# 4.

Portfolio theory

• Portfolio risk and return

• Efficient frontier and optimal portfolio

• Portfolio construction & planning

Portfolio Return

A portfolio p, consisting of n securities, with the each security i having a weight wi in the portfolio, an expected return of E(ri), and risk σi2 - Expected portfolio return, E(rp) = Σ wi E(ri) - Portfolio risk σp depends upon wi, σi, as well as correlation ρij between all the securities.

Portfolio Return and Risk
Expected Return E(Rp) 2 Assets w1r1 + w2r2 Variance (σ2)
w12σ12 + w22σ22 + 2w1w2ρ12σ1σ2 (w12σ12 + w22σ22 + w32σ32) + (2w1w2ρ12σ1σ2 + 2w2w3ρ23σ2σ3 + 2w1w3ρ13σ1σ3)
𝑛 2𝑉𝑎𝑟(𝑟𝑖) 𝑤 𝑖=0 𝑖
3 Assets
w1r1 + w2r2 + w3r3
n Assets
𝑛
𝑤𝑖𝑟𝑖
𝑖=0
+
ΣΣ w w Cov(ri.rj) i≠j i j
.

6 x 10% = 12% • σp2 = [(0.07x.6x0.68%
.3x. Covariance(R1.05 = .0025 60%
ρ1.07x.6x0.2 σ1σ2 = 0.0049 40% 10% 5% 0.0025)] + [2x0.6x0.0049) + (0.3x.0022 σp = 4.3.4x.00105
• rp = 0.05] = 0.4 x 15% + 0.4x0.4x0.R2) = ρ1.2 = 0.Two assets portfolio example
Asset 1 Asset 2 Returns Std Dev Variance Weights 15% 7% 0.

02016 σp = 14. ρDE 8% 12% 0. E(r) Standard deviation.6.4 & wE = 0.30 Equity Mutual Fund 13% 20%
If wD = 0. σ Correlation coeff..2%
.Two assets portfolio example
Debt Mutual Fund Expected return.0% σp2 = wD2σD2 + wE2σE2 + 2wDwEρDEσDσE = 0. E(rp) = wDE(rE) + wEE(rE) = 11.

2% 13.2 0.9 1
wE
1 0.7% 10.5% 12.5% 14.5 0.8% 2.6% 12.3)
20.0% 18.8 0.5% 11.6% 12.3% 10.4% 13.2 0.5)
20.4% 17.1 0.2% 4.9% 12.8% 12.5% 8.Two assets example – Varying weights & correlations
wD
0 0.6% 10.0% 9.0% 16.0% 0.2% 14.0% 19.0% 12.6% 10.7 0.0%
σp (ρ = 0)
20.9% 15.6% 16.4% 14.1 0
E(Rp)
13.0% 8.0%
σp (ρ = -0.6 0.0% 12.3 0.0%
σp (ρ = -1)
20.0% 16.0% 11.0%
.8% 16.9% 11.5% 11.8% 12.3 0.8 0.1% 12.6% 8.0% 10.6 0.0% 15.4% 10.7% 7.4% 16.5% 12.0% 18.5% 10.0%
σp (ρ = 0.7 0.3% 11.6% 7.5% 9.4% 11.2% 18.0% 17.4 0.0%
σp (ρ = 1)
20.5% 8.8% 10.5 0.0% 12.8% 13.5% 8.2% 14.4% 7.4 0.7% 11.9 0.4% 5.

the return-risk frontier is a straight line. • If two assets have perfectly negative correlation. if correlation is less than 1.Two-assets example – Risk & return
• For perfectly correlated assets. there are benefits of diversification. & same returns are available at lower risk. portfolios below the minimum risk point are sub-optimal as each is dominated by a portfolio above that provides higher return for same risk • For assets with correlation below 1. • However. • For a given frontier. as risk is less than the weighted average. there can theoretically be a portfolio having zero risk. the frontier curves to the left.
.

jσiσj = Σwi2.jσiσj • The above equation has n variance and n(n-1)/2 covariance terms. the variance component (diversifiable risks) becomes very small compared to the covariance component (systematic risks). diversifiable risks. while the covariance terms represent systematic risks. where Cov(Ri.σi2 + ΣΣwiwjρi. • The variance terms represent the unique. σp2 = ΣwiwjCov(Ri.
.Rj) = ρi. • As n increases.Rj).Extending to N assets portfolio
• For a portfolio with n assets.

and average correlation of ρ between any pair of 2 assets In this case. portfolio variance can be shown to be σp2 = (1/n) σ 2 + [(n-1)/n] ρσ2
• When n=1. regardless of n • When ρ = 0. σp2 = σ 2 . σp2 = (1/n) σ 2 tending towards 0 as n increases Thus. • As n becomes very high.n-assets portfolio example
Consider a portfolio of ‘n’ assets having average risk of σ . σp2 tends towards ρσ2 • When ρ = 1. σp2 = σ 2 . portfolio variance declines – the greater the n – the smaller the ρ
.

risk declines sharply as n increases initially. the higher the average correlation. that in the 2nd case (more realistic).
. declines slowly thereafter and then becomes stable. as n increases
Note.4. The component of risk that declines is diversifiable risk.Risk-reduction with portfolio size
The example below shows a portfolio of assets with average σ = 50% for ρ = 0 & 0. and the component that does not decline is systematic risk. The higher the systematic risk.

of Securities
.Risk reduction with portfolio size
Portfolio Risk
Diversifiable risk Systematic risk
1 6 11 16 21 26
No.

