MINIMUM VARIANCE PORTFOLIO (MVP)

Minimum Variance Portfolio (MVP) Weight

Benefits of Portfolio risk diversification

depends on following:
1. Variance or Standard deviation of individual security.
2. Correlation/Covariance between each security with
other security.
3. Number of securities in the portfolio and their
weights.
Stock-A
Stock-B

A minimum variance portfolio indicates a well-diversified portfolio that consists of individually risky
assets, which are hedged when traded together, resulting in the lowest possible risk for the rate of
expected return.

The investments in a minimum variance portfolio are individually riskier than the portfolio as a whole.
The name of the term comes from how it is mathematically expressed in Markowitz Portfolio Theory, in
which volatility is used as a replacement for risk, and in which less variance in volatility correlates to less
risk in an investment.

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PORTFOLIO OF TWO RISKY ASSETS

In the previous section we considered portfolio risk diversification using equally-weighted portfolio of
several securities. It is time now to study efficient diversification, whereby we construct risky portfolio to
provide the lowest possible risk for any given level of expected return.

Portfolios of two risky assets are relatively easy to analyze, and they illustrate the principles and
considerations that apply to portfolio of many assets. It makes sense to think about a two-asset portfolio
as an asset allocation decision, and so we consider a portfolio comprised of two mutual funds, a bond
portfolio specializing in long-term debt securities, denoted D, and a stock fund that specialized in equity
securities, E. The rate of return on this portfolio, rp, will be:

, 7.1

Where rd is the rate of return on the bond fund and re is the rate of return on the equity fund; w is the
proportion invested in the bond fund and (1 – w) is the proportion invested in the equity fund.

The expected return on the portfolio is the weighted average of expected returns on the component
securities with portfolio proportions (w) as weights:

7.2

The variance of the two-asset portfolio is:

7.3

To understand the formula for the portfolio variance, recall that the covariance of a variable with itself is
the variance of that variable, that is:

7.4

Therefore, another way to express the variance of the portfolio is:

7.5

Equation 7.3 reveals that portfolio variance is reduced if the covariance/correlation term is negative. It is
important to recognize that even if the covariance term is positive, the portfolio standard deviation still is
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less than the weighted average of the individual security standard deviations, unless the two securities are
perfectly positively correlated. To see this, notice that the covariance can be computed from the
correlation coefficient as:

7.6

Therefore,

7.7

Other things equal, portfolio variance is higher when the correlation coefficient is higher. In the
case of perfect positive correlation, that is, ρDE = 1, the right-hand side of the above equation is a
perfect square and simplifies to”

⇒ 7.8

Therefore, the standard deviation of the portfolio with perfect positive correlation is just the
weighted average of the component standard deviations. In all other cases, the correlation
coefficient is less than 1, making the portfolio standard deviation less than the weighted average
of the component standard deviations. Therefore, other things equal, we will always prefer to
add to our portfolio assets with low or, even better, negative correlation with our existing
position.

Because the portfolio's expected return is the weighted average of its component expected
returns, whereas its standard deviation is less than the weighted average of the component
standard deviations, portfolios of less than perfectly correlated assets always offer better risk-
return opportunities than the individual component securities on their own. The lower the
correlation between the assets, the greater is the gain in efficiency.

How low can portfolio standard deviation be? The lowest possible value of the correlation
coefficient is -1, representing perfect negative correlation. In this case, Equation 7.7 simplifies
to:

⇒ 7.9

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 MINIMUM VARIANCE PORTFOLIO (MVP)
When ρ = -1, a perfectly hedged position can be obtained by choosing the portfolio proportions
to solve for

7.10

The solution to this equation is

, 7.11

These weights drive the standard deviation of the portfolio to zero. We can experiment with
different portfolio proportions to observe the effect on portfolio expected return and variance.

What is the minimum level to which portfolio standard deviation can be held? The portfolio
weights that solve this minimization problem can be found using the following formulas:

COV(rD,rE) = ρDE*σD *σE

σ

WD + WE = 1 7.12

Note that the minimum-variance portfolio has a standard deviation smaller than that of either
of the individual components assets. The perfect hedge potential when the two assets are
perfectly negatively correlated (ρ= -1.0).

The Optimal Portfolio

The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other
things) that investors fanatically try to minimize risk while striving for the highest return possible. The

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theory states that investors will act rationally, always making decisions aimed at maximizing their return
for their acceptable level of risk.

The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that it is possible for
different portfolios to have varying levels of risk and return. Each investor must decide how much risk
they can handle and then allocate (or diversify) their portfolio according to this decision.

The chart below illustrates how the optimal portfolio works. The optimal-risk portfolio is usually
determined to be somewhere in the middle of the curve because as you go higher up the curve, you take
on proportionately more risk for a lower incremental return. On the other end, low risk/low return
portfolios are pointless because you can achieve a similar return by investing in risk-free assets, like
government securities.

