Lecture 4

Optimal Risky Portfolios

 Content
This chapter will introduce asset allocation in the risky portfolio
across broad asset classes. We construct risky portfolios to provide
the lowest possible risk for any given level of expected return.

STRUCTURE
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
3. Asset Allocation with Stocks, Bonds and Bills
4. Markowitz Portfolio Optimization Model
 Diversification
Question:
Suppose your portfolio is composed of only one stock, say, Dell
Inc. What would be the sources of risk to this “portfolio”?

1. Macro factors, such as the business cycle, inflation, interest

rates, and exchange rates.
2. Firm-specific influences. Such as Dell’s success in research
and development, and personnel changes.
 Diversification
If we diversify into many more securities, we would spread out
our exposure to firm-specific factors, and portfolio volatility
should continue to fall. Ultimately, however, even with a large
number of stocks we cannot avoid risk altogether, because
virtually all securities are affected by the common
macroeconomic factors.
 Two types of risk

1.Market Risk
The risk that remains even after extensive diversification is called
market risk, risk that is attributable to market wide risk sources.
Such risk is also called systematic risk, or non-diversifiable risk.

2.Firm-specific risk
The risk that can be eliminated by diversification is called unique
risk , firm-specific risk , nonsystematic risk, or diversifiable risk.
 Graph1:Diversification

Portfolio risk does fall with diversification, but the power of diversification to reduce
risk is limited by systematic or common sources of risk.
 Graph2: Diversification

The average standard deviation of equally weighted portfolios constructed by selecting stocks
at random as a function of the number of stocks in the portfolio (composed of only one stock:
49.2%, whereas, in the limit, could be reduced to 19.2%).
 Portfolios of Two Risky Assets
In the above slides, we considered simple diversification using
equally weighted portfolios of several securities. It is time now to
study efficient diversification, whereby we construct risky
portfolios to provide the lowest possible risk for any given level of
expected return.
 Portfolios of Two Risky Assets
Assume the rate of return on the equity is rE，the rate of return on
the debt is rD. A proportion denoted by WD is invested in the bond
and WE is invested in the equity. The expected return of this
portfolio is
=
E ( rp ) wD E ( rD ) + wE E ( rE )

The variance of the portfolio is

σ p2 = wD2 σ D2 + wE2σ E2 + 2wD wE Cov(rD , rE )

Variance is reduced if the covariance term is negative.

 Portfolios of Two Risky Assets
The variance of the portfolio, unlike the expected return, is not a weighted
average of the individual asset variances. It is a weighted sum of covariances.

Each covariance has been multiplied by the weights from the row and the
column.
 Exercise
Exercise: Prove that if the two securities are perfectly positively
correlated (correlation = 1), then σp is the weighted average of the
component standard deviations. If they are perfectly negatively
correlated (correlation = –1), then σp is the weighted difference of
the component standard deviations.

cov(rD ,rE )
The correlation is by: ρ DE
defined= σ D ⋅σ E
, ρ ∈ [−1,1]
 Exercise
Exercise: Prove that if the two securities are perfectly positively
correlated (correlation = 1), then σp is the weighted average of the
component standard deviations. If they are perfectly negatively
correlated (correlation = –1), then σp is the weighted difference of
the component standard deviations.

σ p2 = wD2 σ D2 + wE2σ E2 + 2wD wE Cov ( rD , rE )

=wD2 σ D2 + wE2σ E2 + 2 wD wE ρ DEσ Dσ D
 ( wDσ D + wEσ E ) ⇒ σ p= wDσ D + wEσ E if ρ DE= 1
2

=
( wDσ D − wEσ E ) ⇒ σ p =wDσ D − wEσ E if ρ DE =−1
2
Exercise
 Hedge

σ p wDσ D − wEσ E
=

wDσ D − wEσ E =
0
wD + wE =
1
σ
⇒ wD = E
σE +σD
σD
wE =
σE +σD
 Hedge
Hedge is like of a insurance. A perfect hedge is one that
eliminates all risk in a position or portfolio. In other words, the
hedge is 100% inversely correlated to the vulnerable asset. This is
more an ideal than a reality on the ground, and even the
hypothetical perfect hedge is not without cost (for example,
buying an option).
 Example
If Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might
hedge his investment by buying a $5 American put option with a strike price of
$8 expiring in one year. This option gives Morty the right to sell 100 shares of
STOCK for $8 any time in the next year.

