The Mean Variance Portfolio Theory1

Honours Notes 2017

Lecturer: Tendai Gwatidzo, PhD.

Introduction
In this topic we seek to explore the risk and return provided by portfolios.

Ultimately we want to be able to establish portfolios that different clients with different
risk profiles would be comfortable with. Basically, we want to explain how point Z in
Figure 1 is reached.

Figure 1: Optimal Portfolio Choice

U4
U3
U2
E( Rp ) U1

rf
Minimum variance opportunity set
0  p

We start by looking at two important moments: mean and standard deviation.

Portfolio return: Expected Value and Variance

Let the return on asset 1 be R1 and that on asset 2 be R2.
If we start with a portfolio made up of two assets then the portfolio return is:

Rp = w1R1+w2R2, where wi’s are the portfolio weights and w1+w2 = 1. (For a portfolio
n
with more than two assets we get: R p   wi Ri ).
i 1

The portfolio expected return is:

E ( Rp )  w2 E ( R1 )  w2 E ( R2 ) ………………………………………………………….[1]

1
Please beware of mistakes!!!!!!!

1
 n
More generally we get E ( R p )   wi E ( Ri ) …………………………………….……..[2]
i 1
Let :

 12  Var ( R1 ) ,  22  Var ( R2 ) ,  12  Cov( R1 , R2 ) , Var (R p )  and 12  12
2

p  1 2
The variance of a portfolio return is:

Var ( R p )  Var (w1 R1  w2 R2 ) (for a portfolio made up of 2 assets)

Var ( R p )  w12Var ( R1 )  w22Var ( R2 )  2w1w2Cov( R1 , R2 )

[Recall Var( aX  bY )  a 2 var( X )  b 2 var(Y )  2abCov( X ,Y ) ]

  w12 12  w22 22  2w1 w2 12 …………………………………………………..…….[3]

2
p

 p  w12 12  w22 22  2w1 w2 12 2

1
The standard deviation is:

n n
More generally,  p   wi w j ij
2

i 1 i 1

If we separate the variance and covariance terms we get;

n n n

 p   wi2 i2   w w 
2
i j ij (for the case of n-assets)……………….………...…….[4]
i 1 i 1 i 1, j i

Example
Consider a portfolio composed of assets X and Y with the following attributes:
Return on X Return on Y Probability (pi)
11 -3 0.2
9 15 0.2
25 2 0.2
7 20 0.2
-2 6 0.2

Assume the portfolio is split equally between the two assets (i.e., wi=0.5).
Calculate portfolio return and portfolio variance:

2
 N
 x2  var( X )   pi [ X i  E ( X )]2  0.0076
i 1
N
 y2   pi [Yi  E (Yi )]2 0.00708
i 1

Cov( X , Y )  E[( X  E ( X ))(Y  E (Y ))]   xy  0.0024

N
E ( X )   pi X i  0.1
i 1
N
E (Y )   piYi  0.08
i 1

E ( R p )  w1E ( R1 )  w2 E ( R2 )  0.5(0.1)  0.5(0.08)  0.09  9%

  w12 12  w22 22  2w1 w2 12  0.00247

2
p

 p  4.97%

Correlation Coefficient 12 

 12
12    12  12 1 2
 1 2
 1  12  1
 12  0.0024
From the above example 12    0.33
 1 2 (0.0872)(0.0841)

The Portfolio Opportunity Set (for a two-asset portfolio)

A portfolio opportunity set (POS) is a set of all feasible portfolios with different
combinations of X and Y.

Let X be asset 1 and Y be asset 2

Let Var(X) =  12 , Var(Y) =  22 , Cov(X, Y) =  12
Let the correlation coefficient between X and Y be = 12

Thus portfolio variance is:  p  w12 12  w22 22  2w1 w2 12

2

To get a portfolio opportunity set we need to look at three main cases:

1. The case where ρ12 = +1

2. The case where ρ12 = - 1

3. The case where ρ12 = 0

3
Case 1: The case where ρ12 = +1

E( Rp )  w1E( R1 )  w2 E ( R2 )  w1E ( R1 )  (1  w1 ) E ( R2 ) , where w1+w2 = 1

  w12 12  w22 22  2w1 w2 12

2
p

Recall:
 12
12    12  12 1 2
 1 2

So:
  w1212  w22 22  2w1 w212
2
p

 w12 12  w22 22  2w1 w2 12 1 2

 w12 12  w22 22  2w1 w2 1 2 , since 12  1
 w1 1  w2 2 
2

 p  w1 1  w2 2 ………..……………………………………………………….….[5]

 p  w1 1  (1  w1 ) 2
Thus,  p 2 ………………………………………………………..…[5]
 w1 
1   2

The expected portfolio return equation can be expressed as a function of the portfolio
variance. After doing that you can differentiate the E(Rp) with respect to the portfolio
variance and show that in the case of positive perfect correlation the portfolio opportunity
set is a straight line.

