Quick Note 3

1. Theoretically, the standard deviation of a portfolio can be reduced to what level?

Explain. Realistically, is it possible to reduce the standard deviation to this level? Explain.

Theoretically, if one could find two securities with perfectly negatively correlated returns
(correlation coefficient = -1), one could solve for the weights of these securities that would
produce the minimum variance portfolio of these two securities. The standard deviation of the
resulting portfolio would be equal to zero. However, in reality, securities with perfect negative
correlations do not exist.

2. Discuss how the investor can use the separation theorem and utility theory to produce an
efficient portfolio suitable for the investor's level of risk tolerance.

One can identify the optimum risky portfolio as the portfolio at the point of tangency between a
ray extending from the risk-free rate and the efficient frontier of risky securities. Below the point
of tangency on this ray from the risk-free rate, the efficient portfolios consist of both the
optimum risky portfolio and risk-free investments (T-bills); above the point of tangency, the
efficient portfolios consist of the optimum risky portfolio purchased on margin. If the investor's
indifference curve, which reflects that investor's preferences regarding risk and return, is
superimposed on the ray from the risk-free rate, the resulting point of tangency represents the
appropriate combination of the optimum risky portfolio and either risk-free assets or margin
buying for that investor. Thus, the separation theorem separates the investing and financing
decisions. That is, all investors will invest in the same optimal risky portfolio, and adjust the risk
level of the portfolio by either lending (investing in U.S. Treasuries, i.e., lending to the U.S.
government) or borrowing (buying risky securities on margin).

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State Markowitz's mean-variance criterion. Discuss Markowitz portfolio selection model.

The mean-variance criterion states that asset A dominates asset B if and only if E(R A) is greater
than or equal to E(RB) and the standard deviation of A's returns is less than or equal to the
standard deviation of B's returns, with at least one strict inequality holding.

The first step in the Markowitz portfolio selection model is to determine the risk–return
opportunities available to the investor. These are summarized by the minimum-variance
frontier of risky assets. 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. The plot of these expected return–standard deviation pairs is presented in Figure
1

Notice that all the individual assets lie to the right inside the frontier, at least when we allow
short sales in the construction of risky portfolios. This tells us that risky portfolios comprising
only a single asset are inefficient. Diversifying investments leads to portfolios with higher
expected returns and lower standard deviations. All the portfolios that lie on the minimum-
variance frontier from the global minimum variance portfolio and upward provide the best risk–
return combinations and thus are candidates for the optimal portfolio. The part of the frontier that
lies above the global minimum-variance portfolio, therefore, is called the efficient frontier of
risky assets. For any portfolio on the lower portion of the minimum-variance frontier, there is a
portfolio with the same standard deviation and a greater expected return positioned directly
above it. Hence the bottom part of the minimum-variance frontier is inefficient.

The second part of the optimization plan involves the risk-free asset. As before, we search for the
capital allocation line with the highest reward-to-volatility ratio (that is, the steepest slope) as
shown in Figure 2

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The CAL that is supported by the optimal portfolio, P, is tangent to the efficient frontier. This
CAL dominates all alternative feasible lines (the broken lines that are drawn through the
frontier). Portfolio P, therefore, is the optimal risky portfolio. Finally, in the last part of the
problem the individual investor chooses the appropriate mix between the optimal risky portfolio
P and T-bills

In the first part of the problem, risk–return analysis, the portfolio manager needs as inputs a set
of estimates for the expected returns of each security and a set of estimates for the covariance
matrix. Once these estimates are compiled, the expected return and variance of any risky
portfolio with weights in each security, wi , can be calculated from the bordered covariance
matrix or, equivalently, from the following formulas:

Markowitz model is precisely step one of portfolio management: the identification of the
efficient set of portfolios, or the efficient frontier of risky assets. The principal idea behind the
frontier set of risky portfolios is that, for any risk level, we are interested only in that portfolio
with the highest expected return. Alternatively, the frontier is the set of portfolios that minimizes
the variance for any target expected return. Indeed, the two methods of computing the efficient
set of risky portfolios are equivalent. To see this, consider the graphical representation of these
procedures.

The points marked by squares are the result of a variance-minimization program. We first draw
the constraints, that is, horizontal lines at the level of required expected returns. We then look for
the portfolio with the lowest standard deviation that plots on each horizontal line—we look for
the portfolio that will plot farthest to the left (smallest standard deviation) on that line. When we
repeat this for many levels of required expected returns, the shape of the minimum-variance
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frontier emerges. We then discard the bottom (dashed) half of the frontier, because it is
inefficient. In the alternative approach, we draw a vertical line that represents the standard
deviation constraint. We then consider all portfolios that plot on this line (have the same standard
deviation) and choose the one with the highest expected return, that is, the portfolio that plots
highest on this vertical line. Repeating this procedure for many vertical lines (levels of standard
deviation) gives us the points marked by circles that trace the upper portion of the minimum-
variance frontier, the efficient frontier. When this step is completed, we have a list of efficient
portfolios, because the solution to the optimization program includes the portfolio proportions, w
i , the expected return, E ( r p ), and the standard deviation, _ p .

Draw a graph of a typical efficient frontier. Explain why the efficient frontier is shaped the
way it is.

The efficient frontier has a curved appearance. Figure 7-5 shows several correlation values and
the corresponding shapes of the frontier. The typical shape results from the fact that assets'
returns are not perfectly (positively or negatively) correlated.

The solid colored curve in Figure 7.5 shows the portfolio opportunity set for correlation=.3.
We call it the portfolio opportunity set because it shows all combinations of portfolio expected
return and standard deviation that can be constructed from the two available assets. The other
lines show the portfolio opportunity set for other values of the correlation coefficient. The solid
black line connecting the two funds shows that there is no benefit from diversification when the
correlation between the two is perfectly positive ( +1). The opportunity set is not “pushed” to the
northwest. The dashed colored line demonstrates the greater benefit from diversification when
the correlation coefficient is lower than .3. Finally, for -1, the portfolio opportunity set is linear,
but now it offers a perfect hedging opportunity and the maximum advantage from diversification.
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,

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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.

Points to remember……….

A) Covariance measures whether security returns move together or in opposition; however,

only the sign, not the magnitude, of covariance may be interpreted. Correlation, which is
covariance standardized by the product of the standard deviations of the two securities,
may assume values only between +1 and - 1; thus, both the sign and the magnitude may
be interpreted regarding the movement of one security's return relative to that of another
security.
B) The indifference curve represents what is acceptable to the investor; the capital allocation
line represents what is available in the market. The point of tangency represents where
the investor can obtain the greatest utility from what is available.
C) An investor who wishes to form a portfolio that lies to the right of the optimal risky
portfolio on the Capital Allocation Line must borrow some money at the risk-free rate
and invest in the optimal risky portfolio and will invest only in risky securities. The only
way that an investor can create portfolios to the right of the Capital Allocation Line is to
create a borrowing portfolio (buy stocks on margin). In this case, the investor will not
hold any of the risk-free security, but will hold only risky securities.
D) The efficient frontier of risky assets is the portion of the investment opportunity set that
lies above the global minimum variance portfolio. Portfolios on the efficient frontier are
those providing the greatest expected return for a given amount of risk. Only those
portfolios above the global minimum variance portfolio meet this criterion.

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