Financial Markets and Investments

Module Modern Portfolio Theory

Session No. III

Version 1.0
 Financial Markets and Investments

Material from the published or unpublished work of others which is referred to in the Class
Notes is credited to the author in question in the text. The Class Notes prepared is of 935
words in length. Research ethics issues have been considered and handled appropriately
within the Globsyn Business School guidelines and procedures.

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III

 Financial Markets and Investments

Table of Contents

1. Introduction ............................................................................................................... 4

2. Computation of Minimum Variance Portfolio.......................................................... 4

3. Computation of Minimum Variance Portfolio Mean and Risk................................ 6

4. Proportion of Optimal Risky Portfolio in Share and Bond .................................... 6

4.1. Graphical Presentation of Optimal Risky Portfolio ............................................................ 7

5. Importance of Tangential Line Intersecting the Point of Optimal Portfolio.......... 7

6. Difference Between Markowitz Theory and Capital Market Line ........................... 8

References ..................................................................................................................... 9

List of Figures and Tables

Table 2.1: Covariance Matrix ..................................................................................................... 4
Figure 2.1:Calculation of minimum variance............................................................................... 4
Figure 2.2:Expected Return and SD at different proportions ...................................................... 5
Figure 4.1:Calculation of weight of share related to optimal portfolio .......................................... 6
Figure 4.2:Optimal Portfolio and Tangential Line at Tangential Point ......................................... 7

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 Financial Markets and Investments

1. Introduction
According to the Markowitz theory of Modern Portfolio Techniques, an efficient frontier is a
certain set, comprised of risky portfolios which are determined through a complex formula
known as quadratic programming. One such portfolio among other portfolios holds the optimal
position in the efficient frontier. It is so because when a certain utility curve, developed by
Markowitz, moves tangentially with this particular point over the efficient frontier the portfolio to
such point is considered as the most efficient risky portfolio providing the best results in
comparison to other portfolios available in the efficient frontier. (Analyst Notes, 2020).

2. Computation of Minimum Variance Portfolio

For any specific value of expected portfolio return, Markowitz determined the least risk portfolio
using quadratic programming. When another value of the expected return is considered the
same rule can be applied to determine the least risk portfolio. The repetition of the process can
be made for different values of expected return (Divakar, 2019). For example, suppose there is
a certain covariance matrix of shares and bonds. It is shown below.

Table 2.1: Covariance Matrix

Bonds 225 45
Shares 45 900

(Divakar, 2019)

Now, we have to compute a minimum variance portfolio from these data. The following formula
is required to determine the minimum variance of shares and bonds.

Figure 2.1: Calculation of Minimum Variance

(fientist, 2019)

Where, WMin (S) is the minimum variance of shares

σ2в= Variance of Bonds

σ2S= Variance of shares

Cov (rS,rB) = Covariance between bonds and shares

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III

 Financial Markets and Investments

σ2 в −Cov(rs ,rв)
Therefore, WMin (S) = 2
σ в + σ2 s −2Cov(rs ,rв)

225−45
=
900+225−(2 ×45)

= 0.1739

WMin (B) = 1 – 0.1739

= 0.8261

Additional data are expected return of bond E(rв) = 12%

Expected return on share = 20%

Standard deviation of share (σs) = 30% and bond (σв) = 15%

The minimum variance portfolio mean and standard deviation are

E(rmin) = (0.1739 × 20) + (0.8261 × 12) = 13.39%

σMin= [ w2sσ2s + w2Bσ2B + 2wswB Cov (rs,rB)]1/2

= [(0.17392 × 900) + (0.82612 × 225) + (2 × 0.1739 × 0.8261 × 45]1/2

= 13.92%

The following data represents various weights of the share fund and bond fund and their
respective expected return and standard deviation.

Figure 1.2: Expected Return and SD at different proportions

(fientist, 2019)

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III

 Financial Markets and Investments

From the above formula of expected return and standard deviation, all the expected returns and
risks of the portfolios have been determined considering the proportion(weight) of shares and
bonds in the portfolio.
Findings:
It is observed that when the proportion in share fund and bond fund is 17.39: 82.6, the least
standard deviation is generated i.e. 13.92%. Therefore, according to the modern portfolio theory
it is considered as the minimum variance portfolio.

