May 24, 2004
Mean-Variance Analysis
We will use the following results to construct a budget constraint.
The budget constraint shows all possible portfolios with one risky asset and one risk-free asset. Here are a few examples.
Add the indifference curves from the handout, and we have a powerful diagram.
An individual's optimal portfolio depends on his or her indifference curves, which basically reflect the degree of risk aversion.
Each diagram also shows one possible shift in the budget constraint caused by a change in the risk and expected return parameters in the markets. These shifts explain the volume of trading in the financial markets.
People with different ideas about the current risk and expected return can optimize over quite different budget constraints. People can also make mistakes. Is the budget constraint really always upward sloping?
