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Portfolio theory

Suppose there are N risky assets, whose rates of returns are given

by the random variables R1, , RN , where

Sn(1) Sn(0)

Rn = , n = 1, 2, , N.

Sn(0)

Let w = (w1 wN )T , wn denotes the proportion of wealth invested

N

X

in asset i, with wn = 1. The rate of return of the portfolio is

n=1

N

X

RP = wnRn.

n=1

Assumptions

assets in the portfolio.

2. = (R1 R2 RN ) and 1 = (1 1 1) are linearly indepen-

dent.

The first two moments of RP are

N

X N

X

P = E[RP ] = E[wnRn] = wnn, where n = Rn,

n=1 n=1

and

X N

N X N X

X N

2 = var(R ) =

P wiwj cov(Ri, Rj ) = wiij wj .

P

i=1 j=1 i=1 j=1

Let denote the covariance matrix so that

2 = w T w .

P

Remark

2 . In mean-variance

The portfolio risk of return is quantified by P

analysis, only the first two moments are considered in the port-

folio model. Investment theory prior to Markowitz considered the

maximization of P but without P .

Two-asset portfolio

Consider two assets with known means R1 and R2, variances 12 and

22, of the expected rates of returns R1 and R2, together with the

correlation coefficient .

portfolio.

2 = (1 )2 2 + 2(1 ) + 2 2.

Portfolio variance: P 1 1 2 2

We represent the two assets in a mean-standard deviation diagram

(recall: standard deviation = variance)

With = 1, it is possible to have = 0 for some suitable choice

of weight.

In particular, when = 1,

q

P (; = 1) = (1 )212 + 2(1 )12 + 222

= (1 )1 + 2.

This is the straight line joining P1(1, R1) and P2(2, R2).

When = 1, we have

q

P (; = 1) = [(1 )1 2]2 = |(1 )1 2|.

When is small (close to zero), the corresponding point is close to

P1(1, R1). The line AP1 corresponds to

P (; = 1) = (1 )1 2.

1

The point A corresponds to = .

1 + 2

1

The quantity (1 )1 2 remains positive until = .

1 + 2

1

When > , the locus traces out the upper line AP2.

1 + 2

Suppose 1 < < 1, the minimum variance point on the curve that

represents various portfolio combinations is determined by

2

P

= 2(1 )12 + 222 + 2(1 2)12 = 0

set

giving

12 12

= 2 .

1 212 + 22

Mathematical formulation of Markowitzs mean-variance analysis

N N

1 XX

minimize wi wj ij

2 i=1 j=1

N

X N

X

subject to wi Ri = P and wi = 1.

i=1 i=1

Solution

N X

N

N

! N !

1 X X X

L= wi wj ij 1 wi 1 2 w i R i P

2 i=1 j=1 i=1 i=1

N

X

L

= ij wj 1 2 Ri = 0, i = 1, 2, , N. (1)

wi j=1

N

X

L

= wi 1 = 0; (2)

1 i=1

XN

L

= wi Ri P = 0. (3)

2 i=1

From Eq. (1), the portfolio weight admits solution of the form

w = 1(11 + 2) (4)

where 1 = (1 1 1)T and = (R1 R2 RN )T .

P = T 1w = 1T 11 + 2T 1. (6)

T T

Write a = 1 11, b = 1 1 and c = T 1, we have

1 = 1a + 2b and P = 1b + 2c.

c bP aP b

Solving for 1 and 2 : 1 = and 2 = , where

2

= ac b .

mean prescribed in the variance minimization problem.

Assume 6= h1, and 1 exists. Since is positive definite, so

a > 0, c > 0. By virtue of the Cauchy-Schwarz inequality, > 0.

The minimum portfolio variance for a given value of P is given by

T T

2

P = w w

= w (11

1 + 21)

a2 P 2bP +c

= 1 + 2P = .

