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Mean Variance
Mean Variance
2
Assets and portfolios
Asset ≡ anything we can purchase
Random price P(t)
P(t+1)
Random gross return R(t) = P(t)
P(t+1)−P(t)
Random net return: r(t) = R(t) − 1 = P(t)
3
How does one deal with randomness?
Pd
Random net return on the portfolio rx = i=1 ri xi
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Random returns on assets and portfolios
Parameters defining asset returns
Mean of asset returns: µi = E[ri (t)]
Variance of asset returns: σi2 = var(ri (t))
Covariance of asset returns: σij = cov ri (t), rj (t) = ρij σi σj
Correlation of asset returns ρij = cor ri (t), rj (t)
All parameters assumed to be constant over time.
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Example
d = 2 assets with Normally distributed returns N (µ, σ 2 )
r1 ∼ N (1, 0.1) r2 ∼ N (2, 0.5) cor(r1 , r2 ) = −0.25
Parameters
µ1 = 1 µ2 = 2
σ12 = var(r1 ) = 0.1 σ22 = var(r2 ) = 0.5
√
σ12 = cov(r1 , r2 ) = cor(r1 , r2 )σ1 σ2 = −0.25 0.05 = 0.0559
Portfolio: (x, 1 − x)
d
X
µx = µi xi = x + 2(1 − x)
i=1
d
X d
X X
σx2 = σij xi xj = σi2 xi2 + 2 σij xi xj
i,j=1 i=1 j>i
Efficient frontier
120
Efficient frontier ≡ max return
100 for a given risk
80
40
−40
−60
0 20 40 60 80 100 120 140 160 180
volatility (%)
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Mean variance formulations
Minimize risk ensuring return ≥ target return
Pd Pd
minx σx2 ≡ minx j=1 σij xi xj
Pi=1
d
s.t. µx ≥ r s.t. µi xi ≥ r
Pi=1
d
i=1 xi = 1.
Pd P
d Pd
maxx µx − τ σx2 ≡ maxx i=1 µi xi − τ i=1 j=1 σij xi xj
Pd
s.t. i=1 xi = 1.
τ ≡ risk-aversion parameter
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Financial Engineering and Risk Management
Efficient frontier
Portfolio: (x, 1 − x)
d
X
µx = µi xi = µ1 x + µ2 (1 − x)
i=1
d
X d
X X
σx2 = σij xi xj = σi2 xi2 + 2 σij xi xj
i,j=1 i=1 j>i
2
Mean-variance for 2-asset market
Minimize risk formulation for the mean-variance portfolio selection problem
r−µ2
Expected return constraint: x = µ1 −µ2
Variance:
r − µ 2 µ − r 2 r − µ µ − r
2 1 2 1
σr2 = σ12 + σ22 + 2ρσ1 σ2
µ1 − µ2 µ1 − µ2 µ1 − µ2 µ1 − µ2
= ar 2 + br + c
3
Efficient frontier
12
10
Efficient
6
Inefficient
return (%)
4
rmin
−2
−4
−6
0 2 4 6 8 10 12 14
σmin volatility (%)
Only the top half is efficient! why did we get the bottom?
∂L
Setting ∂xi = 0 for i = 1, . . . , d gives d equations
d
X
2 σij xj − vµi − u = 0, for all i = 1, . . . d (∗)
j=1
Theorem. A portfolio x is mean-variance optimal if, and only if, it is feasible and
there exists u and v satisfying (∗).
5
Computing the optimal portfolio
Matrix formulation
2σ11 2σ12 ... 2σ1d −µ1 −1 x1 0
2σ21
2σ22 ... 2σ2d −µ2 −1 x2 0
.. .. .. .. .. .. .. ..
.
. . . . .
. = .
2σd1
2σd2 ... 2σdd −µd −1
xd 0
µ1 µ2 ... µd 0 0 v r
1 1 ... 1 0 0 u 1
| {z } |{z}
A b
Therefore
x1
x2
..
.
= A−1 b
xd
v
u
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Two fund theorem
Fix two different target returns: r1 6= r2
Suppose
(1) (1)
x (1) = (x1 , . . . , xd )> optimal for r1 : Lagrange multipliers (v1 , u1 )
(2) (2)
x (2) = (x1 , . . . , xd )> optimal for r2 : Lagrange multipliers (v2 , u2 )
y is a portfolio
d d d
(1) (2)
X X X
yi = (1 − β) xi +β xi = (1 − β) + β = 1
i=1 i=1 i=1
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Two fund theorem (contd)
Set v = (1 − β)v1 + βv2 and u = (1 − β)u1 + βu2 .
d d
(1) (2)
X X
2 σij yj − vµi − u = 2σij ((1 − β)xj + βxj )
j=1 j=1
− µi ((1 − β)v1 + βv2 ) − ((1 − β)u1 + βu2 )
X d
(1)
= (1 − β) 2 σij xj − v1 µi − u1
j=1
Xd
(2)
+β 2 σij xj − v2 µi − u2 = 0
j=1
Therefore
d X
X d
2
σ (r) = σij (rgi + hi )(rgj + hj )
i=1 j=1
d X
X d d X
X d d X
X d
= r2 σij gi gj + 2r σij gi hj + σij hi hj
i=1 j=1 i=1 j=1 i=1 j=1
The d-asset frontier has the same structure as the 2-asset frontier.