You can choose how much volatility you are willing to bear in your portfolio by picking any other point
that falls on the efficient frontier. This will give you the maximum return for the amount of risk you wish
to accept. Optimizing your portfolio is not something you can calculate in your head. There are computer
programs that are dedicated to determining optimal portfolios by estimating hundreds (and sometimes
thousands) of different expected returns for each given amount of risk.

ASSET ALLOCATION WITH STOCKS, BONDS AND BILLS

In the last section we derived the properties of portfolios formed by mixing two risky assets.
Given this background, we now reintroduce the choice of the third, risk-free, portfolio. This will
allow us to complete the basic problem of asset allocation across three key asset classes: stocks,
bonds, and risk-free money market securities.
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The Optimal Portfolio with Two Risky Assets and a Risk-Free Asset

What if our two risky assets (A and B) are still confined to the bond and stock funds, but now we
can also invest in risk-free T-bills yielding 5%? We start with a graphical solution (see Figure
7.6 in the textbook). Two possible capital allocation lines (CALs) are drawn from the risk-free
rate (rf = 5%) to the two feasible portfolios. The first possible CAL is drawn through the
minimum-variance portfolio A, which is invested 82% in bonds and 18% in stocks. Portfolios A’s
expected return is 8.90%and its standard deviation is 11.45% (see Table 7.3, button panel). Now
consider the CAL that uses portfolio B instead of A. Portfolio B invests 70% in bonds and 30%
in stocks. Its expected return is 9.5%and its standard deviation is 11.70%.

With a T-bill rate of 5%, the reward-to-volatility (Sharpe) ratio, which is the slope of the CAL
combining T-bills and the minimum-variance portfolio A or portfolio B, is:

In this case portfolio B dominates A as the reward-to-volatility ratio on the CAL that is supported
by portfolio B is higher that the reward-to-volatility ratio of the CAL that we obtained using
portfolio A. But why stop at portfolio B? We can continue to ratchet the CAL upward until it
ultimately reaches the point of tangency with the investment opportunity set. This must yield the
CAL with the highest feasible reward-to-volatility ratio. Therefore, the tangency portfolio,
labeled P in Figure 7.7 in the textbook, is the optimal risky portfolio to mix with T-bills. We can
read the expected return and standard deviation of Portfolio P (the “optimal”) from the graph in
Figure 7.7.

In practice, when we try to construct optimal risky portfolios from more than two risky assets we
need to rely on a spreadsheet or another computer program. To start, however, we will
demonstrate the solution of the portfolio construction problem with only two risky assets (in our
example, long-term debt and equity) and a risk-free asset. In this simpler two-asset case, we can
derive an explicit formula for the weights of each asset in the optimal portfolio. This will make it
easy to illustrate some of the general issues pertaining to portfolio optimization.

The objective is to find the weights wD and wE that result in the highest slope of the CAL, i.e. the
weights that result in the risky portfolio with the highest reward-to-volatility ratio. Therefore,
the objective is to maximize the slope of the CAL for any possible portfolio, p. Thus our
objective function is the slope (equivalently, the Sharp ratio) that we will call Sp:

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When we maximize the objective function, Sp, we have to satisfy the constraint that the portfolio
weights sum to 1.0 (100%), that is, wD + wE = 1. Therefore, we solve an optimization problem
formally written as:

, 7.13

subject to Σwi = 1. This is a maximization problem that can be solved using standard tools of
calculus. In the case of two risky assets, the solution for the weights of the optimal risky
portfolio, P, is given by Equation 7.14. Notice that the formula in the textbook (7.13) employs
excess rates of returns (denoted R) rather than the total returns (denoted r).

7.14

The expected return and standard deviation of this optimal risky portfolio is:

7.15

Then, the CAL of this optimal portfolio has a slope of: , which is the reward-
to-volatility (Sharpe) ratio of portfolio P.

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In the previous chapter we found the optimal complete portfolio given an optimal risky portfolio
and the CAL, generated by a combination of this portfolio and T-bills. Now that we have
constructed the optimal risky portfolio, P, we can use the individual investor’s degree of risk
aversion, A, to calculate the optimal proportion of the complete portfolio to invest in the risky
component. An investor with a coefficient of risk aversion A would take a position in portfolio P
of:

7.16

Portfolio P consists of 40% invested in bonds and 60% in stocks. So, we can find the fraction of
wealth in bonds and in stocks for our portfolio (see Example 7.3 in the textbook.)

Once we have reached this point, generalizing to the case of many risky assets is straightforward.
Before moving on, recall that our two risky assets, the bond and stock mutual funds, are already
diversified portfolios. The diversification within each of these portfolios must be credited for a
good deal of the risk reduction compared to undiversified single securities. For example, the
standard deviation of the rate of return on an average stock is about 50% (see Figure 7.2). In
contrast, the standard deviation of our stock-index fund is only 20%, about equal to the historical
standard deviation of the S&P 500 portfolio. This is evidence of the importance of diversification
within the asset class.