The set of minimum variance portfolios is represented by a parabolic

curve in the P2 plane. The parabolic curve is generated by

P

varying the value of the parameter P .

dP

How about the asymptotic values of lim ?

dP

dP dP dP2

= 2 d

dP dP P

= 2P

2a

P q 2b

= a2P 2bP + c

aP b

so that

s

dP

lim = .

dP a

Summary

c bP aP b

Given P , we obtain 1 = and 2 = , and the optimal weight

w = 1(1 1 + 2).

To find the global minimum variance portfolio, we set

dP2 2aP 2b

= =0

dP

so that P = b/a and P2 = 1/a. Also, 1 = 1/a and 2 = 0. We obtain

wg =

1 1= 1 .

1

T

a

1 11

Another portfolio that corresponds to 1 = 0 is obtained when P is taken to be

c

. The value of the other Lagrangian multiplier is given by

b

a cb b 1

2 = = .

b

The optimal weight of this particular portfolio is

1 1

wd = = T

.

b

1 1

c 2 c

a 2b +c c

Also, d2 = b b

= .

b2

Feasible set

We plot the point (P , RP ) representing the portfolios in the R

diagram. The collection of these points constitutes the feasible set

or feasible region.

Consider a 3-asset portfolio, the various combinations of assets 2

and 3 sweep out a curve between them (the particular curve taken

depends on the correlation coefficient 12).

asset 1 to form a curve joining 1 and 4. As 4 moves between 2 and

3, the curve joining 1 and 4 traces out a solid region.

Properties of feasible regions

and with different means), then the feasible set is a solid two-

dimensional region.

2. The feasible region is convex to the left. That is, given any two

points in the region, the straight line connecting them does not

cross the left boundary of the feasible region.

The left boundary of a feasible region is called the minimum variance

set. The most left point on the minimum variance set is called the

minimum variance point. The portfolios in the minimum variance

set are called frontier funds.

For a given level of risk, only those portfolios on the upper half

of the efficient frontier are desired by investors. They are called

efficient funds.

no portfolio w with P P and P2 2 . That is, you cannot find

P

a portfolio that has a higher return and lower risk than those for an

efficient portfolio.

Two-fund theorem

tier portfolio can be duplicated, in terms of mean and variance, as

a combination of these two. In other words, all investors seeking

frontier portfolios need only invest in combinations of these two

funds.

Remark

ficient portfolios is an efficient portfolio. Let i 0 be the weight

h i b

i I

of Fund i whose rate of return is Rf . Since E Rf for all i, we

a

have

n

X h i Xn

i b b

iE Rf i = .

i=1 i=1 a a

Proof

Let w1 = (w11 wn

1 ), 1, 1 and w 2 = (w 2 w 2)T , 2, 2 are two

1 2 1 n

known solutions to the minimum variance formulation with expected

rates of return 1 2

P and P , respectively.

n

X

ij wj 1 2Ri = 0, i = 1, 2, , n (1)

j=1

Xn

wiri = P (2)

i=1

n

X

wi = 1. (3)

i=1

to the expected rate of return 1

P + (1 )2.

P

1. w1 + (1 )w2 is a legitimate portfolio with weights that sum

to one.

equations is linear.

3. Note that

n h

X i

wi1 + (1 )wi2 Ri

i=1

Xn n

X

= wi1Ri + (1 ) wi2Ri

i=1 i=1

= 1

P + (1 ) 2.

P

Proposition

decomposed into the sum of two portfolios

wP = Awg + (1 A)wd

c bP

where A = 1a = a.

Proof

multipliers are 1 and 2, the optimal weight is

Observe that the sum of weights is

c P b P a b ac b2

1a + 2b = a +b = = 1.

We set 1a = A and 2b = 1 A.

Indeed, any two minimum-variance portfolios can be used to substi-

tute for wg and wd. Suppose

wu = (1 u)wg + uwd

wv = (1 v)wg + v wd

we then solve for wg and wd in terms of wu and wv . Then

wP = 1awg + (1 1a)wd

1a + v 1 1 u 1a

= wu + wv ,

vu vu

where sum of coefficients = 1.