Selection of Optimal Portfolio
.

• The above steps are based on separation property. Determine the optimal risky portfolio
• Step 2: Determine the optimal portfolio for the investor
– Allocate the investor’s funds to optimal risky portfolio and a risk free asset based on risk aversion of the investor.Using Markowitz Portfolio Selection Model
• Step 1: Determine the optimal risky portfolio
– i. which implies that the portfolio choice problem may be separated into two tasks. Determine the efficient frontier of risky assets – ii.
– the first. and – the second. which is purely technical and same for all investors. which is based on personal preference of the investor.
.

1.
. consisting of portfolios offering the best return-risk trade-off.i Efficient Frontier of Risky Assets
Efficient Frontier of Risky Assets
E(Rp)
Global Minimum Variance Portfolio
Standard deviation of portfolio
Minimum Variance Frontier
The Markowitz portfolio selection model involves determining the efficient frontier of risky assets.

ii.1. The Capital Market Line connects the risk free rate to the point of tangency with the efficient frontier of risky assets. The point of tangency is the optimal risky portfolio.
. it becomes the market portfolio and the most optimal capital allocation line is known as the Capital Market Line. Optimal Risky Portfolio
Efficient Portfolio
With borrowing
Optimal Risky Portfolio CAL Optimal
E(Rp)
Rf
Capital Allocation Lines
Standard deviation of portfolio
If the risky assets portfolio includes all the available assets in the market.

. unique to the investor. which is the slope of the CML.
Standard deviation of portfolio
The optimal investor portfolio lies at the point of tangency between the efficient frontier and a utility indifference curve. the better is its risk-adjusted performance. The Sharpe ratio measures the excess return available for every unit of portfolio risk. σM)
(E(rp) – rf)/σp = [E (rm) – rf]/σm
E(Rp)
Optimal Investor Portfolio
Capital Market Line
Rf
The left-hand side ratio is the Sharpe ratio. Optimal Investor Portfolio based on Risk Aversion
Indifference Curves for an Investor
Equation of Capital Market Line (CML):
E (rp) = rf+[E (rM) – rf]/σm x σp
Hence
(E(rM ). Only for the portfolios lying on the CML. the Sharpe ratio is equal to the right-hand side. The greater a portfolio’s Sharpe ratio.2.

rf] • σp = wmσM • Hence wm = σp / σM • Substituting for wm in the first equation. which is the equation of the capital market line
. • E (rp) = rf + [E (rM) – rf]/ σM x σp. and (1-wm) to risk free asset • E (rp) = (1-wm)rf + wmE(rM) = rf + wm [E(rM) .Optimal Investor Portfolio
• If an investor allocates weight wm to the market portfolio.

Disadvantages of the Markowitz Model & Procedure of Portfolio Selection
• It requires a large number of estimates to construct the efficient frontier of risky assets:
– n variance and n(n-1)/2 covariance terms for n assets
• There is no guideline for determination of expected returns of securities to construct the efficient frontier • These disadvantages led to development of simpler and practical alternatives. such as the use of an index model
.

• It expresses the returns of each security as a function of the return on the broad market index:
– Ri = αi + βiRM + ei …….[this implies the decomposition of total risk into systematic risk & firm-specific risk]
• It needs 3n+2 estimates.Single Index Model
• The single-index model uses the returns and risks of a market index as a proxy for the market portfolio. [where. thus simplifying the calculations required for the Markowitz procedure • These estimations can be prepared by regressing each Ri against RM using historical data.
. (RM. Ri=(ri-rf) & RM=(rM-rf)] – σi 2= βi σM2 + σ2(ei) …. (αi . σM) for the market index. βi & σ(ei)) for n assets.

Portfolio Construction & Planning
.

Portfolio Construction & Planning
Key steps 1. Deciding investment objectives & constraints 2. Portfolio evaluation* *Will be discussed after the session on CAPM
. Portfolio execution 6. Portfolio revision 7. Selection of securities 5. Deciding portfolio strategy 4. Choice of asset mix 3.

Income Objectives & Constraints
• Objectives
– Return requirements: High/moderate. income vs capital growth – Risk tolerance: ability to take risk. willingness to take risk
• Constraints & Preferences
– – – – – Liquidity Investment horizon Taxes Regulations Unique circumstances
.

higher risk tolerance.Choosing Asset Mix
Ex. Stocks vs Bonds More allocation to stocks: Higher return requirement. lower risk tolerance. shorter investment horizon
. longer investment horizon More allocation to bonds: Moderate return requirement.

unless it becomes inconsistent with investment objectives & constraints
. small cap vs large cap)
• Passive strategy
– Define a well-diversified portfolio based on investment objectives & constraints – Hold the portfolio relatively unchanged. growth vs value.Portfolio Strategy
• Active strategy
– – – – Market timing Sector rotation (shifting sector weights) Security selection Portfolio styles (ex.

. BKMM Ch 7 • Home Work
– – – – For your stock and one more stock (any) Take 60 month returns Assume a 2 asset portfolio Calculate portfolio returns and standard deviation varying the weights. Explain its shape. Compare with returns and standard deviation with the individual stocks.Reading
• PC Ch 7. – Plot the 2 asset portfolio return-risk graph.