3. Computation of Minimum Variance Portfolio Mean and Risk

It is already computed in heading 2. The minimum variance portfolio mean is 13.39% and risk is
13.92%.

4. Proportion of Optimal Risky Portfolio in Share and Bond

After calculating the minimum variance portfolio, we are now proceeding to determine the
portion of the optimal risky portfolio into share fund and bond fund.(Azizah, 2017). The following
formula is applicable in determining this process:
Figure 4.1: Calculation of weight of Share related to Optimal Portfolio

(Azizah, 2017)
Where,
Ws= Proportion of optimal portfolio invested in share

rf = risk free return

E(rs), E(rB), σ2в, σ2S are already stated in the earlier section. Therefore, applying this formula we
can determine the weight of share.

[(20−8) ×225]−[(12−8) ×45]

Ws=
[(20−8) ×225]−[(12−8) ×900]−[(20−8+12−8) ×45]

= 0.4516

WB = 1 – 0.4516

= 0.5484

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4.1. Graphical Presentation of Optimal Risky Portfolio

The graphical presentation of Optimal Portfolio is laid down below. This graph is based on the
data of expected return of the portfolio as well as its risk. These are approximately 15.6% and
16.5%.

Figure 2.2: Optimal Portfolio and Tangential Line at Tangential Point

(Analyst Notes, 2020)

E(rmin) = (0.4516 × 20) + (0.5484 × 12) = 15.61%

σMin= [ w2sσ2s + w2Bσ2B + 2wswB Cov (rs,rB)]1/2

= [(0.45162 × 900) + (0.54842 × 225) + (2 × 0.4516 × 0.5484 × 45]1/2

= 16.54%

5. Importance of Tangential Line Intersecting the Point of Optimal

Portfolio
The tangential line is called Capital Market Line comprised of risky shares and risk-free shares.
Since there is no risk in the risk-free shares so the line starts from the Y- axis. It is assumed that
the rate of borrowing and lending is equal to the rate of riskless assets. Based on this

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III

 Financial Markets and Investments

assumption when an investment is made partly in the optimum risky portfolio and partly in the
riskless assets the concave efficient frontier is transformed into a straight line. Whatever
proportion be invested in the risk-free asset and risky asset the result of risk and expected
return of the bulk of these portfolios (summation of return on risky assets and risk-free assets)
would be lower than the expected return and risk of the risky optimal portfolio (Analyst Notes,
2020). However, when all the sets of portfolios are joined a straight line is formed which is
shown in the graph given in Figure 2.2.

6. Difference Between Markowitz Theory and Capital Market Line

In the case of Modern Portfolio Theory, developed by Markowitz, there is no existence of risk-
free assets. This theory speaks only about the risky assets and accordingly an efficient frontier
is prepared. On the other hand, risk-free assets and risky assets are two components under the
capital asset pricing model. The various combinations of these two components form a straight
line that tangentially moves towards the optimal point of the efficient frontier curve comprised of
various risky assets. The straight-line moves beyond the optimal point and forms levered
portfolios (Analyst Notes, 2020). In this connection, it is required to state that when a portfolio is
formed on the basis of borrowed money (where payment of interest to deducted from gross
return) levered portfolio is created. However, the shape of the efficient frontier is concave. An
optimal portfolio falls at a particular point of this frontier.

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III

 Financial Markets and Investments

References
Analyst Notes, 2020. Optimal Portfolio. [Online]
Available at: https://analystnotes.com/cfa-study-notes-discuss-the-selection-of-an-optimal-
portfolio-given-an-investors-utility-or-risk-aversion-and-the-capital-allocation-line.html
[Accessed 29 01 2020].

Azizah, E., 2017. Optimization of investment portfolio weight of. [Online]

Available at: https://iopscience.iop.org/article/10.1088/1757-899X/166/1/012008/pdf
[Accessed 29 01 2020].

Divakar, V., 2019. Calculating The Covariance Matrix And Portfolio Variance. [Online]
Available at: https://blog.quantinsti.com/calculating-covariance-matrix-portfolio-variance/
[Accessed 29 01 2020].

fientist, M., 2019. Minimum Variance Portfolio. [Online]

Available at: https://www.madfientist.com/unique-risk-minimum-variance-portfolio/
[Accessed 29 01 2020].

FM&I/M5S3/v1.0/050220 Modern Portfolio Theory | Session No. III