Example

assets are listed:

Security covariance Ri

1 2.30 0.93 0.62 0.74 0.23 15.1

2 0.93 1.40 0.22 0.56 0.26 12.5

3 0.62 0.22 1.80 0.78 0.27 14.7

4 0.74 0.56 0.78 3.40 0.56 9.02

5 0.23 0.26 0.27 0.56 2.60 17.68

Solution procedure to find the two funds in the minimum variance

set:

5

X

ij vj1 = 1, i = 1, 2, , 5.

j=1

vi1

wi1 = Pn 1

.

j=1 vj

1

After normalization, this gives the solution to wg , where 1 =

a

and 2 = 0.

2. Set 1 = 0 and 2 = 1; solve the system of equations:

5

X

ij vj2 = Ri, i = 1, 2, , 5.

j=1

1

and 2 = .

b

The above procedure avoids the computation of a = 1T 11

T

and b = 1 1.

security v1 v2 w1 w2

1 0.141 3.652 0.088 0.158

2 0.401 3.583 0.251 0.155

3 0.452 7.284 0.282 0.314

4 0.166 0.874 0.104 0.038

5 0.440 7.706 0.275 0.334

mean 14.413 15.202

variance 0.625 0.659

standard deviation 0.791 0.812

We know that g = b/a; how about d?

1 c

T

d = wd = T = .

b b

c b

Difference in expected returns = d g = = > 0.

b a ab

c 1

Also, difference in variances = d2 g2 = 2 = 2 > 0.

b a ab

How about the covariance of portfolio returns for any two minimum

variance portfolios?

Write

u = w T R and Rv = w T R

RP u P v

where R = (R1 RN )T . Recall that

11 1

gd = cov R, R

a b

T !

=

1 1

1

a b

=

11 = 1 since b = 11.

ab a

cov(RPu , Rv ) = (1 u)(1 v) 2 + uv 2 + [u(1 v) + v(1 u)]

P g d gd

(1 u)(1 v) uvc u + v 2uv

= + 2 +

a b a

1 uv

= + 2

.

a ab

In particular,

cov(Rg , RP ) = wTg wP =

1 1wP 1

= = var(Rg )

a a

for any portfolio wP .

For any Portfolio u, we can find another Portfolio v such that these

two portfolios are uncorrelated. This can be done by setting

1 uv

+ 2

= 0.

a ab

Inclusion of a riskfree asset

Consider a portfolio with weight for a risk free asset and 1 for

a risky asset. The mean of the portfolio is

The covariance f j between the risk free asset and any risky asset

is zero since

E[(Rj Rj ) (Rf Rf ) = 0.

| {z }

zero

2 is

Therefore, the variance of portfolio P

2 = 2 2 +(1 )2 2 + 2(1 )

P f j fj

|{z} |{z}

zero zero

so that P = |1 |j .

The points representing (P , RP ) for varying values of lie on a

straight line joining (0, Rf ) and (j , Rj ).

this case, the line extends beyond the right side of (j , Rj ) (possibly

up to infinity).

Consider a portfolio with N risky assets originally, what is the impact

of the inclusion of a risk free asset on the feasible region?

For each original portfolio formed using the N risky assets, the new

combinations with the inclusion of the risk free asset trace out the

infinite straight line originating from the risk free point and passing

through the point representing the original portfolio.

bounded by the two tangent lines through the risk free point to the

original feasible region.

No shorting of risk free asset

The line originating from the risk free point cannot be extended

beyond points in the original feasible region (otherwise entail bor-

rowing of the risk free asset). The new feasible region has straight

line front edges.

The new efficient set is the single straight line on the top of the

new triangular feasible region. This tangent line touches the original

feasible region at a point F , where F lies on the efficient frontier of

the original feasible set.

b

Here, Rf < .

a

One fund theorem

Any efficient portfolio (any point on the upper tangent line) can be

expressed as a combination of the risk free asset and the portfolio

(or fund) represented by F .

portfolio can be constructed as a combination of the fund F and

the risk free asset.

