Module II

Portfolio Theory
Chapter Outline
• Portfolio Return and Risk

• Measurement of Co-movements in Security Returns

• Calculation of Portfolio Risk

• Efficient Frontier
• Optimal Portfolio
• Riskless Lending and Borrowing
• The Single Index Model
Portfolio Expected Return
n
E(RP) =  wi E(Ri)
i=1

where E(RP) = expected portfolio return

wi = weight assigned to security i
E(Ri) = expected return on security i
n = number of securities in the portfolio
Example:
A portfolio consists of four securities with expected returns of 12%,
15%, 18%, and 20% respectively. The proportions of portfolio
value invested in these securities are 0.2, 0.3, 0.3, and 0.2
respectively.

The expected return on the portfolio is:

E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)
= 16.3%
Portfolio Risk
• The risk of a portfolio is measured by the variance (or standard
deviation) of its return.

• Although the expected return on a portfolio is the weighted average of

the expected returns on the individual securities in the portfolio,
portfolio risk is not the weighted average of the risks of the individual
securities in the portfolio (except when the returns from the securities
are uncorrelated).
Measurement of Co-movements in Security
Returns

• To develop the equation for calculating portfolio risk we need

information on weighted individual security risks and weighted co-
movements between the returns of securities included in the portfolio.

• Co-movements between the returns of securities are measured by

covariance (an absolute measure) and coefficient of correlation (a
relative measure).
Covariance:
• Covariance reflects the degree to which the returns of the securities
vary or change together.
• A positive covariance means that the returns of the two securities move
in the same direction
Σ X− 𝑋ത ∗ (𝑌− 𝑌)
ത
𝐶𝑂𝑉. (𝑋,𝑌) =
𝑁−1

Covariance in case of Return:

𝐶𝑂𝑉. (𝑋,𝑌) = σ 𝑃𝑖 {[𝑋 − E R𝑋 ] ∗ [𝑌 − E R 𝑌 ]}

Example:
The returns on assets 1 and 2 under five possible states of nature are
given below

Situations Probability Return on Asset A Return on Asset B

1 0.10 -10 5
2 0.30 15 12
3 0.30 18 19
4 0.20 22 15
5 0.10 27 12
The covariance between the returns on assets A
and B is calculated below :
Deviation of Return on Deviation of Product of the
State of Probability Return on the return on asset B the return deviations
Nature asset A asset A from its on asset B times
mean from its probability
mean
(1) (2) (3) (4) (5) (6) (2) x (4) x (6)

1 0.10 -10% -26% 5% -9% 23.4

2 0.30 15% -1% 12% -2% 0.6
3 0.30 18% 2% 19% 5% 3.0
4 0.20 22% 6% 15% 1% 1.2
5 0.10 27% 11% 12% -2% -2.2
Sum = 26.0
Thus the covariance between the returns on the two assets is 26.0.
Coefficient Of Correlation
• The coefficient of correlation is simply covariance divided by
the product of standard deviations
• Coefficient of correlation can vary between -1 to 1.

Coefficient of correlation between the returns on assets 1 and 2 is

𝐶𝑜𝑒𝑓𝑓𝑖𝑐𝑒𝑛𝑡 𝑜𝑓 𝐶𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑟 𝑃(1,2)

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒1,2
=
𝜎1 ∗ 𝜎2
Dominance Of Covariance
As the number of securities included in an portfolio increases, the
importance of the risk of each individual security decreases whereas the
significance of the covariance relationship increases.
Example: The returns of two assets under four possible states of nature are given below:

State of Probability Return on Return on

nature asset X asset Y

1 0.4 -6 12
2 0.1 18 14
3 0.2 20 16
4 0.3 25 20

a. What is the standard deviation of the return on asset X and on asset Y?

b. What is the covariance between the returns on assets X and Y?
c. What is the coefficient of correlation between the returns on assets X and Y?
 Solution:

State of % Return on % Return Expected Expected P[X-ER(X)] P[X- P[(Y-

Probability asset X on asset Y Return X Return Y X – ER(X) Y- ER(Y)
nature [Y-ER(Y)] ER(X)] ² ER(Y)] ²