Re call E ( R p )  w1E ( R1 )  w2 E ( R2 )  w1E ( R1 )  (1  w1 ) E ( R2 )

Plugging w1 into the portfolio return yields :
 p 2   2 
E(R p )  E ( R1 )  1  p  E ( R2 )...................................................................[5' ' ]
1   2  1   2 

dE ( R p )
dE ( R p ) dw E ( R1 )  E ( R2 )
slope     cons tan t …………..….......….......…………[6]
d p d p 1   2
dw
Example:
dE ( R p )
Use the following information to calculate
d p
E(R1)=20%
E(R2)=16

4
Variance of asset 1=75%
Variance of asset 2=50%
Correlation coefficient = 100%
dE ( R p )
dE ( R p ) E ( R1 )  E ( R2 ) 0.2  0.16
 dw    0.16  16%
d p d p 1   2 0.75  0.5
dw
How do you interpret the slope?

Thus the portfolio opportunity set when ρ12 = +1 is linear. There are no benefits to
diversification since as you change the weights there is a constant relationship between
risk and return, i.e., it is not possible to sacrifice risk without sacrificing some return. XY
line below is a straight line whose points are established by changing the weights wi. At
point X the portfolio is made up of only asset 1 (that is w1 = 1 and w2 = 0). As one
changes the portfolio composition by moving from X to Y, w1 gradually goes down as w2
gradually goes up. Eventually point Y is reached and the whole portfolio is composed of
asset 2 (w1 = 0 and w2 = 1).

Figure 2: The Portfolio Opportunity Set (when ρ12 =1)

E( Rp )

Y(6;14)

X (3;8)

0  p

The straight line of the portfolio opportunity set when ρ12 = +1 can be calculated as
follows.

Recall:
E ( Rp )  w1E ( R1 )  (1  w1 ) E ( R2 ) ……………………………………………………….[7]

To make things more tractable we shall let E ( Rp )  rp , E ( R1 )  r1 and E ( R2 )  r2 . Thus

the portfolio return can now be expressed as follows:

rp  w1r1  (1  w1 )r2 ………………………………………………………………….…..[8]

From equation (5) we know that:

5
 p  w11  w2 2  w11  (1  w1 ) 2 ………………………………………………...[9]

To calculate the portfolio opportunity set we solve for w1 in equation [9] to get:

 p 2
w1  ………………………………………………………………………...…[10]
1   2

Substituting w1 into [8] yields:

 p   2     p   2   r r  r r
rp    1 1  
r   r2  r2   2  1 2   1 2  p ………...……[11]
 1  2     1   2   1  2  1  2

Which is a straight line taking the form:

rp  a  b p ………………………………………………………………………….[12]

 r r  r r
Where: a  r2   2  1 2  and b  1 2
 1  2  1  2

Example:
Expected return Standard deviation
Asset 1 14 6
Asset 2 8 3

Calculate the portfolio opportunity set.

To calculate the portfolio opportunity set substitute the respective values into equation
(11) and get:

 r r   14  8 
a  r2   2  1 2   8   3  2
 1   2   63 
r r 14  8
b 1 2  2
1  2 6  3

Thus the equation of the opportunity set is:

rp  2  2 p

6
Case 2: The case where ρ12 = -1

Going back to our two main equations:

 p2  w12 12  w22 22  2w1 w2 12 1 2 and rp  w1r1  (1  w1 )r2

If ρ12 = -1 the portfolio variance becomes:

 p2  w12 12  w22 22  2w1 w21 2 ……………………………………………………..[13]
rp  w1r1  (1  w1 )r2 …………………………………………………………………..[14]

Equation (13) is a quadratic equation so we can factorize it to get:

 p2  w1  1  w2 2 
2


Thus  p   w1  1  w2 2 
We have to establish two equations for the opportunity set: One equation when
 p  w1  1  w2 2  and rp  w1r1  (1  w1 )r2 (let us call this case, Scenario A) and the
 
other when  p   w1  1  w2 2 and rp  w1r1  (1  w1 )r2 (let us call this case, Scenario
B).