New Lagrangian formulation

2

P 1

minimize = wT w

2 2

subject to wT + (1 wT 1)r = P .

1 T

Define L = w w + [P r ( r1)T w]

2

N

X

L

= ij wj ( r1) = 0, i = 1, 2, , N (1)

wi j=1

L

=0 giving ( r1)T w = P r. (2)

Solving (1): w = 1( r1). Substituting into (2)

Lastly, the relation between P and P is given by the following pair

of half lines

T T T

2 = w w = (w r w

P 1)

= (P r) = (P r)2/(c 2rb + r2a).

With the inclusion of the riskfree asset, the set of minimum variance

portfolios are represented by portfolios on the two half lines

q

Lup : P r = P ar2 2br + c (1a)

q

Llow : P r = P ar2 2br + c. (1b)

Recall that ar2 2br + c > 0 for all values of r since = ac b2 > 0.

The minimum variance portfolios without the riskfree asset lie on

the hyperbola

2 a2

P 2bP + c .

P =

b

When r < g = , the upper half line is a tangent to the hyperbola.

a

The tangency portfolio is the tangent point to the efficient frontier

(upper part of the hyperbolic curve) through the point (0, r).

The tangency portfolio M is represented by the point (P,M , MP ),

and the solution to P,M and M

P are obtained by solving simultane-

ously

2 a2

P 2bP + c

P =

q

P = r + P c 2rb + r2a.

Once P is obtained, we solve for and w from

P r = 1( r 1).

= and w

c 2rb + r2a

The tangency portfolio M is shown to be

1( r1) c br c 2rb + r2a

wM = , M

P = and 2

P,M = 2

.

b ar b ar (b ar)

b

When r < , it can be shown that M

P > r. Note that

a

b b c br b b ar

M

P r

=

a a b ar a a

c br b2 br

= 2+

a a a

ca b2

= 2

= 2

> 0,

a a

M b b

so we deduce that P > > r, where g = . Indeed, we can

a a

b

deduce (P,M , M

P ) does not lie on the upper half line if r .

a

b

When r < , we have the following properties on the minimum

a

variance portfolios.

1. Efficient portfolios

q

P = r + P ar2 2br + c

within the segment F M joining the two points (0, r) and M

involves long holding of the market portfolio and riskfree asset,

while those outside F M involves short selling of the riskfree asset

and long holding of the market portfolio.

2. Any portfolio on the lower half line

q

P = r P ar2 2br + c

involves short selling of the market portfolio and investing the

proceeds in the riskfree asset. This represents non-optimal in-

vestment strategy since the investor faces risk but gains no extra

expected return above r.

What happens when r = b/a? The half lines become

s s

b b2

P = r P c 2 b = r P ,

a a a

which correspond to the asymptotes of the feasible region with risky

assets only.

b

When r = , M

P does not exist. Recall that

a

w = 1( r1) so that

T

1 w = (11 r111) = (b ra).

T

When r = b/a, 1 w = 0 as is finite. Any minimum variance port-

folio involves investing everything in the riskfree asset and holding

a portfolio of risky assets whose weights sum to zero.

b

When r > , only the lower half line touches the feasible region with

a

risky assets only.

Any portfolio on the upper half line involves short selling of the

tangency portfolio and investing the proceeds in the riskfree asset.

Alternative approach

this point and the risk free asset. Let be the angle of inclination

P rf

of this line, where tan = . The tangency portfolio is the

P

feasible point that maximizes or tan .

n

X

Write RP = wiRi, where wi is the weight associated with the

i=1

n

X n

X

risky asset i. Since P = wiRi and rf = wirf , we have

i=1 i=1

n

X

wi(Ri rf )

tan = i=1 1/2 .

n X

X n

ij wiwj

i=1 j=1

Set the derivative of tan with respect to each wk equal to zero:-

tan

wi

1/2 " # n 1/2

n

X n

X X n

X

Ri rf ij wi wj wi (Ri rf ) i,j wi wj ij wj

i,j=1 i=1 i,j=1 j=1

= n

X

ij wi wj

i,j=1

= 0.

