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Lecture

Lecture 2
2
Portfolio
Portfolio Theory
Theory

I. Very Simple World

Two assets:
One risky asset (e.g., S&P 500 Index)
One risk-free (T-Bill) asset
How much of your wealth will you allocate to
each asset?

Step
Step 3
3
Identifying
Identifying
Investment
Investment Opportunity
Opportunity Set
Set

Portfolio Return and Risk

Proportion of wealth:
in risky asset = y;
in risk-free asset = (1-y)
Portfolio (C) return: rC = W1 r1 + W2 r2
= y rp + (1 y) rf
= rf + y (rp rf)
Portfolio (C) Variance: C2 = W1212 + W22 22 + 2W1W2Cov(r1,r2)
= y2 p2
Standard Deviation:
Substituting:

C = y p y = (C / p)

rC = rf + (C / p) (rp rf)

Investment opportunity set is a straight line, called the capital

allocation line (CAL)
Infinite combinations are possible. Which one is optimal?

Numerical Problem
(old exam)

Risk-free asset is expected to yield 7%.

Expected return & risk of the risky portfolio is 15% & 22%.
Describe and plot the investment options available to the investor.
Go to Return&Risk.xls; Tab to Corr and Portfolio Risk.
Plug in: E(rp) = r1= 15%; E(rf) = r2= 7%;

1 = 22%;

2 = 0%;

Corr = 0.

(a) w1=0, w2=1

(b) w1=0.1, w2=0.9
(c) w1=0.2, w2=0.8 and so on.
Note portfolio return and standard deviation in each case.
Plot it CAL_OneRisky.xls

Portfolio C: Let us invest y% of the wealth in the risky portfolio

and (1-y%) in the riskfree asset.
rC = 7% + y (15% - 7%) ; C = y (22%)

Graphically:
E(r)

CAL
P

E(rp) = 15%
) S = 8/22

rf = 7%

E(rp) - rf = 8%

F
0

p = 22%

Dominant Portfolio
Would you rather hold portfolios of F and P,
or F and Q?

E(r)
P

F
0

Step
Step 4
4
Optimal
Optimal Asset
Asset Allocation
Allocation
(Involves
(Involves some
some calculus!)
calculus!)

Optimal Asset Allocation

Combining investor risk tolerance with investment
options in the mean-variance framework

(In English)
Objective: Choose y that will maximize Investor Utility
Subject to: Available investment opportunity (CAL)

(Not English)
Objective: Choose y that will max.

U = E(rC) - .005 A C2
C2 = y2 p2

Subject to:

Solving:

y* = (E(rp) rf) / (0.01 A p2)

Example:
Numerical Problem
(old exam)

Risk-free asset: rf = 7% ,
Risky asset: rp = 15% , p = 22% , Weight = y
Let us assume the standard utility function
If A = 4: y* = (15 7) / (0.01*4*222) = 0.41
Invest \$0.41 in Risky Asset and lend \$0.59 at Risk-free rate
E (rC*) = 10.28% C* = 9.02% U*=8.65
If A = 2 (Aggressive): y* = (157) / (0.01*2*222) = 0.83
E (rC*) = 13.61% C* = 18.18% U*=10.30
If A = 8 (Conservative): y* = (157) / (0.01*8*222) = 0.21
E (rC*) = 8.65%
C* = 4.55%
U*=7.82

Example: Summary
Investor
Type

Allocatio
n in
risky
asset
(y*)

Allocatio
n in riskfree
asset

Optimal Optimal
portfoli portfolio
o return risk (C)
(E(rC))

Optimal
investor
utility
(U*)

Conservati
ve (A=8)

21%

79%

8.65%

4.55%

7.82

Moderate
(A=4)

41%

59%

10.28%

9.02%

8.65

Aggressive
(A=2)

83%

17%

13.61%

18.18%

10.30

Example: Using Leverage

When A = 1: y* = (15 7) / (0.01*1*222) = 1.65
E (rC) = 20.22% C = 36.3%
What is the investment strategy when y* > 1 ?

Borrow at the risk-free rate and invest in stock.

For each \$1 of your wealth:

Borrow \$0.65 at the risk-free rate

Invest \$1.65 in the risky asset

Note that leverage increases investment risk!