If one year later STOCK is trading at $12, Morty will not exercise the option
and just lose $5. He's unlikely to fret, though, since his gain is $200 ($195
including the price of the put).

If STOCK is trading at $0, on the other hand, Morty will exercise the option
and sell his shares for $8, for a loss of $200 ($205 including the price of the
put). Without the option, he will lose his entire investment.
We have two assets: equity and bond. If we change the proportion invested in
bonds, we observe the expected returns and variance of the portfolio (using
various values of correlation.
Bond Equity
Expected return (%) 8 13
SD (%) 12 20
Covariance 72
Correlation 0.3
 Exercise

Debt Equity
Expected return (%) 8 13
SD (%) 12 20
Covariance 72
Correlation 0.3

(1) Calculate the expected return of portfolio, write it as the function of wE,
draw its graph.
(2) Calculate the variance of portfolio, write it as the function of wE , draw
its graph.
(3) Solve wE if the variance of portfolio get the minimum value.
 Exercise
Expected return： =
EP 8wD + 13wE
=8(1 − wE ) + 13wE
= 8 + 5wE

Variance： 𝜎𝜎𝑝𝑝 = 𝑣𝑣𝑣𝑣𝑣𝑣(𝑤𝑤𝐷𝐷 𝑟𝑟𝐷𝐷 + 𝑤𝑤𝐸𝐸 𝑟𝑟𝐸𝐸 )

1
= 144𝑤𝑤𝐷𝐷2 + 400𝑤𝑤𝐸𝐸2 + 2 � 72𝑤𝑤𝐷𝐷 𝑤𝑤𝐸𝐸 2
1
= 400𝑤𝑤𝐸𝐸2 − 144𝑤𝑤𝐸𝐸 + 144 2

−144
𝑤𝑤𝐸𝐸 𝜎𝜎𝑝𝑝 = 𝑚𝑚𝑚𝑚𝑚𝑚 = − = 0.18
400 � 2
 Figure

short bond

short stock Minimum variance portfolio, with WE=0.18

 Conclusion
1.The minimum variance portfolio is constructed by make the variance of
the portfolio achieve the minimum value.
2.The variance of the minimum variance portfolio is positive associated
with the correlation of the two assets.
3.The minimum-variance portfolio has a standard deviation smaller than
that of either of the individual component assets. This illustrates the
effect of diversification.
 Conclusion
4. When 𝜌𝜌 = 1, there is no advantage from diversification, the s.d. is the
simple weighted average of the component asset s.d.

If 𝜌𝜌=+1: cannot diversify any risk;

If 𝜌𝜌 < 0: 𝜎𝜎𝑝𝑝 can be lower than the s.d. of each individual asset;
If 𝜌𝜌=−1: can realize perfectly hedge.
 Conclusion
To summarize, although the expected return of any portfolio is simply
the weighted average of the asset expected returns, this is not true of
the standard deviation. Potential benefits from diversification arise
when correlation is less than perfectly positive.

The lower the correlation, the greater the potential benefit from
diversification. In the extreme case of perfect negative correlation, we
have a perfect hedging opportunity and can construct a zero-variance
portfolio.
 Portfolio opportunity set
1
We have obtained 𝐸𝐸𝑝𝑝 = 8 + 5𝑤𝑤𝐸𝐸 and 𝜎𝜎𝑝𝑝 = 400𝑤𝑤𝐸𝐸2 − 144𝑤𝑤𝐸𝐸 + 144 .
2

Questions:
What is the equation of the curve if we plot the expected return and
standard deviation of portfolio p in a diagram? What is the shape of the
curve that you expected?
 Portfolio opportunity set
Solution:
𝐸𝐸𝑝𝑝 −8
Since 𝐸𝐸𝑝𝑝 = 8 + 5𝑤𝑤𝐸𝐸 , we obtain 𝑤𝑤𝐸𝐸 = . We then plug this equation
5
into 𝜎𝜎𝑝𝑝2 = 400𝑤𝑤𝐸𝐸2 − 144𝑤𝑤𝐸𝐸 + 144.

