Lecture 4: Portfolio

Diversification and Supporting

Financial Institutions
Economics 252, Spring 2011
Prof. Robert Shiller, Yale University
A Portfolio of a Risky and
Riskless Asset

r = xr1 + (1 − x )rf
x 2 var(return1 )
A Portfolio of Two Risky Assets
• Put x1 dollars in risky asset 1 and (1- x1)
dollars in risky asset 2 .
• Portfolio expected value r=x1r1+(1-x1)r2
• Portfolio variance =
x12 var(return1 ) + (1 − x1 ) 2 var(return2 ) + 2 x1 (1 − x1 ) cov(return1 , return2 )
 Efficient Portfolio Frontier with
Two Assets
• Frontier expresses portfolio standard
deviation in terms of portfolio expected
return r rather than in terms of x1.
• r − r2
x1 =
r1 − r2
r − r2 2 r1 − r 2
σ 2
= ( )σ 2
1 +( )σ 2
2
r1 − r2 r1 − r2
(r − r2 )(r1 − r )
+ 2 σ 12
(r1 − r2 ) 2
 Portfolio Variance, Three Risky
Assets
• Portfolio variance =
2
x12 var(return1 ) + x2 var(return2 ) + x32 var(return3 )
+ 2 x1 x2 cov(return1 , return2 ) + 2 x1 x3 cov(return1 , return3 )
+ 2 x2 x3 cov(return2 , return3 )
3
( where∑ xi = 1)
i= 1
 Sharpe Ratio for a Portfolio
R ( portfolio ) − R f
SharpeRatio =
σ ( portfolio )
• The Sharpe Ratio is
constant along the
tangency line
• A portfolio manager is
outperforming only if
her portfolio has a
greater Sharpe ratio
 Beta
• The CAPM implies that the expected return
on the ith asset is determined from its beta.
• Beta (βi) is the regression slope coefficient
when the return on the ith asset is regressed
on the return on the market.
• Fundamental equation of the CAPM:
ri = rf + β i (rm − r f )