The Definition Of Separation Theorem Finance Essay

Separation theorem is a basic fiscal theory, it has been good accepted in academic, it is besides the foundation theory and scheme for the common fund. By utilizing separation theorem, the investors would hold a better plus allotment with measures, bonds, stocks and other investing areai??in another word the investors are looking for the best investing portfolioi??with the higher return and limited their hazard.

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Asi??Bodie & A ; Kane & A ; Marcus 1989i?‰agree that For happen the optimum complete portfolio there are two stagesi??the foremost is to pick the optimum hazardous portfolio happen the best weights in different hazardous assets and the 2nd is to add the hazard free assets in the portfolio and so happen the best portfolio between hazard free and hazardous assets i??in the terminal get the optimum complete portfolio and make up one’s mind the concluding weight in bondsi??equity i??and exchequer measures.

In this essayi??I will discourse the definition of the separation theoremi??and how to happen the optimum complete portfolio use the two stairss of separation theorem. Then, I will besides discourse about the importance of separation theorem.

The definition of separation theorem

As i??Bodie & A ; Kane & A ; Marcus1989i?‰ agree that For happen the optimum complete portfolio there are two stagesi??the foremost is to pick the optimum hazardous portfolio happen the best weights in different hazard assets and the 2nd is to add the hazard free assets in the portfolio and so happen the best portfolio between hazard free and hazardous assets i??in the terminal get the optimum complete portfolio. In the first phase happen the tangency point between the chance set of hazardous assets and CAL i??in this point the Sharpe rate wiil acquire its soap valuei??the 2nd find the tangency point between apathetic curve and CALi??then in this point the public-service corporation acquire its soap value.In the terminal the weight of each assets can be calculated i??then the complete portfolio can be determined.

Harmonizing to Tobini??1958i?‰i??the hazardous assets portfolio has no relevant to the investors ‘ hazard aversioni??the optimum portfolio has no relevant to the public-service corporation and apathetic curve.And alsoi??Bodie & A ; Kane & A ; Marcus 1989i?‰pointed that when the invest directors make the determination of the optimum hazardous portfolio for their clients they do non necessitate to care about their hazard antipathy degree. The determine of the optimum hazard portfolio is independent signifier the investors ‘ hazard antipathy, merely in the 2nd phase pick of optimum complete portfolio.For the invest director and their clients, the invest directors provide the same hazard portfolio without consider their hazard antipathy degree, in the phase of pick of optimum complete portfolio the clients need to the determination how to set up their hazard and hazard free plus in the BASIC of their hazard antipathy level.i??Bodie & A ; Kane & A ; Marcus 1989i?‰

Two phases

The optimum hazardous portfolio

The first phase to happen the optimum complete portfolio is to make up one’s mind the optimum hazardous portfolio, and cipher the weight in the hazardous portfolio. Harmonizing to ( Bodie & A ; Kane & A ; Marcus1989i?‰ , for determine the optimum hazardous portfolioi??it besides portion into two phase First it need to happen the risk-return portfolio organize the all possible portfolioi??second use the capital allotment line and cipher the weights in different hazardous assetsi??in the terminal decided the optimum hazardous portfolio.

Suppose there are two hazardous assets in portfolio, bond and equity, for easy depict the investing map, denoted debt as D, equity as E, and their weight in the all portfolio is and, the return rate is and i??so the whole rate of portfolio can be defined as i??1i?‰

and so the expected return rate i?si??2i?‰to estimate the hazardous degree of the whole hazardous portfolio we still need the discrepancy of two assetsi?s


As the this discrepancy expression can besides be described as:


And the correlativity coefficient,

So i??5i?‰

as we know the value of is between -1 to 1.the particular instance is when =1 i??-1. When =-1i??means there is no relevant with two hazardous assetsi??these two assets face the different nonsystematic riskyi??form the map i??5i?‰ when =-1 i??the



When =-1 there is no hazard so so i??the figure below

in this situationi??there would be a minimal discrepancy portfolio

the it would be two lines form the point in the horizontal axis if investors arrange the sum of invest equal in these two assets so this portfolio can against the nonsystematic hazardous really expeditiously.=-1i??it would be two lines separate from point 0.5 When =1 i??it means the plus D and E is relevanti??the tendency of the two assets are about samei??in the figure it is merely one line organize the map

It is really easy to cognize, the value of is more less the efficient of the portfolio is better.

portfolio criterion divergence ( % )

As the systematic hazard is ever exist in the marketi??so the state of affairs like is non exist really. It is the lone ideal state of affairs. But when i??there are chances to distribute the hazard by allotment the fund in these two assets. But this is a perfect state of affairs non ever go on in practical application. The value of two assets risk degree is affect by both weight in these plus and the correlativity coefficient. The figure below shows the relationship between expected return rate and standard divergence

So ignore the utmost state of affairs like i??in the state of affairs like i??there can be a portfolio chance seti??At the same clip the CAL exist organize the figure below i??the CAL line move signifier B to A i??the point of intersections are A and B

As we know the incline of the two point is besides the form ratioi?? this incline is besides be called as sharpi??reward-to-volatilityi?‰i??it is a really of import ratio to measure the public presentation of investmenti??it shows the unite hazard can acquire how much return for investors.i?‰ i??So the If the CAL move to tangency with the portfolio chance seti??then the tangency point is the best point at this point the form ration would acquire its soap value.