n

X

ij wj = (Ri rf ), is some constant, i = 1, 2, , n.

j=1

Hint Use the following relation

1/2 1/2

n

X X X

wiij wj = wiij wj ij wj .

wi i,j i,j j=1

We write vj = wj for each j, the above system becomes

n

X

ij vj = ri rf , i = 1, 2, , n.

j=1

We then solve for vj by a linear system solver.

vj

Finally, we normalize wj s by wj = Pn , j = 1, , n.

j=1 vk

Example (5 risky assets and one risk free asset)

Data of the 5 risky assets are given in the earlier example, and

rf = 10%.

5

X

ij vj = Ri rf = 1 Ri rf 1, i = 1, 2, , 5.

j=1

5

X 5

X

ij vj1 =1 and ij vj2 = Ri, respectively.

j=1 j=1

10%).

Addition of risk tolerance factor

Maximize 2 P P

2 subject to

Optimization problem: max 2 P P 1 w = 1.

wRN

Remark

initial wealth W0 and under a portfolio choice w, the end-of-period

wealth is W0(1 + RP ). Let P = E[RP ] and P 2 = var(R ).

P

W 2

u[W0(1 + RP )] u(W0) + W0u0(W0)RP + 0 u00(W0)RP

2 + .

2

2] =

Neglecting third and higher order moments and noting E[RP

2 + 2 .

P P

W 2

E[u(W0(1 + P ))] u(W0) + W0u0(W0)P + 0 u00(W0)(P 2 + 2 ) +

P

" 2 #

2

W0 00 0

2u (W0)

= u(W0) u (W0) ( 2 + 2 )

P P P

2 W0u00(W0)

+

W u00 (W )

0 0

Neglecting 2

P compared to P

2 and letting R =

R , we

u0(W0)

2 2.

have the objective function: P P

RR

2 when

mean P and variance P

(ii) RP is normal.

Quadratic optimization problem

max [2 T w wT w] subject to 1 w = 1.

wRN

The Lagrangian formulation becomes:

The first order conditions are

(

2 2w + 1 = 0

.

1w =1

Express the optimal solution w as wg + z , 0.

1. When = 0, 2w = 01 and 1T w g = 1

0 1 T T

wg = 1 and 1 = 1 wg = 0 1 11

2 2

hence

11

wg = T

(independent of ).

1 11

2. When 0, w = 1 + 11.

2

T T T 1 1 11

1 = 1 w = 1 1 + 1 1 so that = T .

2 2 1 11

T T

w= 1+

1 1 1 1

1 = 1

1 1 11+w .

T T 1 g

1 11 1 1

We obtain

T 1

1 1

z = T

1 T

1 and 1 z = 0.

1 11

Observe that cov(Rwg , Rz) = z T wg = 0.

Financial interpretation

by investing in the self-financing portfolio z so as to maximize

2 T w wT 1w.

Efficient frontier

Consider

P = T (wg + z ) = g + P,z

2 = 2 + 2 cov(R

P , R ) + 2 2 .

g |

w g z

{z

} z

z T wg =0

!2

2 2 P g 2 . Hence, the frontier is

By eliminating , P = g + z

P,z

2 )-diagram and hyperbolic in the ( , )-

parabolic in the (P , P P P

diagram.

Inclusion of riskfree asset (deterministic rate of return R0 = r)

N

X

Let w = (w0 wN )T and wi = 1.

i=0

c

bTw

L = 2 cT w

cw cT 1 1) + 2 w0r + w0

c + (w

T

b = (1 N )T RN , 1 = (1 1)T

c = (w1 wn)T RN ,

where w

RN .

2 r + = 0 (i)

2 c + 1 = 0

b 2w (ii)

N

X

wi = 1 (iii)

i=0

Estimation of risk tolerance (inverse problem)

) and . Taking the inner product

to express in terms of var(RP P

of w

c with (ii), we obtain

T

2 (rw0 +

bTw

c) 2w

c w

c + = 0.

follows:

var(RP)

= .

