Introductory Finance

Lecture 8 - Mean-Variance Portfolio Theory (Part II)

Teimuraz Gogsadze

ISET

May, 2017

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Content

Recap of the previous lecture

Portfolio with N risky assets
E cient set with N risky assets and one risk-free asset
Description of equilibrium in the existence of capital markets
Portfolio diversication and individual asset risk

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Recap of Lecture 7

Assets with normally distributed returns

Portfolio of two risky assets
Minimum variance portfolio:

2Y rX Y X Y VAR (Y ) COV (X , Y )
a = =
2 + 2Y 2rX Y X Y VAR (X ) + VAR (Y ) 2COV (X , Y )

X

Minimum variance opportunity set:

dE (R p ) dE (R p )/da
slope = =
d R p d R p /da

Optimal portfolio: MRS = MRT

One risky and one risk-free asset: linear investment opportunity set.

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Portfolio with N risky assets

Generalizing the results for portfolio with two risky assets

Consider portfolio of N = 3 risky assets: asset 1, 2 and 3
1 , 2 and 3 Proportions of wealth invested in the assets
R1 , R2 and R3 Random returns
E (R1 ), E (R2 ) and E (R3 ) Expected returns
21 , 22 and 23 Variances
12 , 23 and 13 Covariances (note: 11 = 21 and 12 = 21 )
Then, portfolio mean return:
3
E (Rp ) = 1 E (R1 ) + 2 E (R2 ) + 3 E (R3 ) = i E (Ri ) (1)
i =1

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Portfolio with N risky assets

Portfolio variance:

VAR (Rp ) =
E f[( 1 R1 + 2 R2 + 3 R3 ) ( 1 E (R1 ) + 2 E (R2 ) + 3 E (R3 ))]2 g =
... =
21 21 + 22 22 + 23 23 + 2 1 2 12 + 2 1 3 13 + 2 2 3 23 =)

3 3
VAR (Rp ) = i j ij (2)
i =1 j =1

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Portfolio with N risky assets

We can write (1) and (2) in matrix form (for matrix algebra see Appendix
B at the end of Copeland et al.):
2 3
1
0
E (Rp ) = E (R1 ) E (R2 ) E (R3 ) 4 2 5 = R W (3)
3
2 32 3
21 12 13 1
VAR (Rp ) = 1 2 3 4 21 22 23 5 4 2 5 = W0 VW
31 32 23 3
(4)
where (for N = 3):
0
R is the (1 X N) row vector of expected returns,
W is the (N X 1) column vector of weights held in each asset,
V is the (N X N) variance-covariance matrix.

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Portfolio with N risky assets
Covariance between portfolios

Consider two assets - 1 and 2 and two portfolios of these assets - A and B
0
Let W1 be (1 X N) row vector of weights used to construct portfolio
A
Let W2 be (N X 1) column vector of weights used to construct
portfolio B
Let V be variance-covariance matrix
Then, the covariance between the two portfolios is:
0
COV (RA , RB ) = W1 VW2 (5)
21 12 1b
= 1a 2a
21 22 2b
Check that the result is the same as in the traditional case: COV (RA ,
RB ) = E [(RA E (RA ))(RB E (RB ))], where RA = 1a R1 + 2a R2 and
RB = 1b R1 + 2b R2
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The investment opportunity set with N risky assets

Same shape (convex) as with N = 2 risky assets (For the proof, see
Merton (1972) "An Analytic Derivation of the E cient Set" Journal
of Financial and Quantitative Analysis)
BUT: some assets may fall in the interior of the set
E cient set - positively sloped portion of the minimum variance
opportunity set.
Optimal portfolio choice (N risky assets)
Point of tangency between the highest IC and the e cient set
Key: No riskless asset, hence the same logic as with 2 risky assets
BUT: now must estimate all means, variances and covariances.

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The investment opportunity set with N risky assets
Source: Copeland et al.

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E cient set with N risky assets and one risk-free asset

Generalizing the results for portfolio with one risky asset and one risk
free asset
Assume: lending rate = borrowing rate
Draw a straight line between any risky asset (portfolio) and the
risk-free asset
Points along the line represent portfolios consisting of combinations of
the risk-free asset and the risky asset (portfolio)
Among plenty of such lines only one line dominates

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E cient set with N risky assets and one risk-free asset

Any investor would prefer combinations of the risk-free asset and

portfolio M on the e cient set (Why?)
All an investor needs to know is the combination of assets that
constitute portfolio M (Compare it with the case of N risky assets
and no risk-free asset).

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Portfolio of two risky assets
Degree of risk aversion and the optimal portfolio choice

Source: Copeland et al.

