Financial Modeling

Topic #4: Portfolio Risk-Return

Optimization
L. Gattis

1
 References
•
Financial Modeling 3rd Edition by Simon
Benninga
– Modeling Support
– Ch. 8: Portfolio Models
– Ch. 9: Efficient Portfolios with Short Sales
– Ch. 12: Efficient Portfolios without Short Sales

2
 Learning Objectives
•
Compute optimal portfolio weights that combine
risky portfolios and risk free assets
– Compute efficient (max return/min risk) and optimal
risky portfolios
– Compute optimal complete portfolios that combine a
risk free asset or borrowing.

3
 Data
Asset Exp Ret Std Dev Weights Correl. SPY EFA EEM Covar SPY EFA EEM
SPY 6.50% 16.00% 33.33% SPY 1 0.89281 0.544844 SPY 0.025596 0.025711 0.021792
EFA 6.75% 18.00% 33.33% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 33.33% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.00% 17.34% 100.00% vols*transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe
Rf 2.00% 0.00% BSharpe
Rb 5.50% 0.00%

Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)

17.34% 7.00% 33.33% 33.33% 33.33%
Copy, paste, special value, Alt-h-v-v
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
#1 6.50%
#2 6.75%
#3 7.00%
#4 7.25%
#5 7.50%
#6 7.75%
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP OBP
Rf 0.00% 2.00% 1.5OBP*
*Portfolio that is invested 150% in OBB and -50% Rb
Optimal Complete Portfolios -- Targeting Vol
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
V1 18.00% 0.00% < Solver Envelope Solution
V2 9.00% 0.00% < on CAL
V3 27.00% 0.00% < on CAL-B
100%
Optimal Complete Portfolios -- Targeting Mean
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
R1 0.00% < Solver Envelope Solution
R2
R3
0.00%
0.00%
< on CAL
< on CAL-B
4
 Envelope
•
An efficient risky portfolio is one that
– maximizes return for a given volatility or
– minimizes volatility for a given return
•
A set of efficient portfolios is called the
portfolio envelope or efficient frontier
•
You find an efficient portfolio by running
Excel’s Solver add-in.
– Objective: Max Expected (Mean) Return (or
minimize vol) 5
 Envelope – Optimal Risky
Asset
SPY
Portfolio
Exp Ret Std Dev Weights
6.50% 16.00% 0.00%
Correl.
SPY
SPY EFA EEM
1 0.89281 0.544844
Covar
SPY
SPY EFA EEM
0.025596 0.025711 0.021792
EFA
EEM
Portfolio
(Minimize σ, given µ, S.T.
6.75% 18.00% 0.00%
7.75% 25.00% 100.00%
7.75% 25.00% 100.00%
EFA
EEM
0.89281 1 0.612985
0.544844 0.612985 1
EFA
EEM
0.025711 0.0324 0.027584
0.021792 0.027584
vols* transpose(vols)* correl
0.0625

Ʃwi=1, Wi=0)
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev 8.00%
Rf 2.00% 0.00% 7.80%
Rb 5.50% 0.00%
7.60%
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
7.40%
25.00% 7.75% 0.00% 0.00% 100.00%
Copy, paste, special value, Alt-h-v-v 7.20%
Envelope
Envelope: Efficient Risky Portfolios with NO short sales (w >=0) 7.00%