P r

Marginal utilities

c

With w0 = 1 1 w

c, we obtain the objective function

c

F (w b r 1)T w

c) = 2 [r + ( cT w

c] w c

c

b r 1) 2w

F = 2 ( c

so that

(F )i = 2 [i r] 2cov(RP , Ri), i = 1, 2, , N.

An increase of amount dwi in the weight of asset i and a corre-

sponding reduction of the riskless asset leads to a marginal change

(F )i dwi of the objective function. By increasing (decreasing) the

positions with high (low) marginal utilities, an efficient portfolio w

can be considerably improved.

Summary

maximizing return 2 T w against risk wT w, where the weigh-

ing factor is related to the reciprocal of relative risk aversion

coefficient RR .

w = wg + z

where wg is the portfolio weight of the global minimum variance

portfolio and the weights in z are summed to zero.

3. The additional variance above g2 is given by

2z

2 .

are uncorrelated

of the ith asset can be increased by

(ii) higher positive value of i r

(iii) higher negative correlation between portfolios rate of return

RP and assets rate of return Ri.

Asset-Liability Model

Market value can hardly be determined since liabilities are not readily

marketable. Assume that some specific accounting rules are used to

calculate an initial value L0. If the same rule is applied one period

later, a value L1 results.

L1 L0

Growth rate of the liabilities = RL = , where RL is expected

L0

to depend on the changes of interest rate structure, mortality and

other stochastic factors. Let A0 be the initial value of assets. The

investment strategy of the pension fund is given by the portfolio

choice w.

Surplus optimization

period

The return on surplus is defined by

S1 S0 1

RS = = Rw RL

A0 f0

where f0 = A0/L0 is the initial funding ratio.

Maximization formulation:-

( " # !)

1 1

max 2 E Rw RL var Rw RL

w RN f0 f0

N

X 1

subject to wi = 1. Note that RL and var(RL) are independent

i=1 f0

of w so that they do not enter into the objective function.

( )

2

max 2 E[Rw ] var(Rw ) + cov(Rw , RL)

w RN f0

N

X

subject to wi = 1. Recall that

i=1

N

X N

X

cov(Rw , RL) = cov wiRi, RL = wicov(Ri, RL).

i=1 i=1

max {2 T w + 2 T w wT w} subject to 1T w = 1,

w RN

1

where T = (1 N ) with i = cov(Ri, RL),

f0

Remarks

the correlation cov(Ri, RL) between return of risky asset i and

return of liability multiplied by the factor L0/A0.

1

T + T . The efficient portfolios are of the form

w = wg + z L + z , 0,

T 1

1

where z L = 1 T

11 with

N

X

ziL = 0.

1 11 i=1

The occurrence of liabilities leads only to parallel shifts of the

set of efficient portfolios.

The mean-variance criterion can be reconciled with the expected

utility approach in either of two ways: (1) using a quadratic utility

function, or (2) making the assumption that the random returns are

normal variables.

Quadratic utility

b 2

The quadratic utility function can be defined as U (x) = ax x ,

2

where a > 0 and b > 0. This utility function is really meaningful

only in the range x a/b, for it is in this range that the function is

increasing. Note also that for b > 0 the function is strictly concave

everywhere and thus exhibits risk aversion.

mean-variance analysis maximum expected utility criterion

based on quadratic utility

expected utility criterion, we evaluate the portfolio using

b 2

E[U (y)] = E ay y

2

b

= aE[y] E[y 2]

2

b 2 b

= aE[y] (E[y]) var(y).

2 2

The optimal portfolio is the one that maximizes this value with

respect to all feasible choices of the random wealth variable y.

Normal Returns

criterion is also equivalent to the expected utility approach for any

risk-averse utility function.

wealth variable y that is a normal random variable with mean value

M and standard deviation . Since the probability distribution is

completely defined by M and , it follows that the expected utility

is a function of M and . If U is risk averse, then

f f

E[U (y)] = f (M, ), with >0 and < 0.

