CHAPTER EIGHT

PORTFOLIO ANALYSIS

1
 THE EFFICIENT SET THEOREM

• THE THEOREM
– An investor will choose his optimal portfolio
from the set of portfolios that offer
• maximum expected returns for varying levels of
risk, and
• minimum risk for varying levels of returns

2
 THE EFFICIENT SET THEOREM

• THE FEASIBLE SET

– DEFINITION: represents all portfolios that
could be formed from a group of N securities

3
 THE EFFICIENT SET THEOREM

THE FEASIBLE SET

rP

P
0
4
 THE EFFICIENT SET THEOREM

• EFFICIENT SET THEOREM APPLIED TO

THE FEASIBLE SET
– Apply the efficient set theorem to the feasible set
• the set of portfolios that meet first conditions of efficient set
theorem must be identified
• consider 2nd condition set offering minimum risk for varying
levels of expected return lies on the “western” boundary
• remember both conditions: “northwest” set meets the
requirements

5
 THE EFFICIENT SET THEOREM

• THE EFFICIENT SET

– where the investor plots indifference curves and
chooses the one that is furthest “northwest”
– the point of tangency at point E

6
 THE EFFICIENT SET THEOREM
THE OPTIMAL PORTFOLIO

rP

P
0

7
 CONCAVITY OF THE EFFICIENT
SET
• WHY IS THE EFFICIENT SET
CONCAVE?
– BOUNDS ON THE LOCATION OF
PORFOLIOS
– EXAMPLE:
• Consider two securities
– Ark Shipping Company
» E(r) = 5%  = 20%
– Gold Jewelry Company
» E(r) = 15%  = 40%

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 CONCAVITY OF THE EFFICIENT
SET

rP
rG=15 G

rA = 5
A
P
A=20 G=40

9
 CONCAVITY OF THE EFFICIENT
SET
• ALL POSSIBLE COMBINATIONS RELIE
ON THE WEIGHTS (X1 , X 2)
X2= 1 - X1
Consider 7 weighting combinations

using the formula

N
rP  X
i 1
i ri  X 1 r1  X 2 r2

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 CONCAVITY OF THE EFFICIENT
SET
Portfolio return
A 5
B 6.7
C 8.3
D 10
E 11.7
F 13.3
G 15
11
 CONCAVITY OF THE EFFICIENT
SET
• USING THE FORMULA
1/ 2
N N 
P   X i X j ij 
 i 1 j 1 

we can derive the following:

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 CONCAVITY OF THE EFFICIENT
SET
rP P=+1 P=-1
A 5 20 20
B 6.7 10 23.33
C 8.3 0 26.67
D 10 10 30.00
E 11.7 20 33.33
F 13.3 30 36.67
G 15 40 40.00

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 CONCAVITY OF THE EFFICIENT
SET
• UPPER BOUNDS
– lie on a straight line connecting A and G
• i.e. all  must lie on or to the left of the straight line
• which implies that diversification generally leads to
risk reduction

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 CONCAVITY OF THE EFFICIENT
SET
• LOWER BOUNDS
– all lie on two line segments
• one connecting A to the vertical axis
• the other connecting the vertical axis to point G
– any portfolio of A and G cannot plot to the left
of the two line segments
– which implies that any portfolio lies within the
boundary of the triangle

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CONCAVITY OF THE EFFICIENT
SET

rP
G

lower bound
upper
bound
 P


16
 CONCAVITY OF THE EFFICIENT
SET
• ACTUAL LOCATIONS OF THE
PORTFOLIO
– What if correlation coefficient (ij ) is zero?

17
CONCAVITY OF THE EFFICIENT
SET
RESULTS:
B = 17.94%
B = 18.81%
B = 22.36%
B = 27.60%
B = 33.37%
18
 CONCAVITY OF THE EFFICIENT
SET
ACTUAL PORTFOLIO LOCATIONS

D F

C


19
 CONCAVITY OF THE EFFICIENT
SET
• IMPLICATION:
– If ij < 0 line curves more to left
– If ij = 0 line curves to left
– If ij > 0 line curves less to left

20
 CONCAVITY OF THE EFFICIENT
SET
• KEY POINT
– As long as -1 < the portfolio line
curves to the left and the northwest portion is
concave
– i.e. the efficient set is concave

21
 THE MARKET MODEL

• A RELATIONSHIP MAY EXIST BETWEEN

A STOCK’S RETURN AN THE MARKET
INDEX RETURN

ri   iI   i1rI   iI
where intercept term
ri = return on security
rI = return on market index I
slope term
 random error term
22
 THE MARKET MODEL

• THE RANDOM ERROR TERMS i, I

– shows that the market model cannot explain
perfectly
– the difference between what the actual return
value is and
– what the model expects it to be is attributable to
i, I

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 THE MARKET MODEL

 i, I CAN BE CONSIDERED A RANDOM

VARIABLE
– DISTRIBUTION:
• MEAN = 0

• VARIANCE = i

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 DIVERSIFICATION
• PORTFOLIO RISK
TOTAL SECURITY RISK: i
• has two parts:

    
i
2 2
iI i
2 2
i

where = the
2 market variance of index returns
 iI 2

= the unique variance of security i


returns i
2

25
 DIVERSIFICATION

• TOTAL PORTFOLIO RISK

– also has two parts: market and unique
• Market Risk
– diversification leads to an averaging of market risk
• Unique Risk
– as a portfolio becomes more diversified, the smaller will
be its unique risk

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 DIVERSIFICATION
• Unique Risk
– mathematically can be expressed as

2
N
 1 
 2
P     2
i
i 1  N 

1   21   22  ...   2N 

  
N  N 

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