Form the mathematics view this job would be explicate how to acquire the soap value of form ratioi??in the tangency point with the capital allotment line with the chance set is the best point of the hazardous portfolio i??in this point the has the maximal value i??MAX, so cipher the first derived function of so the weight of optimum hazardous portfolio should bei?s


After acquire the consequence of i??form the map of

The can be calculatedi??in the terminal the optimum weight in two hazardous plus can be determine. It is point P in the figure below.

Optimal complete portfolio

The chief different of optimum hazardous portfolio and optimum complete portfolio is that the optimum consider the investor ‘s hazard antipathy i??and the degree of the hazard antipathy is used in calculate the map of the complete optimum portfolio.

As we know different investors have different position about the hazard i?? for estimation the investors ‘ hazard antipathy, denoted A as index of investor ‘s hazard antipathy.So U called the public-service corporation of the investing it represent the public assistance from the invest.


When add the riskless plus in the invest portfolioi??the two-assets portfolio can be assumed as one hazardous asseti??as a complete hazard bundle with the hazard free plus. So denote P as the hazard plus

and F as hazardous free asseti?? as the return of hazardous plus as the hazard free plus and the as the entire return rate of whole portfolio. The return and the expected of the all portfolio can be express asi?s i??9i?‰


As there is a hazard free plus exist in portfolioi??the standard divergence of hazard free plus is zero i??so the standard divergence of the whole portfolio can be express as so

the figure of map i??10 i?‰ i??it is the capital allotment line i??CALi?‰ can be showed as i?s

unite the public-service corporation and the expected return map together i??it can be a new map as i?s


To cipher the soap value of Ui??it need to happen the first derivation of this formi?? Lashkar-e-Taiba i??then the i?? the value of Y shows the weight should put in hazardous plus i??and the when i??the value of U is maximumi??and the return rate is the highest. In the figure this point is the tangency of the apathetic curve and the capital allotment line.

Why the tangency point is the best pointi??as we know there are many possible apathetic curve existi??in the BASIC of hazard antipathy any rational investors ever looking for the high returni??high public-service corporation this means the apathetic curve should be higher. When the curve get highi??the value of public-service corporation get higher i??the investors are prefer to pick the higher apathetic curve instead the lower 1.

But When consider the possible investing chance with the indifferent curvei??the capital allotment line has been giveni??so the curves which higher than the tangency point are non available for the investors, the curves lower of merely intersect with the CALi??they would non supply the best invest chance. So when the capital allotment line be touched with one of the apathetic curve i??the tangency point with capital allotment line is the lone best point i??this point shows the investors face the unit hazard can acquire the best unit return in capital allotment linei??per hazard can acquire the best per return.

From the figure blow i??the point C is the best point of the optimum complete portfolio i??and point is the best point of the optimum hazardous portfolio

So the weight in hazard free plus is 1-yi??the weight in bonds is and the weight in equity is i?‰ i??In the endi??each plus ‘s weight can be determine.

The importance of separation theorem

One of import rule in investing country is diversificationi??as the return of the plus is an random value and the hazard of plus is unsure i??the variegation of the assets is an easy manner to distributing hazards and better invest return.It can distribute put on the line really efficaciously. In theoryi??the separation theorem use the discrepancy and the average value method to analysis the hazard and investing return i??this theory has been well-known by investing areai??the application of the separation theorem make the analysis the portfolio more easilyi??it provide an easy manner for invest analyst and common fund i??it is the basic theory for manage the modern common fund.For the common fund it merely necessitate to analyst the optimum hazardous portfolioi??and so supply the same hazardous portfolio to their clientsi??only in the 2nd phase the investors different position of hazard are been consider in the complete portfolio.

In another wordi??the separation theorem separate the invest determination and the fiscal determination i??So the same hazardous portfolio can available for immense figure of clientsi??it make manage an investing fund more efficient and easy i??it cut the cost of pull offing the common fund better the net income and return i??and it is the basic scheme of modern common fund.


The separation theorem provide an easy method to divide the hazard and allotment the assets expeditiously. It separate the invest determination into two phases i??first find the optimum hazardous portfolio signifier two hazardous assets i??second make up one’s mind the optimum complete portfolio when add one hazard free plus.

But the disadvantage of the separation theorem is obviousi??it did non see many economic variables like system risk the investor ‘s penchant for each company and so on. This theory is benefit for the common fund but it besides non so much benefit for the investors.In the BASIC of separation theorem i??the other fiscal theory has been createdi??the separation theorem give a great part to the modern invest theory.


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