M

Now suppose that the returns of all assets are normal random

variables. Then any linear combination of these asset is a normal

random variable. Hence any portfolio problem is therefore equiv-

alent to the selection of combination of assets that maximizes

the function f (M, ) with respect to all feasible combinations.

should be minimized for any given value of the mean. In other

words, the solution must be mean-variance efficient.

with respect to all feasible combinations.

Two fund monetary separation

Consider a financial market with the riskfree asset and several risky

assets, suppose the utility function satisfies

u0(z)

00 = a + bz, valid for all z,

u (z)

then the optimal portfolio at different wealth levels is given by the

combination of the riskfree asset and market fund consisting of the

risky assets. The relative proportions of risky assets in the market

fund remain the same, irrespective of W0.

Remark

(i) quadratic utility

(ii) log utility: a = 0

(iii) exponential utility: b = 0

(iv) power utility: a = 0.

Let W0 be the initial wealth, then the wealth amount aj (W0) of

risky asset j in the optimal portfolio satisfies

so that the relative proportion bj is given by

aj (W0) j

bj = n = n , independent of W0.

X X

ak (W0) k

k=1 k=1

Lemma

u0(W1)

00 = a + bW1, for all W1,

u (W1)

then the optimal portfolio is given by

e = 1 + re , j = 1, 2, , n.

where R = 1 + rf and R j j

E[u(W

j=1

1

m

X n

X n

X

f = W

where W aj R + e = RW +

aj R e R),

aj (R

1 0 j 0 j

j=1 j=1 j=1

then

V 0(W0) a

00 = + bW0, for all initial wealth W0. (B)

V (W0) R

Proof

Assume that

aj (W0) = j (W0)(a + bRW0)

where j (W0), j = 1, , n, is a differentiable function.

deduce that

f )]

E[u(W 1

ak

N

X

0 e R)

e R) (W )(a + bRW ) (R

= E u RW0 + (Rj j 0 0 k = 0,

j=1

| {z }

f1

W

(1)

k = 1, 2, , N.

Next, we differentiate eq (1) with respect to W0. First, we observe

that

f N

X

dW 1 e R) (W )b

= R 1 + (R j j 0

dW0 j=1

N d (W )

X j 0 e R)(a + bRW ).

+ (Rj 0

j=1 dW 0

N

X dj (W0)

E[u00(W

f )(R

1

e

j

e

R)(Rk R)(a + bRW0)]

j=1 dW0

N

X

00 f

= E u (W1)(Rk R)R 1 + e R) (W )b ,

(R j j 0

j=1

k = 1, 2, , N.

In matrix form, we have

d1 (W0 )

e1 R)

(R 2 (R e1 R)(R eN R) dW0

(R e2 R)(R e1 R) (R e2 R)(R eN R) 00

d2 (W0 )

E

... ... ...

u ( f

W 1 )(a + bRW 0 )

dW0

...

eN R)(R

(R e1 R) (ReN R)2 dN (W0 )

dW0

n h PN io

E u (W00 f1)(R e1 R)R 1 + e

j=1 (Rj R)j (W0 )b

n h PN io

00 f1)(R e2 R)R 1 + ej R)j (W0)b

E u (W j=1 ( R

=

...

n h PN io

00

E u (W f1)(R eN R)R 1 + e

j=1 (Rj R)j (W0 )b

(2)

From the assumption

u0(W1)

00 = a + bW1,

u (W1)

we obtain

u0 (W

f )

1

u00(W

f )

1 = h PN i

e

a + b RW0 + j=1(Rj R)j (W0)(a + bRW0)

u0 (W

f )

1

= h PN i. (3)

e

(a + bRW0) 1 + j=1(Rj R)j (W0)b

observe that

N

X

u00(W

f )(R

1

e R)R 1 +

k

e R) (W )b

(R j j 0

j=1

R

= u0 (W

f )(R

1

e

k R) , k = 1, 2, N. (4)

a + bRW0

Recall the first order condition:

E[u0(W

f )(R

1

e R)] = 0

k k = 1, 2, , N.

