Friday, December 23, 2016

Tangency portfolio and CML - Why does it have the highest sharpe ratio?


In the book that I am studying, the tangent portfolio was defined as the regular efficient portfolio in the case with n risky assets and 1 riskfree asset with the extra requirement that the portfolio invests fully in the risky assets. So the tangent portfolio can be derived using the solutions to the mean/variance analysis problem: w=μPμTΣ1μΣ1μ

σ2P=μ2PμTΣ1μ
where one can apply the restrictions on w to obtain weights, mean excess return, and variance of the portfolio.


Yet I know that in other books, this portfolio is actually defined as the one with the highest sharpe ratio. I don't see the connection. How is this proven, if we used the derivation described above? I can calculate the sharpe ratio (it turns out to be the square root of the denominator in the second equation above), but how do I know it's bigger than the ones corresponding to all other investments in risky assets?




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