset pricing model are mathematically equivalent. It presents a proposition, then provides a detailed mathematical proof showing that any portfolio that is mean-variance efficient must satisfy the CAPM equation, and vice versa.

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    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd

    Meanvariance Efficiency Proof

    Uploaded by

    Alberto Wilkins
    37 views3 pages
    This document provides a proof that mean-variance efficiency and the capital asset pricing model are mathematically equivalent. It presents a proposition, then provides a detailed mathematical proof showing that any portfolio that is mean-variance efficient must satisfy the CAPM equation, and vice versa.

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    © Attribution Non-Commercial (BY-NC)

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    This document provides a proof that mean-variance efficiency and the capital asset pricing model are mathematically equivalent. It presents a proposition, then provides a detailed mathematical proof showing that any portfolio that is mean-variance efficient must satisfy the CAPM equation, and vice versa.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    37 views3 pages

    Meanvariance Efficiency Proof

    Uploaded by

    Alberto Wilkins
    This document provides a proof that mean-variance efficiency and the capital asset pricing model are mathematically equivalent. It presents a proposition, then provides a detailed mathematical proof showing that any portfolio that is mean-variance efficient must satisfy the CAPM equation, and vice versa.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 3

    Mean-Variance Eciency and the Capital Asset Pricing Model

    Matthew Pollard 28th April 2008


    Abstract I provide a simple proof of Rolls (1977) result that mean-variance eciency and the capital asset pricing model equation are mathematically equivalent.

    Proposition
    Let xp denote any mean-variance ecient portfolio with expected return E[Rp ], except for the minimum variance portfolio. For all assets i, the Capital Asset Pricing Model equation holds: E[Ri ] E[Rzp ] = i (E[Rp ] E[Rzp ]) where E[Rzp ] the unique mean-variance ecient portfolio satisfying Cov(Rp , Rzp ) = 0. Furthermore, any pair of portfolios (xp , xzp ) that satisfy the above conditions are necessarily both mean-variance ecient.

    Proof
    Let = (i,j )N N denote the matrix of asset covariances. Suppose xp is ecient; that is, it is the solution to the optimization problem 1 xp = arg min xT x subject to xp = ERp , xT 1 = 1. p 2 The necessary and sucient rst order conditions for a solution are: xp = + 1 ERp = xp 1 = xp 1. Solving these rst order conditions for xp yields xp = (1 + 1 1), xp = E[Rp ] where and are = 1 1 (CE[Rp ] A), = (B AE[Rp ]) . D D 1 (2) (1)

    and where the scalars (A, B, C, D) are dened as A = 1 1, B = 1 , C = 11 1, D = BC A2 . By denition of covariance, Cov(Rp , Rq ) = xp xq . for all portfolios xp and xq . Suppose xp is ecient. Using the rst order (1) it follows that Cov(Rp , Rq ) = (1 + 1 1) xq = 1 xq + 1 1 xq = xq + 1 xq = E[Rq ] + . Substituting in values of and yields the expression Cov(Rp , Rq ) = C D E[Rp ] A C E[Rq ] A C + 1 . C

    Let xzp denote any portfolio satisfying Cov(Rp , Rzp ) = 0. Such a portfolio always exists and lies on the frontier. The expected return E[Rzp ] is given by rearranging the covariance expression: E[Rzp ] =
    D A C2 C E[Rp ] A C

    The variance of Rp is Cov(Rp , Rp ). Dividing the above by V ar(Rp ) yields Cov(Rp , Rq ) V ar(Rp ) Isolating E[Rq ] and setting =
    C D

    E[Rp ]
    C D

    A C

    E[Rq ]
    A 2 C

    E[Rp ]

    A C 1 C

    1 C

    Cov(Rp ,Rq ) V ar(Rp )

    = q yields,
    1 C A C

    E[Rq ] = = =

    q V ar(Rp )
    C D

    E[Rp ]

    A C
    A C

    D q V ar(Rp ) A C2 + C A C E[Rp ] D E[Rp ] C q V ar(Rp ) + E[Rzp ]. C A D E[Rp ] C

    The rst term in this epression can be further decomposed: q V ar(Rp ) C A D E[Rp ] C = q
    C D

    E[Rp ]
    C D

    A 2 1 +C C A E[Rp ] C

    = q

    E[Rp ]

    D A C2 + C E[Rp ]

    A C

    = q (E[Rp ] E[Rzp ]) Substituting this this back into the expression E[Rq ] yields the CAPM equation E[Rq ] = q (E[Rp ] E[Rzp ]) + E[Rzp ]. We have now proven that mean-variance eciency of xp implies the CAPM equation. To prove that the CAPM equation implies mean-variance eciency of xp , the previous algebraic manipulations can be reversed to obtain the necessary and sucient rst order conditions for mean-variance eciency. By suciency, it immediately follows xp is mean-variance ecient. ;

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