CAL with
Higher Borrowing Rate
E(r)
Lending rate = 7%, Borrowing rate = 9%

P
) S = .27
9%
7%

) S = .36

p = 22%

CAL with
Risk Preferences
E(r)

The lender has a larger A when

compared to the borrower

P
Borrower
7%
Lender

p = 22%

(old exam)

An investor who can tolerate more risk (low value of A)

will optimally invest a larger proportion of her portfolio in
risky assets (higher y*).
How to measure risk tolerance?
What about life-cycle effect?

An increase in risky assets volatility (e.g., higher next

month) will lower allocation in the risky asset

An increase in risk premium (E(rp)-rf) will increase

allocation in the risky asset

This simple derivation motivates the importance of the risk

premium in the asset allocation decision.

II. More Complex World

Two risky assets:
Stocks (e.g., S&P500 Index)
Bonds (e.g., Barclays Aggregate Bond Index)

No risk-free asset
How much of your wealth will you allocate to
each asset?

Bonds Produced Greater Income

Percentage of total return 19702014

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An
investment cannot be made directly in an index.

Adding a Bond Allocation to Diversify

19702014

Past performance is no guarantee of future results. Risk is measured by standard deviation. Risk and return are based on annual data
over the period 19702014. Portfolios presented are based on modern portfolio theory. This is for illustrative purposes only and not
indicative of any investment. An investment cannot be made directly in an index.

Step
Step 3
3
Identifying
Identifying
Investment
Investment Opportunity
Opportunity Set
Set
(More
(More Calculus!)
Calculus!)

Complex World:
TWO RISKY ASSETS
RISKY ASSETS (1 and 2):
Expected Return = E(r1) and E(r2)

Risky asset proportion in portfolio = w1 and w2

Portfolio Return: rp = W1 r1 + W2 r2
Variance: p2 = W1212 + W22 22 + 2W1W2Cov(r1,r2)
p2 = W1212 + W22 22 + 2W1W21212
Objective: Identify the set of investment options
See CAL_TwoRisky.xls : IOS-TwoRisky

Asset Correlations
and Portfolio Parameters
Portfolio return
Correlation (doesnt depend
coefficient on correlation)
=1
(straight
line)

W1 r1 + W2 r2

Portfolio variance
& standard deviation
(depend on correlation)
Var = W1212 + W22 22 + 2W1W212
Std. Dev. = (W11 + W2 2 )

-1<<1
(BLOB)

W1 r1 + W2 r2

=-1

W1 r1 + W2 r2

Var = W1212 + W22 22 + 2W1W212

12
Std. Dev. = (W1212 + W22 22)(1/2)
Var = W1212 + W22 22 - 2W1W212
Std. Dev.= |(W11 - W2 2 )|

Stocks and Bonds: Risk Versus Return

19702014

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and arithmetic mean,
respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an

Implication:
Correlation and Portfolio Parameters
(old exam)

If

= +1.0, no risk reduction is possible.

Portfolio standard deviation is simply the weighted
average of individual asset standard deviation

As the correlation declines, we observe greater

potential for portfolio risk reduction.
Portfolio standard deviation is LESS THAN the
weighted average of individual asset standard
deviation

Numerical Problem
(old exam)

The expected return and risk of Asset 1 and Asset 2 are

summarized below.
E(r)
(r)
Risky Asset 1
5%
15%
Risky Asset 2
7%
20%
Let the correlation between the two assets be -1. Calculate
the portfolio weights such that Portfolio P, composed of
the two assets, is risk free.

0.57 ; w2 = 0.43

Step
Step 4
4
Optimal
Optimal Asset
Asset Allocation
Allocation
Suppose
Suppose you
you can
can invest
invest only
only in
in risky
risky assets
assets A
A and
and
B
B that
that are
are imperfectly
imperfectly correlated.
correlated. Your
set of
of
investment
investment options
options is
is the
the BLOB
BLOB (curve).
(curve).
How
How would
would you
you choose
choose where
where to
to be
be on
on the
the BLOB?
BLOB?

