An Analytic Derivation of the Efficient Portfolio Frontier

Robert C. Merton

Journal of Financial and Quantitative Analysis · 1972 · 1.1K citations · 15 references

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TL;DR

The mean‑variance efficient portfolio frontier has been extensively studied, but for portfolios with more than three assets it is usually illustrated only qualitatively with graphs. The paper aims to derive efficient portfolio frontiers explicitly and verify their characteristics. The authors analytically derive the efficient frontier equations and confirm the stated characteristics. They prove the separation theorem in a mutual fund setting and demonstrate that the conventional graphical method for deriving the efficient frontier can be incorrect under certain conditions.

Abstract

The characteristics of the mean-variance, efficient portfolio frontier have been discussed at length in the literature. However, for more than three assets, the general approach has been to display qualitative results in terms of graphs. In this paper, the efficient portfolio frontiers are derived explicitly, and the characteristics claimed for these frontiers are verified. The most important implication derived from these characteristics, the separation theorem, is stated and proved in the context of a mutual fund theorem. It is shown that under certain conditions, the classic graphical technique for deriving the efficient portfolio frontier is incorrect.

References

15