Scenario A
 
 p  w1  1  w2 2  w1 1  ( 1  w1 ) 2 ……………………………………….……[15]
and rp  w1r1  (1  w1 )r2 ……………………………………………………………..…[16]
We can now use [15] and [16] to derive a relationship between rp and  p as follows:
From [15] you can solve for wi to get:
 2
w1  p
1   2

Substituting w1 into [16] yields:

 2      2   r r   r r 
rp  p r1  1   p  r2  r2   2  1 2    1 2  p ……………….[17]
1   2    1   2   1   2   1   2 

This can be expressed as follows:

 r r  r r
rp  a  b p , where a  r2   2  1 2  and b  1 2
 1   2  1   2

7
Example:
Expected return Standard deviation
Asset 1 14 6
Asset 2 8 3

Using data from the above table we get:

 r r  14  8
a  r2   2  1 2   8  3  10
 1   2  63

r1  r2 14  8 6 2
b   
1   2 6  3 9 3

2
Thus: rp  a  b p  10   p
3

Scenario B
 p  w1  1  w2 2  and rp  w1r1  (1  w1 )r2

We shall use the two equations to get the portfolio opportunity set.
Try this case and show that the equation of the opportunity set is:

 r r   r r 
rp  r2   2  1 2    1 2  p …………………………………………….….[18]
 1   2   1   2 

 r r  r r
rp  a  b p , where a  r2   2  1 2  and b   1 2
 1   2  1   2

Using the figures from the above example we calculate the portfolio opportunity set as
follows:

 r r  14  8
a  r2   2  1 2   8  3  10
 1   2  63

r1  r2 14  8 6 2
b   
1   2 63 9 3

2
Thus: rp  a  b p  10   p
3

8
 2
Thus if 12  1 the POS would have two segments: rp  a  b p  10   p
3
The POS in this particular case is as shown in the following figure.

The Portfolio Opportunity Set when 12  1

E( Rp )
Y

10 2
rp  a  b p  10  p
3

X
(3;8)

0  p

Case 3: The case where 12  0

Going back to our two main equations:

 p2  w12 12  w22 22  2w1 w2 12 1 2 and rp  w1r1  (1  w1 )r2

But now 12  0 , therefore  p2  w12 12  w22 22

 p  w12 12  w22 22 2 ………………………………………………………………...[19]

1

rp  w1r1  (1  w1 )r2 ……………………………………………………………….….[20]

Equation [19] and [20] can be used to calculate the relationship between portfolio
expected return and the portfolio variance. The opportunity set is no longer a straight line
but a hyperbola; which you can get by making w1 (from equation 19) the subject and then
plugging it into (20). You get rp  f ( p2 ) .

We can however find the minimum risk portfolio for the case where 12  0 . To do that
we differentiate equation [19] with respect to w1 and equate the derivative to zero.

d p
  .2w  
1
1 2 2 
 w1  1  (1  w12 ) 22 2 2
1 1  2(1  w1 ) 22  0 …………………………...[21]
dw1 2

 22  12
w  2 *
and w2  2
*

 1   22  1   22
1

9
w1* and w2* are the portfolio weights that generate the minimum variance portfolio,
when 12  0 .

 12 6 2
 w1*   
1   2 9 3
2 2

 12 3 1
w2*   
1   2 9 3
2 2

With such weights we can also calculate the  p2 and rp .

 p  w12 12  w22 22 2 , recall 12  0

1

 p  w12 12  w22 22 2   .36  .9  

1
4 1 
17  4.123
9 9 

So the opportunity set when 12  0 has three crucial points:

Point 1: where w1=1 and w2=0,
Point 2: where w1=0 and w2=1 and,
Point 3: the minimum variance point.

The other points of the POS can be derived by changing the weights giving us a curve
depicted by XBY in the following figure.

If 0 < 12 < 1 then we have the POS lying between XBY and XY. One such example
being XAY.

If -1 < 12 < 0 then we have the POS lying between XBY and XZY. One such example
being XCY.

10
 The Portfolio Opportunity Set for different 1 2
values
E( Rp )
Y
12  1 (6;14)

(0;10) Z 12  0
C
B
A

12  1
X
(3;8)

0  p

Portfolio Opportunity Set: The Case of One Risky Asset and One Risk-free Asset
Let asset 1 be the risky asset and the other asset be the risk-free asset. Let the return from
the risk-free asset be rf . Note that the mean and variance of the risk-free asset have a
subscript f.

Now our expected portfolio return is:

 
rp  w1r1  (1  w1 )rf  w1r1  rf  w1rf  rf  w1 (r1  rf ) ……..…………………………[21]

 p2  w12 12  w2f  2f  2w1 w f 1 f 1 f

But for the risk-free asset variance is zero (σf = 0), so:

 p2  w12 12

 
1
Which implies that  p  w12 12 2  w1 1 ………………………………...……………[22]

As before we can use equations [21] and [22] to derive the equation for the POS. To do
that we make w1 in [22] the subject and substitute it into [21] as follows;
 p  w12 12 2  w1 1
1

p
 w1 
1
Substituting w1 into 21 yields:

p
rp  rf  w1 (r1  rf )  rf  r  r ………………………………..……………...… [23]
1 1 f

11
The resultant POS is a straight as shown in equation [23]. It has an intercept equal to the
r  r 
risk free rate (rf) and a slope equal to 1 f . See the following figure for the
1
diagrammatic representation.