Optimizing the asset allocation between bonds and stocks contributed incrementally to the
improvement in the reward-to-volatility ratio of the complete portfolio. The CAL using the
optimal combination of stocks and bonds (see Figure 7.8) shows that one can achieve an
expected return of 13% (matching that of the stock portfolio) with a standard deviation of 18%,
which is less than the 20% standard deviation of the stock portfolio.

Example: Use the following two portfolios to answer parts one to four.

Portfolio Expected Return Standard Deviation

Bond Portfolio (B) 6% 10%
Stock (S) 13% 30%

If the correlation coefficient (ρ) is -0.40 for these two risky assets.

1. What is the minimum variance portfolio you can construct? (Hint: What percent of your
wealth is invested in each portfolio?)
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WB= [(30)2 - (30)*(10)*(-0.40)] / [(30)2 + (10)2 – 2*(30)*(10)*(-0.40)]

= [(900 –(-120)] / [(900 + 100) – (-240)]

=[1020 / 1240]

WBOND = 0.8226 OR 82.26%

WSTOCK = (1 - WBOND)

Weight in the stock is 1 minus weight in the bond or 1 – 0.8226 = 0.1774 OR 17.74%

82.26% in Bond and 17.74% in Stock

2. What is the expected return on the MVP (minimum variance portfolio) in part one using
your allocation of wealth to bonds and stocks?

E(rMVP) = E (RB) + E (RS)

E(rMVP) = (0.8226) x (6) + (0.1774) x (13)

= 4.94 + 2.30

= 7.24%

3. What is the standard deviation of the minimum variance portfolio?

σ2 =(WS)2 *(σS)2 + (WB)2 *(σB)2 + 2* WS* WB* ρSB*σS *σB

σ2 = (0.1774)2 (30)2 + (0.8226)2 (10)2 + 2*(0.1774) *(0.8226) *(-0.4)* (30)*(10)

σ2 = 28.32 + 67.67 – 35.02

σ2= 60.97

σ =√ 60.97

= 7.81%

Portfolio Expected Return Standard Deviation

Bond Portfolio (B) 6% 10%
Stock (S) 13% 30%
Portfolio 7.24% 7.81%

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Hint, must be less than 10% the standard deviation of the bond portfolio.

4. What is the optimal portfolio of these two assets if the risk-free rate is 3% (i.e., how do you
allocate of your wealth in stocks and bonds)?

And the weight in the stocks is 1 – 0.7414 or 0.2586 or 25.86%

The expected return on the optimal portfolio is:

E(rOPT) = (0.7414) x (0.06) + (0.2586) x (0.13) = 0.0781 or 7.81%

And the standard deviation of the optimal portfolio is:

σ2 = (.2586)2 (0.30)2 + (0.7414)2 (0.10)2 + 2 (.2586) (.7414) (0.30) (0.10) (-0.4)

σ2 = 0.006017 + 0.005497 - 0.004601 = 0.006913

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Exam Type Problems

1. A pension fund manager is considering two investment funds. The first is a common stock bond
and corporate bond. The characteristics of the investments are given as follows:
Portfolio Expected Return Standard Deviation
Common Stock (S) 20% 30%
Corporate Bond (B) 12% 15%
The correlation between the fund returns is -1
a. What are the investment proportions in the minimum-variance portfolio of the two risky
funds?
b. What is the expected return and standard deviation of the portfolio?

Answer:
Stock ER SD Weight
S 20% 30% 0.33
B 12% 15% 0.67
Portfolio 14.64% 0.14%

2. The universe of available securities includes two risky stock funds, X and Y, and T-Bills. The
expected returns and standard deviations for the universe are as follows:
Asset Expected Return Standard Deviation
X 8% 12%
Y 13% 20%
T-Bills 5% 0%
The correlation coefficient between funds X and Y is -0.3.
a. Calculate the expected return and standard deviation for the optimal risky portfolio, P.
b. Find the slope of the capital allocation line, CAL, supported by T-Bills and optimal
portfolio P, from above.
c. If an investor has a coefficient of risk aversion, A, equal to 4, what proportion will he or
she invest in fund X, fund Y, and in T-Bills?

3. You are given the following information about stocks and gold.
Asset Expected Return Standard Deviation
Stock 15% 25%
Gold 10% 30%
The correlation between the fund returns is -0.50
a. What are the investment proportions in the minimum-variance portfolio of the two risky
funds?
b. What is the expected value and standard deviation of the portfolio?

4. You are considering three portfolios in which to allocate your investment:

▪ A risk-free asset that yields 4.0%.

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▪ A stock fund with an expected return of 22.0% and a standard deviation of 30.0%.
▪ A bond fund with an expected return of 8.0% and a standard deviation of 10.0%.
The correlation between the returns of this stock fund and this bond fund is -0.10.

a. Calculate the percentages of the optimal portfolio that would be allocated to the stock fund
and to the bond fund.
b. Given the answer from part a. above, calculate the expected return & standard deviation of
the optimal portfolio?

Solution of Exam Type Problem: 2

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