1 0.4 -6 12 -2.4 4.8 -16.9 -3.40 22.984 114.244 4.624

2 0.1 18 14 1.8 1.4 7.1 -1.40 -0.994 5.041 0.196

3 0.2 20 16 4 3.2 9.1 0.60 1.092 16.562 0.072

4 0.3 25 20 7.5 6 14.1 4.60 19.458 59.643 6.348

10.90 15.40 42.54 195.49 11.24

cov 13.98177 3.352611

Corr(xy) 0.907511332 sd sd
Example: The returns of 4 stocks, A, B, C, and D over a period of 5 years have
been as follows:

1 2 3 4 5

A 8 1 -6 -1 9
B 10 6 9 4 11
C 9 6 3 5 8
D 1 8 13 7 12

Calculate the return on:

a. portfolio of one stock at a time
b. portfolios of two stocks at a time
c. portfolios of three stocks at a time
d. a portfolio of all the four stocks
Assume equiproportional investment.
 1 2 3 4 5 Expected Returns Weightage

A 8 1 -6 -1 9 2.20 0.25

B 10 6 9 4 11 8.00 0.500000 0.333333 0.25

C 9 6 3 5 8 6.20 0.333333 0.25

D 1 8 13 7 12 8.20 1.00 0.500000 0.333333 0.25

Expected Portfolio
8.2 8.1 7.466667 6.15
Returns =
Calculation of Portfolio Risk

Portfolio Risk : 2 – Security Case

p = [w12 12 + w22 22 + 2w1w2 12 1 2]½

Portfolio Risk : 3 – Security Case

p = [w12 12 + w22 22 + w32 32 + 2 w1 w2  12  1  2 + 2w1 w3 13 1 3

+ 2w2 w3 232 3] ½
Example
• A portfolio consists of two securities, 1 and 2 in the proportions of 0.6
and 0.4. The standard deviations of the returns of the securities are 10
and 16 respectively. The co-effecient of correlation between the returns
on securities is 0.5

• What is the standard deviation of the portfolio?

 Portfolio Risk : 2 – Security Case

Example : w1 = 0.6 , w2 = 0.4,

1 = 10%, 2 = 16%
12 = 0.5

p = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½

= 10.7%
Portfolio Risk : n – Security Case

Example : w1 = 0.5 , w2 = 0.3, and w3 = 0.2

1 = 10%, 2 = 15%, 3 = 20%
12 = 0.3, 13 = 0.5, 23 = 0.6

p = [w12 12 + w22 22 + w32 32 + 2 w1 w2 12 1 2

+ 2w1 w3 13 1 3 + 2w2 w3 232 3] ½

Example: Consider two stocks, P and Q

Expected Return SD (%)

(%)

P 18 12
Q 24 17

The returns on the two stocks are perfectly negatively correlated. What
is the expected return of a portfolio constructed to drive the standard
deviation of the portfolio to zero?
 σQ 17
wP = = = 0.586
σP + σQ 12 + 17
wQ = 1 – wP = 0.414

The expected return of the portfolio is:

0.586 x 18 % + 0.414 x 24 % = 20.484 %

Example: Consider two stocks, X and Y

Expected Return SD (%)

(%)
X 10 18
Y 25 24

The returns on the two stocks are perfectly negatively correlated.

What is the expected return of a portfolio constructed to drive the
standard deviation of the portfolio to zero?
The weights that drive the standard deviation of portfolio to zero,
when the returns are perfectly correlated, are:

σY 24
wX = = = 0.571
σX +σY 18 +24
wY = 1 – wX =0.429

The expected return of the portfolio is:

0.571 x 10 % + 0.429 x 25 % = 16.435 %

Example: The following information is available

Stock A Stock B
Expected Return 12% 26%
SD 15% 21%
Coefficient of Correlation 0.30

What is the covariance between stocks A & B?