We can obtain:
𝐸𝐸𝑝𝑝 −8 2 𝐸𝐸𝑝𝑝 −8
𝜎𝜎𝑝𝑝2 = 400 5
− 144( 5
) + 144.
𝐸𝐸𝑝𝑝 −8 2 𝐸𝐸𝑝𝑝 −8
Or: 𝜎𝜎𝑝𝑝2 − 400 5
+ 144 5
= 144.
Portfolio opportunity set
 Portfolio opportunity set
Portfolio opportunity set (the curve) shows all combinations of
portfolio expected return and standard deviation that can be
constructed from the available assets (notes: for given assets, the
correlation is pinned down.)
 Minimum-Variance Frontier
If there are N risky assets, the portfolio opportunity set will be the minimum-
variance frontier.

Minimum-variance frontier: This

frontier is a graph of the lowest
possible variance that can be
attained for a given portfolio
expected return. Given the input
data for expected returns,
variances, and covariances, we
can calculate the minimum-
variance portfolio for any
targeted expected return.
 Minimum-Variance Frontier
NOTE:
1. All the individual assets lie to the right inside the frontier;
2. Diversifying investments leads to portfolios with higher expected
returns or lower standard deviations;
3. All the portfolios that lie on the minimum-variance frontier from the
global minimum-variance portfolio and upward part. It is the efficient
frontier of risky assets.

Question: Now, do investors choose the minimum variance portfolio?

 Asset Allocation with Stocks, Bonds and Bills

Question: Now, do investors choose the minimum variance

portfolio?

Ans: The optimal portfolio from the opportunity set for a investor
does not mean the minimum variance portfolio. Though it has the
minimum variance, its expected return is also low.
Asset Allocation with Stocks, Bonds and Bills

Now we can choose each portfolio on the efficient frontier. The

question is which one we should choose, and thus we allocate assets
among two (or more) risky assets?

A direct way to compare risky assets is to consider their Sharpe ratio.

Recalling the slope of the CAL measures Sharpe ratio.

The portfolio on efficient frontier that maximizes the Sharpe ratio is

the solution to the asset allocation problem.
Asset Allocation with Stocks, Bonds and Bills

Suppose there is a risk-free asset, such as T-bill. Now the asset

allocation decision requires that we consider along with the risky asset
classes.
 The optimal
CAL and the optimal risky portfolio

The optimal CAL

The optimal risky portfolio

 The optimization problem for getting the
risky portfolio
We can formalize our asset allocation problem in mathematical ways. Make
the Sharpe Ratio of the risky portfolio to be maximum, and solve the fraction
that invest on equity and bond.

E (rP ) − rf
max
ωE ,ωD σP
s.t. wE + wD =
1
=
where rP wE rE + wD rD
1
σ P = [ w σ + w σ + 2wE wD cov(rE , rD )]
2
E
2
E
2
D
2
D
2
 7-35

The optimization problem for getting the

risky portfolio

We can get

rDσ E2 − rE cov(rD , rE )
wD =
rDσ E2 + rEσ D2 − [rD + rE ]cov(rD , rE )
wE = 1 − wD
Markowitz Portfolio Optimization Model

Three Steps for Portfolio Construction

First, we identify the risk–return combinations available from the set of risky
assets (Minimum-variance frontier).
Second, we involves the risk-free asset, and identify the optimal portfolio of
risky assets by finding the portfolio weights that result in the steepest CAL
(The optimal risky portfolio).
Finally, the individual investor chooses the appropriate mix between the
optimal risky portfolio P and T-bills based on her utility maximum problem.
Markowitz Portfolio Optimization Model
 Separation Property
Capital Allocation and the Separation Property

It tells us that the portfolio choice problem may be separated into two
independent tasks.
The first task, determination of the optimal risky portfolio, is purely
technical. Given the manager’s input list, the best risky portfolio is the
same for all clients, regardless of risk aversion.
The second task, capital allocation, depends on personal preference. Here
the client is the decision maker.
 Separation Property
Video: Hear What Dr. Harry Markowitz Has To Say About Investing
(https://www.youtube.com/watch?v=os0B1oQfNdo)

Homework: using the input sheets to figure out the efficient frontier.