(Calculus
(Calculus is
is messy.
messy.
Let
Let us
us solve
solve graphically.)
graphically.)

Asset Allocation
(In English)
Objective: Choose w1 and w2 such that
Maximize Investor Utility
subject to: available investment opportunity (Blob)
(Not English)
Objective: Choose w1 and w2 such that
Maximize: U = E (rp) - .005 A p2
Subject to:
rp = W1 r1 + W2 r2
p2 = W1212 + W22 22 + 2W1W2Cov(r1,r2)
w 1 + w2 = 1
Solving: (Graphically
see CAL_TwoRisky.xls: Optimal-TwoRisky A=4)

U U U

E(r)

S
P
Q

More
risk-averse
investor

Less
risk-averse
investor

St. Dev

III. Lets Bump Up

the Complexity a Notch
Two risky assets:
Stocks (e.g., S&P500 Index)
Bonds (e.g., Barclays Aggregate Bond Index)

Plus one risk-free asset (T-bill)

How much of your wealth will you allocate to
each asset?

Step
Step 3
3
Identifying
Identifying
Investment
Investment Opportunity
Opportunity Set
Set
(Tangency
(Tangency Portfolio!)
Portfolio!)

Investment Opportunity Set:

Blob + CAL

M
P

P
A

CAL (A)

CAL (P)

E(r)

CAL (Global
minimum variance)

A
G

F
P

P&F M

A&F

How to Find
Tangency Portfolio P?
(In English)
Objective: Choose w1 and w2 such that
Maximize: Reward-to-Variability Ratio
Subject to: available investment option (Blob+CAL)
(Not English)
Objective: Choose w1 and w2 such that
Maximize: Sp = (E(rp) - rf) / p
Subject to: rp = w1 r1 + w2 r2
p2 = w1212 + w22 22 + 2w1w2Cov(r1,r2)
w1 + w 2 = 1
Solving: Graphically
see CAL_TwoRisky.xls: CAL-TwoRisky+Riskfree

Numerical Problem
(old exam)

The risk-free rate is 5%

Assume that all five portfolios below lie on the
efficient frontier of N-risky assets
Portfolio A
Portfolio B
Portfolio C
Portfolio D
Portfolio E

Exp.
Return (%)
17.0
12.2
9.8
8.4
14.2

S.D. (%)
32.0
20.6
10.3
9.11
26.4

If one among them is the tangency portfolio, which

one?

Step
Step 4
4
Optimal
Optimal Asset
Asset Allocation
Allocation
Portfolio
Portfolio PP dominates
dominates all
all others
others because
because it
it has
has
the
the highest
highest reward-to-risk
reward-to-risk ratio
ratio
Investment
Investment opportunity
opportunity set:
set: The
The CAL
CAL from
from the
the
risk-free
risk-free asset
asset to
to tangency
tangency portfolio
portfolio P
P
How
How would
would you
you decide
decide where
where to
to be
be on
on the
the CAL?
CAL?

Optimal Allocation
Similar to 1 risky asset & 1 risk-free asset scenario
(In English)
Objective: Choose y (proportion in Portfolio P) such that
Maximize Investor Utility
subject to: New CAL (P)
(Not English)
Objective: Choose y such that
Maximize: U = E (rC) - .005
subject to: E (rC) = rf + y (E(rp) rf)

A C 2

C2 = y2 p2

Solution:

See CAL_TwoRisky.xls: Optimal-TwoRisky+Riskfree

Efficient Frontier
with Lending & Borrowing
CAL

E(r)

B
Q
P
A

rf

F
St. Dev

Multiple Risky Assets Stocks, Bonds, etc.

Plus one risk-free asset (T-bill)
How much of your wealth will you allocate
to each asset?

Step
Step 3
3
Identifying
Identifying
Investment
Investment Opportunity
Opportunity Set
Set
(Tangency
(Tangency Portfolio,
Portfolio, again)
again)

Investment Opportunity
Set of Risky Assets: Entire BLOB
E(r)

Efficient
frontier
Global
minimum
variance
portfolio

Individual
assets
Minimum
variance
frontier
Std.
Dev.