What is the expected return and risk of a portfolio in which A & B have
weights of 0.3 and 0.7?
Efficient Frontier For ATwo Security-Case

Security A Security B
Expected return 12% 20%
Standard deviation 20% 40%
Coefficient of correlation -0.2

Proportion of A Proportion of B Expected return Standard deviation

Portfolio wA wB E (Rp) p

1 (A) 1.00 0.00 12.00% 20.00%

2 0.90 0.10 12.80% 17.64%

3 0.75 0.25 13.93% 16.27%

4 0.50 0.50 16.00% 20.49%

5 0.25 0.75 18.00% 29.41%

6 (B) 0.00 1.00 20.00% 40.00%

Portfolio Options And The Efficient Frontier

Expected
return , E(Rp)

20% 5 6 (B)
4
3•
2•
12% 1 (A)

Risk, p
20% 40%
 The same Expected return and a lower std
deviation
 The same Std deviation and a Higher
Expected Return
 A Higher Expected Return and Lower Std
deviation
Efficient Frontier For The n-Security Case
Expected
return , E (Rp)

•X

F •D
• BZ• •M

•N
•O
A•

Standard deviation, p
 All the feasible portfolios are contained in
the region AFXMNO, however only
portfolios AFX are efficient

 All the other portfolios are inefficient.

 Portfolio like Z is inefficient as portfolios

like B and D dominate it
 Portfolio Options And The Efficient Frontier

Lets form an Efficient Frontier with actual securities..

 P & Q are hypothetical investors. Q is
more risk averse than P.
 Each investor has a map of indifference
curves.
 All the points lying on a given indifference
curve offer the same level of satisfaction
 Optimal
Expected Portfolio
return , E (Rp) IP3
IP2 IP
IQ2 1
IQ3 IQ1
•X
• *
P
•
Q* • M

•
N

•
O

Standard deviation, p
Riskless Lending And Borrowing Opportunity

• Suppose that investors can lend and borrow money at a risk-

free rate of Rf .
• Since Rf is risk-free asset it has zero correlation with all the points
in the feasible region of risky securities.
• So a combination of Rf and any point in the feasible region
will be represented by a straight line
 Riskless Lending And Borrowing Opportunity
Expected
return , E (Rp)
G
II

EV•
•
• • X
S
• B I

D •M
• •F Y
C• •
u •N
•
Rf • •O
•
A

Standard deviation, p
Thus, with the opportunity of lending and borrowing, the efficient frontier
changes. It is no longerAFX. Rather, it becomes Rf SG as iCtodomniates AFX.
mpiled by: Dr. Rajsee Joshi
 Case study for Portfolio Management

There are two stocks Tata Steel and Cipla that the investor is wanting to invest in. Tata Steel has a beta of
more than 1 whereas Cipla has a negative beta. Tata Steel is selling at Rs. 1343.35 whereas Cipla Rs. 925.
The rupee return after 1 year on both these stocks are expected as under:

Market performance
Strong Bullish Low Bullish Low Bearish Strong Bearish
Probability 0.3 0.4 0.2 0.1
Return on Tata Steel 150 130 80 50
Return on Cipla 100 110 120 140

The investor wants to decide whether to:

1. Invest Rs. 10000 in Tata Steel
2. Invest Rs. 10000 in Cipla
3. Invest equally in Tata Steel and Cipla
 SUMMING UP
Portfolio theory, originally proposed by Markowitz,
is the first formal attempt to quantify the risk of a
portfolio and develop a methodology for
determining the optimal portfolio.

A portfolio is efficient if (and only if) there is an

alternative with (i) the same E(Rp) and a lower p
or (ii) the same p and a higher E(Rp), or (iii) a
higher E(Rp) and a lower p
Given the efficient frontier and the risk-return indifference
curves, the optimal portfolio is found at the tangency between
the efficient frontier and a utility indifference curve.

If we introduce the opportunity for lending and borrowing at the

risk-free rate, the efficient frontier changes dramatically.

It is simply the straight line from the risk-free rate which is

tangential to the broken-egg shaped feasible region
representing all possible combinations of risky assets.

The Markowitz model is highly information-intensive.

The single index model, proposed by sharpe, is a very helpful

simplification of the Markowitz model.