9
Efficient frontier
12
10
Efficient
6
Inefficient
return (%)
4
rmin
−2
−4
−6
0 2 4 6 8 10 12 14
σmin volatility (%)
10
Financial Engineering and Risk Management
Mean-variance with a risk-free asset
2
Mean-variance optimal portfolio
Taking derivatives we get
d
X
µ̂i − 2τ σij xj = 0, i = 1, . . . , d.
j=1
Matrix formulation
σ11 σ12 ...σ1d x1
µ̂
σ21 σ22 ...σ2d x2 .1
1 −1
2τ . .. .. = .. ⇒ x(τ ) = V µ̂
.. ..
.. . . . . 2τ
µ̂d
σd1 σd2 . . . σdd xd | {z }
µ̂
| {z }
V
3
One-fund theorem
The positions in the risky assets in the frontier portfolio
1 −1
x= V µ̂
2τ
do not add up to 1.
4
Efficient frontier with risk-free asset
Pd qP
d
Return and risk of portfolio s∗ : µ∗s = ∗
σs∗ = σij2 si∗ sj∗
P
i=1 µi si , i=1 j=1
Efficient Frontier
10
Straight line with an intercept rf
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at σ = 0 and slope
8
µs − rf
7 m=
σs
6
return (%)
5
(σs∗ , µ∗s ) ≡ s∗
How does this relate to the fron-
4 tier with only risky assets?
3
volatility (%)
5
Efficient frontier with risk-free asset
9
2 θ
rf
1
0 1 2 3 4 5 6 7 8 9
volatility (%)
6
Sharpe Ratio
Definition. The Sharpe ratio of a portfolio or an asset is the ratio of the
expected excess return to the volatility. The Sharpe optimal portfolio is a
portfolio that maximizes the Sharpe ratio.
Investors diversify between the risk-free asset and the Sharpe optimal portfolio.
The investment in the various risky assets are in fixed proportions ...
prices/returns should be correlated! This insight leads to the Capital Asset
Pricing Model.
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Financial Engineering and Risk Management
Capital Asset Pricing Model
Let µm denote the expected net rate of return on the market portfolio, and let
σm denote the volatility of the market portfolio.
Suppose all investors in the market are mean-variance optimizers. Then all of
them invest in the Sharpe optimal portfolio s∗ . Let
Then
(k)
X
Ci = w (k) (1 − x0 )si∗
k
Recall: Efficient frontier = line though the points (0, rf ) and (σm , µm )
1000 µ − r
m f
roil = − 1 = 14% r̄ = rf + σ = 45%
875 σm
Not worth considering!
3
Inferring asset returns from market returns
An asset is a portfolio: asset j ≡ x (j) = (0, . . . , 1, . . . , 0)> , 1 in the j-th position.
Diversify between x (j) and market portfolio x (m) : γx (j) + (1 − γ)x (m)
return µγ = γµj + (1 − γ)µm
q
volatility σγ = γ 2 σj2 + (1 − γ)2 σm
2 + 2σ γ(1 − γ)
jm
6
return (%)
(σm , µm ) ≡ x(m)
5
4
All three curves are tangent at (σm , rm )
Slope of the capital market line
µm − rf
mCML =
σm
This pricing formula is called the Capital Asset Pricing Model (CAPM).
5
Connecting CAPM to regression
Regress the excess return rj − rf of asset j on the excess market return rm − rf
(rj − rf ) = α + β(rm − rf ) + j
Parameter estimates
cov(rj −rf ,rm −rf ) σ
coefficient βj = var(r m −rf )
= σjm
2
m
intercept αj = (E[rj ] − rf ) − β(E[rm ] − rf ) = (µj − rf ) − β(µm − rf ).
residuals j and (rm − rf ) are uncorrelated, i.e. cor(j , rm − rf ) = 0.
CAPM implies that αj = 0 for all assets.
Effective relation: rj − rf = βj (rm − rf ) + j
Decomposition of risk
var(rj − rf ) = βj2 var(rm − rf ) + var()
σj2 = βj2 σm
2
+ var()
| {z } | {z }
market risk residual risk
Only compensated for taking on market risk and not residual risk
6
Security Market Line
Plot of the historical returns on an asset vs rf + β(µm − rf )
Security market line
4
2
2
0
6
return (%)
−2
−4
−6
3
5 7
−8
−2 −1.5 −1 −0.5 0 0.5
beta
The assets are labeled in the order they appears in the spreadsheet.
All assets should lie on the security line if CAPM holds. So why the discrepancy?
7
Assumptions underlying CAPM
All investors have identical information about the uncertain returns.
All investors are mean-variance optimizers (or the returns are Normal)
The markets are in equilibrium.
α = (µ̂j − rf ) − βj (µ̂m − rf )
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CAPM as a pricing formula
Suppose the payoff from an investment in 1yr is X . What is the fair price for this
investment.
X
Let rX = P − 1 denote the net rate of return on X . The beta of X is given by
cov(rX , rm ) 1 cov(X , rm )
βX = 2
= 2
σm P σm
Suppose CAPM holds. Then µX = E[rX ] must lie on the security market line, i.e.
µX = rf + βX (rm − rf )
E[X ] 1 cov(X , rm )
−1 = rf + (µm − rf )
P P var(rm )
Rearranging terms:
E[X ] cov(X , rm )
P= − (µm − rf )
1 + rf (1 + rf )var(rm )