1

CHAPTER EIGHT
PORTFOLIO ANALYSIS
2
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
3
THE EFFICIENT SET THEOREM
THE FEASIBLE SET
DEFINITION: represents all portfolios that
could be formed from a group of N securities
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THE EFFICIENT SET THEOREM
THE FEASIBLE SET
r
P

o
P

0
5
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
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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
7
THE EFFICIENT SET THEOREM
THE OPTIMAL PORTFOLIO

E
r
P

o
P

0
8
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% o = 20%
Gold Jewelry Company
E(r) = 15% o = 40%
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CONCAVITY OF THE EFFICIENT
SET

o
P
r
P
A
G
r
A
= 5
o
A
=20
r
G
=15
o
G
=40
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CONCAVITY OF THE EFFICIENT
SET
ALL POSSIBLE COMBINATIONS RELIE
ON THE WEIGHTS (X
1
, X
2
)
X
2
= 1 - X
1
Consider 7 weighting combinations

using the formula



2 2 1 1
1
r X r X r X r
N
i
i i P
+ = =

=
11
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
12
CONCAVITY OF THE EFFICIENT
SET
USING THE FORMULA



we can derive the following:



2 / 1
1 1
(

= =
N
i
N
j
ij j i P
X X o o
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CONCAVITY OF THE EFFICIENT
SET
r
P
o
P=+1
o
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 o 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

A
G
upper
bound
lower bound
r
P
o
P
0
17
CONCAVITY OF THE EFFICIENT
SET
ACTUAL LOCATIONS OF THE
PORTFOLIO
What if correlation coefficient (
ij
) is zero?

18
CONCAVITY OF THE EFFICIENT
SET
RESULTS:
o
B
= 17.94%
o
B
= 18.81%


o
B
= 22.36%


o
B
= 27.60%


o
B
= 33.37%

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CONCAVITY OF THE EFFICIENT
SET
ACTUAL PORTFOLIO LOCATIONS
B
C
D
E
F
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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

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CONCAVITY OF THE EFFICIENT
SET
KEY POINT
As long as -1 < < +1 , the portfolio line
curves to the left and the northwest portion is
concave
i.e. the efficient set is concave
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THE MARKET MODEL
A RELATIONSHIP MAY EXIST
BETWEEN A STOCKS RETURN AN
THE MARKET INDEX RETURN


where o
iI
= intercept term
r
i
= return on security
r
I
= return on market index I
|
iI
= slope term
c
iI
= random error term

iI I i iI i
r r c | o + + =
1
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THE MARKET MODEL
THE RANDOM ERROR TERMS c
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
c
i, I
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THE MARKET MODEL
c
i, I
CAN BE CONSIDERED A RANDOM
VARIABLE

DISTRIBUTION:
MEAN = 0
VARIANCE = o
ci
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DIVERSIFICATION
PORTFOLIO RISK
TOTAL SECURITY RISK: o
2
i
has two parts:





where = the market variance of index
returns

= the unique variance of security i
returns



2 2 2 2
i i iI i c
o o | o + =
2 2
o |
iI
2
i c
o
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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

=
(

=
N
i
i P
N
1
2
2
2
1
c c
o o
(

+ + +
=
N N
N
2 2
2
2
1
... 1
c c c
o o o