Efficient Frontier
Set of efficient investment options available to
an investor
Minimum variance frontier: For a given portfolio return,
the lowest possible variance that can be attained

Global minimum-variance portfolio: The lowest variance

that can be attained
Efficient frontier: For a given variance, the highest
expected return in the minimum variance frontier

Bonds Expand Efficient Opportunities

17%
16%

Stock portfolios
Stock and bond portfolios

Small
company
stocks

15%

Return

14%
13%
Large
company
stocks

12%
11%
10%
9%
8%
5%

Bonds
7%

9%

11%

13%

15%

17%

19%

21%

23%

25%

Risk

Risk is measured by standard deviation.

Risk and return are based on annual data over the period 19702014.
Portfolios presented are based on modern portfolio theory.

International Markets
Expand Efficient Opportunities Even More...
International Securities:

Return Risk

Return r
Domestic & foreign securities

ri

Domestic securities only

rd

Risk

International Assets
Enhance Domestic Portfolios
17%
Domestic portfolios
Global portfolios

16%

Japanese
stocks
U.K. stocks

15%

Return

Pacific
stocks

European
stocks

14%
13%

U.S. stocks

12%

11%
10%

U.S. bonds

9%
5%

10%

15%

20%

Risk

25%

30%

35%

Risk is measured by standard deviation.

Risk and return are based on 19702014 data. Data in U.S. dollars.

40%

Efficient Frontier + Risk-Free:

Find Tangency Portfolio P

M
P

P
A

CAL (A)

CAL (P)

E(r)

CAL (Global
minimum variance)

A
G

F
P

P&F M

A&F

Step
Step 4
4
Optimal
Optimal Asset
Asset Allocation
Allocation
(Involves
(Involves some
some calculus!)
calculus!)

Efficient Frontier with

Lending & Borrowing
CAL

E(r)
B
Q
P
A
rf

F
St. Dev

Two Fund Separation

Property
Consider three investors with different risk profiles:
conservative, moderate, and aggressive
All investors, regardless of their degree of risk
aversion, will invest only in the same risky portfolio
P

Investors will select the desired point along CAL based on

their degree of risk aversion

Harry Markowitz won the 1990 Nobel Prize for

Economics for his contributions to portfolio
management

Example using Historical Data

See: CAL_TwoRiskly.xls: IOS-TwoRisky
Stock: E(R) = 13%, SD(R) = 20%
Bond: E(R) = 8%, SD(R) = 12%
Corr=0.3
Risk-free: E(R) = 5%

Tangency portfolio P : 50% stocks and 50% bonds

E(Rp) = 10.5%, SD(Rp) = 13.1%

Representative investor: A = 4
Optimal allocation (y*) in Portfolio P = 74%
Example: Initial Investment = \$100,000
Invest \$26,000 in T-Bills and \$74,000 in Portfolio P
Within Portfolio P: Invest \$37,000 in bonds & \$37,000 in stocks

Asset Allocation:
Constrained Optimization Problem
First STEP: Forecasts/estimates for the investment horizon
Expected return (r)
Standard deviation ()
Cross correlation () or Covariance
We call this the INPUT LIST (subjective)
Based on the INPUT LIST:
Form portfolios using all possible combinations
Plot Expected Return - Standard deviation of all
combinations
Find the efficient frontier of portfolios
Using the Risk-free asset, find tangency risky portfolio P
Portfolio P represents the asset allocation within risky assets
Risk tolerance determines the final allocation between risky
and risk-free asset (capital allocation decision)

Asset Allocation:
Assignment 1 (due Week 5)
REAL Challenge: Forecast of risk, return and
correlation
Assignment 1:
Let us simply rely on historical parameters

S&P500, Russell2000, LT Bond, MSCI EAFE, T-bill

Estimates based on historical data

Plot the efficient frontier of portfolios

Find tangency portfolio P
Calculate optimal allocations for two investors.

Asset Allocation in Practice

Numerical Problem
(old exam)

Consider a portfolio that offers an expected return of

12% and a standard deviation of 18%.
T-bills offer a risk-free 7% rate of return.
Describe the entire range of A for which the risky
portfolio is still preferred to bills.
You may assume the common form of utility
function: U = E(R) (0.005*A*2), and risk averse
investors.