Minimum Variance Portfolio Weight

Weight BOND 
 2
s   s B  S , B 
 2
S   B2  2 s B  S , B 
Portfolio Variance with Weights and Standard Deviations

 P2  wS2 S2  wB2 B2  2 wS wB S B  S , B

Optimal Portfolio (Weight in Bonds)

 E r   r      E r   r     
B f
2
S S f S B S,B

 E r   r      E r   r      E r   r  E r   r    
B f
2
S S f
2
B B f S f S B S,B

Covariance and Correlation Coefficient

Covariance (rS , rB ) = σS σB ρS,B

Or

ρS,B = Covariance (rS , rB ) / (σS σB )

Correlation Coefficient = ρS,B

Portfolio Problem

Use the following two portfolios to answer parts one to four.

Portfolio Expected Return Standard Deviation

Bond Portfolio 6% 10%
Stock 13% 30%

If the correlation coefficient () is -0.40 for these two risky assets, what is the minimum
variance portfolio you can construct? (Hint: What percent of your wealth is invested in
each portfolio?)

Weight BOND 
 0.30 
  .30  .10   0.4 
2

0.102
 0.8226
 .30 2 2

  0.10   2   .30  0.10   0.4 0.124

Weight in the stock is 1 minus weight in the bond or 1 – 0.8226 = 0.1774

82.26% in Bond, and 17.74% in Stock

What is the expected return on the MVP (minimum variance portfolio) in part one using
your allocation of wealth to bonds and stocks?

E(rMVP) = (0.8226) x (0.06) + (0.1774) x (0.13) = 0.0724 or 7.24%

What is the standard deviation of the minimum variance portfolio?

σ2 = (.1774)2 (0.30)2 + (0.8226)2 (0.10)2 + 2 (.8226) (.1774) (0.30) (0.10) (-0.4)

σ2 = 0.002833 + 0.006766 - 0.003593 = 0.006097

  0.006097  0.078082  7.8082%

Hint, must be less than 10% the standard deviation of the bond portfolio.

What is the optimal portfolio of these two assets if the risk-free rate is 3% (i.e., how do
you allocate of your wealth in stocks and bonds)?
Wb 
 0.06 - 0.03 0.30 2   0.13  0.03 0.30 0.10  0.4 
 0.06 - 0.03 0.30 2   0.13  0.03 0.10 2   0.06  0.03  0.13  0.03 0.30 0.10  0.4
0.0027  0.0012 0.0039
Wb    0.7414  74.14%
0.0027  0.001  0.00156 0.00526

And the weight in the stocks is 1 – 0.7414 or 0.2586 or 25.86%

The expected return on the optimal portfolio is:

E(rOPT) = (0.7414) x (0.06) + (0.2586) x (0.13) = 0.0781 or 7.81%

And the standard deviation of the optimal portfolio is:

σ2 = (.2586)2 (0.30)2 + (0.7414)2 (0.10)2 + 2 (.2586) (.7414) (0.30) (0.10) (-0.4)

σ2 = 0.006017 + 0.005497 - 0.004601 = 0.006913

  0.006913  0.083145  8.3145%