Combining eqs (1) and (4), and knowing that the column vector on

the right hand side of eq (2) is a zero vector, we deduce that

dj

(W0) = 0, j = 1, 2, , n,

dW0

provided that the matrix in eq (2) is non-singular. We then have

Now, aj = j (a + bW0), a > 0. When b = 0, aj is independent of the

initial wealth W0.

aj (W0)/aj 0 (W0) is independent of W0, and it is said to be completely

separated if aj is independent of W0.

To show eq (B), we start from the optimality condition on

aj (W0) = j (a + bRW0)

to obtain

n

X

V (W0) = E u RW0 + e R) (a + bRW )

(R j j 0

j=1

n

X N

X

= E u 1 + (Re R)j b RW0 + e R) a .

(R

j j j

j=1 j=1

Differentiate V (W0) twice with respect to W0

n

X

V 0(W 0) = E u0(W

f )R 1 +

1

e R) b

(R j j

j=1

2

n

X

e R) b

V 00(W0) = E u00(W

f )R2 1 +

1 ( Rj j .

j=1

Relating u00(W

f ) with u0(W

1

f ) using eq (3), we obtain

1

h Pn i

RE u0 (W

f )R

1

e

1 + j=1(Rj R)j b R

V 00(W 0) = = V 0(W0).

a + bRW0 a + bRW0

Combining the results

V 0(W0) a

00 = + bW0.

V (W0) R

Formulation for finding the optimal portfolio

Let be the weight of the riskfree asset so that the wealth invested in risky

assets is W0 (1 ). Let bj be the weight of risky asset j within W0(1 ) so that

Xn

bj = 1. The random wealth W f at the end of the investment period is

j=1

f )]

max E[u(W

{,bj }

where

n

X

f

W = W0 (1 + rf ) + W0 (1 )bj (1 + rej )

j=1

n

X

= W0 1 + rf + (1 ) bj rej

j=1

subject to

n

X

bj = 1.

j=1

Lagrangian formulation

n

X

f )] + 1

max E[u(W bj .

{,bj ,} j=1

First order conditions give

n

X

E u0(W

f )W r

0 f bj rej = 0 (1)

j=1

h i

E 0 f

u (W )W0(1 )rej = , j = 1, 2, , n, (2)

n

X

bj = 1. (3)

j=1

n

X

From eq. (1), E[u0(W

f )r ]

f = E u0(W

f) bj rej ,

j=1

n

X

= E u0(W

f )W

0(1 ) bj rej .

j=1

Substituting into eq (2)

n

X

f )re ] = E u0(W

E[u0(W j

f) bj rej , j = 1, 2, , n,

j=1

and using eq (1), we obtain

E[u0(W

f )(re r )] = 0

j f

or equivalently,

n

X

E u0 W0 1 + rf + (1 ) b`(re` rf ) (rej rf ) = 0,

`=1

j = 1, 2, , n. (4)

Exponential utility

n

X

E A exp a W0 (1 + rf ) + (1 ) b`(re` rf ) (rej rf ) = 0

`=1

and since A exp(aW0(1 + rf )) is non-random, we have

h Pn i

a e`rf ) e

`=1 W0 (1)b` (r

E e (r j rf ) = 0, j = 1, 2, , n. (5a)

For another initial wealth W00 , we have similar result

Pn

0 0 0 e r )

E ea `=1 W0 (1 )b` (r` f (r

ej rf ) = 0, j = 1, 2, , n. (5b)

Suppose we postulate that the solution to the system of equations

h Pn i

a e`rf ) e

`=1 ` (r

E e (rj rf ) = 0, j = 1, 2, , n,

is unique, then by comparing eqs (5a,b), we obtain

Summing ` from 1 to n, we obtain

hence

b` = b0`, ` = 1, 2, , n.

The total wealth amount W0(1 ) invested in risky assets and the

wealth amount in each asset are independent of W0.

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