R
SPY

rn
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ctd
eE
xp
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
EFA
#1 16.00% 6.50% 100.00% 0.00% 0.00% 6.80%
#2 16.08% 6.75% 80.00% 0.00% 20.00% EEM
6.60%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
#4 19.20% 7.25% 26.07% 17.41% 56.52% 6.40%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP OBP
Rf 0.00% 2.00% 1.5OBP*
* Portfolio that is invested 150% in OBB and -50% Rb
Insert XY Scatter with Lines (for Envelope Vols and
Returns
Adding Asset Data Points on graph
6
- Right click on graph, Select data / add
 Portfolio Choice
With No Risk-Free Asset
•
Select an efficient portfolio that meets your
risk or return preferences
Asset Exp Ret Std Dev Weights Correl. SPY EFA EEM Covar SPY EFA EEM
SPY 6.50% 16.00% 0.00% SPY 1 0.89281 0.544844 SPY 0.025596 0.025711 0.021792
EFA 6.75% 18.00% 0.00% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 100.00% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.75% 25.00% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev 8.00%
Rf 2.00% 0.00% 7.80%
Rb 5.50% 0.00%
7.60%
Notice how
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
25.00% 7.75% 0.00% 0.00% 100.00%
7.40%
EFA is
Copy, paste, special value, Alt-h-v-v
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)
7.20%
dominated Envelope
7.00%
R
SPY
rn
u
ctd
eE
xp
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
EFA
#1 16.00% 6.50% 100.00% 0.00% 0.00% 6.80%
#2 16.08% 6.75% 80.00% 0.00% 20.00% EEM
6.60%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
#4 19.20% 7.25% 26.07% 17.41% 56.52% 6.40%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP OBP
Rf 0.00% 2.00% 1.5OBP* 7
* Portfolio that is invested 150% in OBB and -50% Rb
Optimal Portfolios With a Risk-Free
Asset
•
When you combine a risk free asset and a risky asset (or
portfolio), the combined portfolio mean is the weighted
average mean and the volatility is the weight in the risky
asset times the volatility of the risky asset
– σCombined = Wrisky x σRisky
– Portfolio combination of risky and risk free plot along a straight
line
•
There is only one portfolio that you will choose to
combine with a risk free assets -- the portfolio is at a
tangency between a line extending from Rf and the top
Envelope
surface of the envelope.
Tangency – Optimal Risky Portfolio

R 8
f
 Optimal Risky Portfolio
•
The tangency line maximizes the slope
•
Slope = Sharpe Ratio = (Rp – Rf) / σp
•
Run Solver: Max Sharpe s.t. ƩWi=1, Wi>=0
Asset Exp Ret Std Dev Weights Correl. SPY EFA EEM Covar SPY EFA EEM
SPY •
EFA
The line is called the capital allocation line (CAL)
6.50%
6.75%
16.00%
18.00%
76.05%
0.00%
SPY
EFA
1 0.89281 0.544844
0.89281 1 0.612985
SPY
EFA
0.025596 0.025711 0.021792
0.025711 0.0324 0.027584
EEM 7.75% 25.00% 23.95% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 6.80% 16.23% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe 0.2958 9.00%
Rf 2.00% 0.00% 8.00%
Rb 5.50% 0.00%
7.00%

Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%

16.23% 6.80% 76.05% 0.00% 23.95% 5.00%
Copy, paste, special value, Alt-h-v-v Envelope
4.00%
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)
xpectdR
SPY
urn E
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 3.00%
EFA
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00%
#2 16.08% 6.75% 80.00% 0.00% 20.00% EEM
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64% CAL
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00%

#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol

CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP
Rf 0.00% 2.00% 1.5OBP*
9
Optimal Portfolios With Borrowing
•
Borrowing allows you to leverage the
returns (and risk) of an envelope portfolio
•
There is only one portfolio that you will
choose to combine with borrowing -- the
portfolio is at a tangency between a line
extending from Rb and the top surface of
the envelope.
CAL-
B
Tangency – Optimal Borrowing
R Portfolio
b
R CAL
10
f
 Optimal Borrowing Portfolio –
•
CAL-B
The tangency line maximizes the slope
•
Slope = Sharpe Ratio = (Rp – Rb) / σp
•
Run Solver: Max BSharpe s.t. ƩW=0, W>=0
Asset
SPY
Exp Ret Std Dev Weights
6.50% 16.00% 4.88%
Correl.
SPY
SPY EFA EEM
1 0.89281 0.544844
Covar
SPY
SPY EFA EEM
0.025596 0.025711 0.021792
EFA 6.75% 18.00% 25.30% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 69.82% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.44% 21.09% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe 0.2578 9.00%
Rf 2.00% 0.00% BSharpe 0.0918 8.00%
Rb 5.50% 0.00%
7.00%

Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%

Envelope
21.09% 7.44% 4.88% 25.30% 69.82% 5.00%
Copy, paste, special value, Alt-h-v-v SPY
4.00%
Envelope: Efficient Risky Portfolios with NO short sales (w >=0) R
rn
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td
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p
c
x EFA
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 3.00% EEM
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00% CAL
#2 16.08% 6.75% 80.00% 0.00% 20.00% B_CAL
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP 21.09% 7.44% 4.88% 25.30% 69.82%
Rf 0.00% 2.00% 1.5OBP* 31.63% 8.40% 7.32% 37.95% 104.73%
* Portfolio that is invested 150% in OBB and -50% Rb
11
 Finding Optimal Complete
• Portfolio
An optimal complete portfolio is a portfolio
that combines
– ORP + Rf or
– OBP + Rb or
– Envelope Portfolio
On CAL: Combine ORP and Rb On Envelope: Run Solver to Max μ or Min
σ
OBP=7.4
4
ORP=6.8 On CAL-B: Combine OBP
0 and Rb
R
f σ
ORP= OBP= 12
16.23 21.09
 Finding Optimal Complete
(Combining Rf/Rb and risky)
•
Find optimal complete portfolios for complete
portfolio volatilityPortfolio
of 9%, 18%, and 27%
•
Complete (or combined) portfolios may combine
risky assets with risk-free assets and borrowing
– 18%: Envelope Portfolio: Contains SPY, EFA, EEM
– 9:%: ORP + Rf: Contains SPY, EFA, EEM, and Rf
– 27%: OBP + Rb: Contains SPY, EFA,
Risky+borrowing EEM, and -Rb
OBP=7.4
4
ORP=6.8 Risky+Rf
0 R
b
R
σ 13
f ORP= OBP=
16.23 21.09
 On Envelope Solution: 18% Vol
•
Run solver: Max Mean, S.t. 18% Vol, ƩWi=1,
Asset
SPY Wi>=0 Exp Ret Std Dev Weights
6.50% 16.00% 41.94%
Correl.
SPY
SPY EFA EEM
1 0.89281 0.544844
Covar
SPY
SPY EFA EEM
0.025596 0.025711 0.021792
EFA 6.75% 18.00% 11.58% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 46.47% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.11% 18.00% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe 0.2839 9.00%
Rf 2.00% 0.00% BSharpe 0.0894 8.00%
Rb 5.50% 0.00%
7.00%

Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%

Envelope
18.00% 7.11% 41.94% 11.58% 46.47% 5.00%
Copy, paste, special value, Alt-h-v-v SPY
4.00%
Envelope: Efficient Risky Portfolios with NO short sales (w >=0) EFA
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) xpectdR
urn E 3.00% EEM
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00% CAL
#2 16.08% 6.75% 80.00% 0.00% 20.00% B_CAL
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
V1
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP 21.09% 7.44% 4.88% 25.30% 69.82%
Rf 0.00% 2.00% 1.5OBP* 31.63% 8.40% 7.32% 37.95% 104.73%
* Portfolio that is invested 150% in OBB and -50% Rb
Optimal Complete Portfolios -- Targeting Vol
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
V1 18.00% 7.11% 14
41.94% 11.58% 46.47% 100.00% 100.00% < Solver Envelope Solution
 On CAL Solution: 9% Complete
Vol
• Since σComplete = WRisky x σRisky

• WRisky = σComplete / σRisky

• WRisky = 9%/16.23% = 55.47%
• RRisky =55.47% x RORP + (1-55.37%) *
Rf
Asset Exp Ret Std Dev Weights Correl. SPY EFA EEM Covar SPY EFA EEM
SPY 6.50% 16.00% 41.94% SPY 1 0.89281 0.544844 SPY 0.025596 0.025711 0.021792
EFA 6.75% 18.00% 11.58% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 46.47% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.11% 18.00% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5

• WSPY, EEM, EFA= WRisky x (WSPY,

Asset Exp Ret Std Dev Sharpe 0.2839 9.00%
Rf 2.00% 0.00% BSharpe 0.0894 8.00%
Rb 5.50% 0.00% Envelope
7.00%

EEM, EFA in ORP)