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Description of equilibrium
A world with capital markets

Risk-free asset:each investor can borrow or lend unlimited amount at

Rf (= borrowing rate = lending rate).
Homogeneous beliefs about E (R ) : all investors perceive the same
e cient set. Hence, every investor holds some combination of
risk-free asset and portfolio M.
In equilibrium "market clears" (prices are such that, there is no excess
demand for any asset) - all assets must be held and hence, portfolio
M must contain all assets according to their market value weights:
Vi
i = N
, (6)
Vi
i =1
where, i is the weight of asset i in the market portfolio, Vi is the
N
market value of asset i and Vi is the total market value of all
i =1
assets
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Description of equilibrium
A world with capital markets

Market equilibrium is not reached until the tangency portfolio, M, is

the market portfolio
Rf is such that aggregate borrowing and lending are equal
Two-Fund Separation: Each investor will have a utility-maximizing
portfolio that is a combination of the risk-free asset and the market
portfolio.
Properties:
1 Everyone holds the same risky portfolio
2 Preferences only determine the mix of risk-free asset and the risky
portfolio
3 Risky portfolio is the market portfolio, otherwise assets not in the
market portfolio will have no value
4 The minimum variance portfolio of the e cient set is unlikely to be the
optimal risky portfolio.

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Description of equilibrium
A world with capital markets

The straight line joining risk-free asset with the market portfolio will
be the e cient set for all investors. This line has come to be known
as the Capital Market Line.
Capital Market Line (CML): If investors have homogeneous beliefs,
then they all have the same linear e cient set called Capital Market
Line.
The equation for the CML:

E (R m ) Rf
E (R p ) = Rf + (R p ) (7)
(R m )

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Description of equilibrium
A world with capital markets

Source: Copeland et al.

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Description of equilibrium
A world with capital markets

Lecture 3 - in the world of certainty everyone is better o if the

capital market exists (also, Fisher separation obtains)
Now extending this result to the world with mean-variance uncertainty

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Description of equilibrium
A world with capital markets

Three results:
1 Almost everyone is better o in a world with capital markets and no
one is worse o
2 Two-fund separation obtains
3 In equilibrium MRS between risk and return is the same for everyone
If MRS is the same for everyone in equilibrium, the slope of CML is
the market price of risk (MPR):

E (R m ) Rf
MPR = MRS = (8)
(R m )

Implication: managers can use MPR to evaluate investment projects

regardless of the tastes of the shareholders.

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Portfolio diversication and individual asset risk

Variance of a portfolio of N assets (equivalent of (2)):

N N
VAR (Rp ) = i j ij (9)
i =1 j =1

Note that the number of variance terms equals to the number of

assets in the portfolio, N, and the number of covariance terms equals
to N (N 1).
Consider an equally weighted portfolio, i.e., i = j = N1 . Then (9)
can be written as:
N N 1 1 1 N N
VAR (Rp ) = ij = 2 ij =) (10)
i =1 j =1 N N N i =1 j =1
1 N 1 N N
VAR (Rp ) = ii + ij
N 2 i =1 N 2 i =1 j =1
i 6 =j

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Portfolio diversication and individual asset risk
Next suppose the largest variance of an individual asset is L.Then:
1 N 1 N LN L
ii L= 2 = and hence (11)
N 2 i =1 N 2 i =1 N N
L
lim =0
N ! N
Let ij be the average covariance. Then in (10) there are
N (N 1) = (N 2 N ) covariance terms, all equal to ij . Hence:
1 N N 1 1
2 ij = 2 (N 2 N ) ij = ij ij and (12)
N i =1 j =1 N N
i 6 =j
1
lim ( ij ij ) = ij
N ! N
Therefore
1 N N
lim ij = ij (13)
N ! N 2 i =1 j =1

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Portfolio diversication and individual asset risk

As the number of assets in the portfolio increases, the portfolio

variance decreases and approaches the average covariance. The
covariance terms are relatively more important for portfolios of larger
numbers of assets.
Fama (1976) illustrated this empirically:

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Portfolio diversication and individual asset risk

Another way of looking at the risk of a single asset is to evaluate its

contribution to the total portfolio risk. Taking the partial derivative of
(9) results in:

VAR (Rp ) N
= 2 i 2i + 2 j ij (14)
i j =1

Consider again the equally weighted portfolio. As the number of

N
assets, N, increases i approaches 0 and j approaches 1.
j =1
Hence, for a well-diversied portfolio the appropriate measure of an
asset contribution to the total portfolio risk is its covariance with
other assets in the portfolio.

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 End of Lecture 8

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