FINS2624

Portfolio Management
Lecture 5: Optimal Portfolios

Broader Asset Space & Uncertainty

Returns Under Uncertainty

P
R
O
B
A
B
I
L
I
T
Y

POSSIBLE OUTCOMES

On most asset types our cash flows are not known

Decision Making Framework based on

Risk & Return
E(r)

Harry M Markowitz - Portfolio Selection:

Efficient Diversification of Investments
(1959)

The satisfaction/utility of
investors captured via a trade
off between risk and return

They serve as the basis for asset and portfolio selection

= as general representation

Conditions of Uncertainty
Measuring Return and Risk
Returns Under Uncertainty
P
R
O
B
A
B
I
L
I
T
Y

POSSIBLE OUTCOMES

Returns Under Uncertainty

P
R
O
B
A
B
I
L
I
T
Y

Expected return =
as a measure of central tendency
Easily transferred to portfolios

POSSIBLE OUTCOMES

Variance 2 =
as a measure of dispersion

Not so easily transferred to portfolios

ij

Simplifying Variance/Covariance
The Covariance Matrix

2
,
,
2

,
,
OR

,
,

2
,

,
2

,
,

Multiplying out the components as product of 2 vectors and summing the parts.
Method can be applied not just to variance but to any portfolio combination covariance

Investment Decision & Way Forward

E(r)
Optimal
Portfolio

Eligible Portfolios
The Efficient Frontier

Dominated (Excluded)
Portfolios

We choose the portfolio

which maximises utility
amongst all the possible
combinations mapped out

Conceptually this is given by

the intersection of the
Efficient Frontier (which
includes only the best
risk/return combinations)
with the highest possible
utility indifference curve

The task from here is to translate this idea into an actual portfolio of choice

Introducing a Risk Free Asset

Consider an asset which is risk free, defined by:
= and = 0
This could be thought of as a short term US Government obligation
(Treasury Bill) or the like basically a security with a certain cash flow
If we combine a holding in a risky portfolio (proportion y) with the risk free
asset we can express the return on the Complete Portfolio (C) as:
= 1 + . From that we can deduce:
= 1 + ( ) or:
= + [ ]

( ) = 1 2 + 2
+2 1 ( , )
= 2 , = 2 2 (since is fixed)
Hence =

Both the expected return and the standard deviation are linear functions increasing
( )

in y with = [ ] and =

The Risk Free Asset & the Capital

Allocation Line
The linear property makes it easy to map the different possible allocations
between the risk free and the risky portfolio out

E(r) Points on line represent

E(rP)

allocations between & risky P

P

= ( )
=
When 100% invested in risky P
We call the line formed by
joining the combinations of
return and risk from allocations
between the risk free asset
and some risky portfolio a
Capital Allocation Line (CALP)

[ ]

rf

P
= , = 0
When 100% invested in
P

Capital Allocation Lines for All Risky

Portfolios
Moreover we need not stop with just the one risky portfolio. We can map
out CALs for all possibilities

E(r)

P2
The slope of each line,

gives reflects the implied trade off

between risk and return

PN

rf

Hence the steeper the CAL, the

better the additional return
expected from adding more risk
and the more attractive the portfolio

P1

Flexibility & Portfolio CALs: Adding

Some Scope for Borrowing
E(r)
Combinations beyond PP
are associated with y > 1
P2

This implies more the 100% of

allocation is going into risky
portfolio P the risk free
weight is negative, and we are
borrowing to invest

PN

rf

In practice though borrowing

rates (for investors) > lending
(deposit) rates

P1

rf beyond PP such that

& slope of CAL kinks lower

Portfolio CALs and Investment Choice

Interplay with the Efficient Frontier
E(r)
Recall the Efficient Frontier as the
list of superior risky portfolio
combinations from which we will
select. It is therefore only these
we are concerned with

Efficient Frontier

P1
rf

CALP

Including a risk free asset effectively excludes everything

to the left/below where the CAL intersects. This is due
the risk/return trade off being better it is possible to
achieve a zero risk with a still positive return

The Optimal Risky Portfolio

Conceptualised
E(r)

The portfolio whose CAL

intersects Efficient Frontier
at the highest point allows
for the exclusion the most
amount of portfolios
P*

rf

P2
P1

Note that in this case that

even Efficient Frontier
portfolios to right are
dominated as well the
capacity to borrow at the risk
free rate allows improvement
on expected return outcomes
by taking on less additional
risk than we would be
possible otherwise

The Optimal Risky Portfolio

The Mechanics
There are 2 deductions that can help us here:

Deduction 1: That the best achievable risk

& returns combinations are captured by the
efficient frontier. Hence it is not possible to
go further to the left and higher at the same
time in risk return space

E(r)