SPY
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%
EFA
18.00% 7.11% 41.94% 11.58% 46.47% 5.00%
EEM
Copy, paste, special value, Alt-h-v-v
4.00% CAL
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)
ExpectdRurn
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 3.00% B_CAL
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00% V1
#2 16.08% 6.75% 80.00% 0.00% 20.00% V2
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP 21.09% 7.44% 4.88% 25.30% 69.82%
Rf 0.00% 2.00% 1.5OBP* 31.63% 8.40% 7.32% 37.95% 104.73%
* Portfolio that is invested 150% in OBB and -50% Rb
Optimal Complete Portfolios -- Targeting Vol
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
V1 18.00% 7.11% 41.94% 11.58% 46.47% 100.00% 100.00% < Solver Envelope Solution
V2
V3
9.00%
27.00%
4.66% 44.53% 42.18% 0.00% 13.28% 100.00%
0.00%
55.47% < on CAL
< on CAL-B
15
 On CAL-B Solution: 27%
• Wrisky = σCombined /σRisky
Combined Vol
• Wrisky = 27%/21.09% = 128.04%
• Rrisky = 128.04% x ROBP + (1-
128.04%) * Rf
Asset Exp Ret Std Dev Weights Correl. SPY EFA EEM Covar SPY EFA EEM
SPY 6.50% 16.00% 41.94% SPY 1 0.89281 0.544844 SPY 0.025596 0.025711 0.021792
EFA
EEM
Portfolio
•
6.75%
7.75%
7.11%
WSPY, EEM, EFA= Wrisky x (WSPY,
18.00%
25.00%
18.00%
11.58%
46.47%
100.00%
EFA
EEM
0.89281 1 0.612985
0.544844 0.612985 1
EFA
EEM
0.025711 0.0324 0.027584
0.021792 0.027584
vols* transpose(vols)* correl
0.0625

EEM, EFA in OBP)

σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe 0.2839 9.00%
Rf 2.00% 0.00% BSharpe 0.0894 8.00%
Rb 5.50% 0.00% Envelope
7.00%
SPY
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%
EFA
18.00% 7.11% 41.94% 11.58% 46.47% 5.00%
EEM
Copy, paste, special value, Alt-h-v-v
4.00% CAL
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)
ExpectdR
urn
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 3.00% B_CAL
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00% V1
#2 16.08% 6.75% 80.00% 0.00% 20.00% V2
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64%
V3
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP 21.09% 7.44% 4.88% 25.30% 69.82%
Rf 0.00% 2.00% 1.5OBP* 31.63% 8.40% 7.32% 37.95% 104.73%
* Portfolio that is invested 150% in OBB and -50% Rb
Optimal Complete Portfolios -- Targeting Vol
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
V1 18.00% 7.11% 41.94% 11.58% 46.47% 100.00% 100.00% < Solver Envelope Solution
V2 9.00% 4.66% 44.53% 42.18% 0.00% 13.28% 100.00% 55.47% < on CAL
V3 27.00% 7.98% -28.04% 6.24% 32.39% 89.40% 100.00% 128.04% < on CAL-B16
 Finding Optimal Complete
Portfolio
•
Find optimal complete portfolios for
With Expected Return Targets
complete portfolio expected returns 5%,
7%, 8%
– 7%: Envelope Portfolio: Contains SPY, EFA,
EEM
–5:%: ORP + Rf: Contains SPY, EFA, EEM,
Risky+borrowing
and
OBP=7.4
Rf
4
8%: OBP
–ORP=6.8 + Rb:
Risky+Rf Contains SPY, EFA, EEM, and
0
-Rb Rb
R
σ
f ORP= OBP= 17
16.23 21.09
 Finding Optimal Complete
• Portfolio
Find optimal complete portfolios for
complete portfolio expected returns 5%,
7%, 8%
– 7%: Envelope Portfolio: Contains SPY, EFA,
EEM
•
Run Solver: Minimize Vol, S.t. mean = 7%
•
Which happens to be envelope portfolio #3
– 5:%: ORP + Rf: Contains SPY, EFA, EEM, and
Rf
•
Rcomplete=WRiskyRrisky+(1-WRisky)Rf
 Asset
SPY
Exp Ret
6.50%
Std Dev
16.00%
Weights
54.55% SPY
Solution
Correl. SPY EFA EEM
1 0.89281 0.544844
Covar
SPY
SPY EFA EEM
0.025596 0.025711 0.021792
EFA 6.75% 18.00% 6.81% EFA 0.89281 1 0.612985 EFA 0.025711 0.0324 0.027584
EEM 7.75% 25.00% 38.64% EEM 0.544844 0.612985 1 EEM 0.021792 0.027584 0.0625
Portfolio 7.00% 17.22% 100.00% vols* transpose(vols)* correl
σ=MMULT(MMULT(TRANSPOSE(W),S),W)^0.5
Asset Exp Ret Std Dev Sharpe 0.2904 9.00%
Rf 2.00% 0.00% BSharpe 0.0871 8.00%
Rb 5.50% 0.00%
7.00%

Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 6.00%

17.22% 7.00% 54.55% 6.81% 38.64% 5.00% Envelope SPY
Copy, paste, special value, Alt-h-v-v EFA EEM
4.00%
Envelope: Efficient Risky Portfolios with NO short sales (w >=0)

R
CAL B_CAL

rn
u
ctd
eE
xp
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) 3.00%
V1 V2
#1 16.00% 6.50% 100.00% 0.00% 0.00% 2.00%
#2 16.08% 6.75% 80.00% 0.00% 20.00% V3 R1
1.00%
#3 17.22% 7.00% 54.55% 6.81% 38.64% R2 R3
#4 19.20% 7.25% 26.07% 17.41% 56.52% 0.00%
#5 21.80% 7.50% 0.00% 25.00% 75.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%
#6 25.00% 7.75% 0.00% 0.00% 100.00% Vol
CAL-B: Optimal Borrowing Portfolio (Tangency of Rb and Envelope)
CAL: Optimal Risky Portfolio (Tangency of Rf and Envelope) Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM)
Portolio Vol Exp Ret W(SPY) W(EFA) W(EEM) Rb 0.00% 5.50%
ORP 16.23% 6.80% 76.05% 0.00% 23.95% OBP 21.09% 7.44% 4.88% 25.30% 69.82%
Rf 0.00% 2.00% 1.5OBP* 31.63% 8.40% 7.32% 37.95% 104.73%
* Portfolio that is invested 150% in OBB and -50% Rb
Optimal Complete Portfolios -- Targeting Vol
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
V1 18.00% 7.00% 41.94% 11.58% 46.47% 100.00% 100.00% < Solver Envelope Solution
V2 9.00% 4.66% 44.53% 42.18% 0.00% 13.28% 100.00% 55.47% < on CAL
V3 27.00% 7.98% -28.04% 6.24% 32.39% 89.40% 100.00% 128.04% < on CAL-B
100%
Optimal Complete Portfolios -- Targeting Mean
Portfolio Volatility Exp Ret W(Rf) W(Rb) W(SPY) W(EFA) W(EEM) Weights W(Risky)
R1 17.22% 7.00% 54.55% 6.81% 38.64% 100.00% 100.00% < Solver Envelope Solution
R2 10.14% 5.00% 37.49% 47.54% 0.00% 14.97% 100.00% 19
62.51% < on CAL
R3 27.23% 8.00% -29.13% 6.30% 32.67% 90.16% 100.00% 129.13% < on CAL-B
 Notes on Assignments and
Exams
•
Assignment and exam problems may
require much less effort to find an optimal
complete portfolio.
– ORP and/or OBP may be given
– No Rf and/or borrowing (only envelope
solutions)
•
Short sales may be allowed. (do not
restrict constraint values >= 0 (checked
box in solver)
20
 Want More?
•
http://
www.investopedia.com/articles/06/mpt.asp
•
http://
www.amazon.com/Capital-Ideas-Improbable-O
•
http://
www.amazon.com/Capital-Ideas-Evolving-Pete
•
http://
www.amazon.com/Random-Walk-Down-Wall-S
•
http:// 21
 Learning Objectives
•
Compute efficient (max return/min risk) and
optimal risky portfolios
•
Compute optimal complete portfolios that
combine a risk free asset or borrowing.

22