Best set of combinations

that can be attained

Deduction2: That introducing a risk free

asset and associated risky portfolio CALs
allows us to choose portfolio P* (at highest
possible intersection point with the Efficient
Frontier) which dominates all others

Implication: Can identify optimal portfolio

by simply considering the universe of
CALs. The one with the highest slope
will by definition run tangential to the
Efficient Frontier and so be associated
with the optimal risky portfolio

The Optimal Risky Portfolio

The Mechanics
E(r)

Recall that:

Efficient This represents the risk reward

Frontier
trade-off on the portfolio

involved and is otherwise

known at the Shape Ratio (SP)

P*
P2

rf

P1

Hence our problem amounts to

solving for portfolio weights in

= amongst universe of
assets according to

max =

via a suitable computer program

The Optimal Risky Portfolio

Interpretation
E(r)

P* is the portfolio that gives the

best risk return trade-off
amongst all alternatives. CAL* is
called The Capital Allocation
Efficient Line and shortened to just CAL
Frontier

P*

rf

It is derived on an objective basis

on the assumption that all asset
variances and returns are known.
Therefore it is the optimal choice
for all investors and since all will
hold it the weights in the aggregate
will be the same too. That is why it
is also termed the Market Portfolio.
Approximations in reality would be
the market indices eg. S&P 500

Alternatives Narrowed Down but More

Work to Do
E(r)
The analytical framework so
far has delivered us with an
optimal risky portfolio, P*, and
the associated CAL - which
represents its different
possible combinations with
the risk free asset

P*

Hence it has narrowed down

our list of choices to just rf
and P*. However, we are yet
to consider how best to
allocate between them

rf

Bringing Back Preferences

The Separation Theorem
Having recognised our optimal Complete Portfolio lies on the CAL belonging to P*,
the objective criteria for narrowing down our choices has gone as far as it can go

E(r)

PC

To determine the end allocation

we need to incorporate
preferences for risk and return.
This is the Separation Theorem
The idea is to select the
implied combination of risk and
return which maximises
investor utility

rf

This is represented by the point

at which the CAL intersects with
the highest possible
indifference curve

Different Preferences Different

Outcomes
Less Risk Averse Investor

E(r)
Recall that each indifferent curve represents
combinations of risk and return that give the
same level of satisfaction/utility
U

And the generalised utility function:

= , where A is a risk
aversion parameter than will differ by investor

E(r)

More
Risk
Averse
Investor

Hence utility curves can have

different contours leading
different investors to vary in
their complete portfolio choice

Completing the Portfolio

In mathematical terms we are choosing the risk allocation (y) on the

CAL which maximises utility

Hence we substitute: = + [ ] and 2 = 2 2 into our utility

2
function to give = + 1 2 2
as our representation
of utility for any point on the CAL
It can help to picture this in y, U space
U
Max U with respect to y

Our solution then becomes:

2
= + 1 2 2
y*

Completing the Portfolio

U

To determine the turning point we find the

derivative, set to zero and solve for y
So

2
=
=0

=
y*

is known as the reward to risk ratio and is closely related to

the Sharpe ratio,

More gets allocated to the risky portfolio at higher reward to risk ratios while the
allocation is lower with the degree of risk aversion (A)

Breaking Down Market Portfolio

Expected Value
Given its prominence the properties of the market portfolio are worth
considering in more detail, Some useful applications come from it as well

Consider =
= and in particular the contribution,
, coming from each asset, i
If we rearrange in terms of portfolio excess return (over rf) we get:

[ ]
=

with the contribution of each asset being [ ]

Breaking Down Market Portfolio

Variance
We calculate the variance of the market portfolio in the usual way
ie. we set up the covariance matrix:

2
,

,
2

,
,

And then sum the components

The contribution of each asset can be seen as the sum of the elements in its row

[ 1 ]

( , ) ( , )

Therefore contribution asset i = ,

=1

( , )

= , or ,

Breaking Down the Reward to Risk

Ratio
With the asset contributions to market portfolio expected return and
variance worked out it follows that the contribution of asset i to the reward
to risk ratio,

is given by

[ ]
,

[ ]
,

But the market portfolio is the portfolio with the best return to risk ratio so
it is not possible to improve on this by varying asset weights
The implication is that the asset reward to risk ratios must match that of
the market portfolio as well as each other
Therefore

[ ]
,

[ ]

Importance of Contributions Result:

The Capital Asset Pricing Model

Taking our

[ ]

result and expressing in terms of E( )

we get = +

This gives the required

(expected) return for a given
asset when these optimal
conditions hold

[ ]

It suggests this goes up with the

assets market covariance risk and
the excess return on the market
portfolio

Hence in this framework it is only systematic risk that matters. The

expression is known as the Capital Asset Pricing Model