The POS when there is a riskless security

p
E( Rp )

rp  rf  r1  rf  POS Equation

1

Slope of POS =
r  r 
1 f

1

rf

0  p

Finding Minimum Variance Portfolio (two-asset portfolio case)

If we have two assets (X and Y) then a MVP is the combination of X and Y that provides
the portfolio with minimum variance. Investors who are extremely risk averse will select
the MVP if no risk-free investment is available. In this section we focus on the two-asset
portfolio case, the case of portfolios with many assets shall be looked at in later sections.

R p  w1 Rx  1 w1 Ry

 xy
 p  w12 x2  (1  w1 ) 2  y2  2w1 (1  w1 ) xy , but  xy    xy   xy x y
2

 x y

  w12 x2  (1  w1 ) 2  y2  2w1 (1  w1 )  xy x y

2
p

We minimize the portfolio variance by setting the first derivative with respect to w1 equal
to zero:

12
d
2

 2w1  x2  2 y2  2w1 y2  2  xy x y  4w1  xy x y  0

p

dw1

Solving for w1 yields:

 y2   xy x y
w1 *  2
 x   y2  2  xy x y

Example : The returns for two assets are as given below.

Use the information in the following table to calculate the minimum variance portfolio?

Asset X (%) Asset Y (%) Probability

11 -3 0.2
9 15 0.2
25 2 0.2
7 20 0.2
-2 6 0.2

Expected value of X is 10%

Expected value of Y is 8%

Var(X) = 0.0076
Var (Y)=0.00708
Cov(X,Y) = -0.0024

0.00708  (0.33)(0.0872)(0.0841)
w1*   0.487
0.0076  0.00708  2(0.33)(0.0872)(0.0841)

Thus 48.7% of the investor’s wealth should be invested in asset X and the remainder
(51.3%) in Y.

The portfolio return and variance for the MVP are:

E( R p )  w1 E( R1 )  w2 E( R2 )  0.487(0.10)  0.513(0.08)  8.974%

  w12 12  (1  w1 ) 22  2w1 (1  w1 ) 2  12
2
p

 (0.487) 2 (0.0076)  (0.513) 2 (0.00708)  2(0.487)(0.513)(0.33)(0.0872)(0.0841)

 0.0018025  0.0018632  0.0012092
 0.0024565
 p  4.956%

13
The point [ p , E ( Rp )]  (4.956, 8.974%) in the mean-variance plane is just one point of
the minimum variance opportunity set. We can get several points of the opportunity set
by looking for combinations of risk and return offered by portfolios of risky assets that
yield minimum variance for a given rate of return.

Mean-Variance Frontier (MVF) for N-Risky Assets

Derivation

Up to now we have learnt how to compute the mean-variance frontier in the following
cases:
a) Portfolios made up of two risky assets
b) Portfolios made up of two assets (one is risky and the other is risk-free)

How do we compute the mean variance frontier when dealing with a portfolio with more
than two assets (i.e., the N-assets portfolio case, with N>2)?

There are two important cases to be looked at:

a) Portfolios made up of many risky assets (no risk-free asset)
b) Portfolios made up of many risky assets (with a risk-free)

Case 1: MVF - Many risky assets (no risk-free asset)

The formal optimization problem that should be solved to get the MVF is: for a given
value of expected portfolio return, choose portfolio weights (wi’s) to minimize portfolio
risk. That is, minimize the variance of a portfolio given a value for the portfolio mean.

That is:
n
min var (Rp) s.t. E (Rp) = μ and  wi  1 ……………………………..…………..…[24]
i 1
Carry out a separate minimization for each given value of E(Rp), so that as E(Rp) changes
the frontier is traced out.

The portfolio return Rp is a combination of N individual asset returns, so:

n n
R p   wi Ri and w i  1 ………………………………………………………….[25]
i 1 i 1

The w’s are portfolio weights; they express what fraction of your wealth goes into each
asset. Thus, they sum to 1. Thus, you choose portfolio weights to do the minimization.
It is much easier to do all this with matrix notation. Let:

 w1   R1  1
 .   R2  1
W= . ; R = .  ; 1= . 
     
 .  .  . 
w  R  1
 N  N  

14
The above column vectors can be transposed to get W, R and 1 as follows:

W = w1 w2 ........... wN ; R = R1 R2 ........... RN ;

1 = 1 1 1...........1 1

The return for an N-assets portfolio is:

N
R p   wi Ri = w1R1  w2 R2  ....................  wn RN
i 1

In vector form the return is:

N  R1 
R p   wi Ri = w1 w2 ........... wN   R2  = WR ………………………………….[26]
i 1 . 
. 
R 
 N

The condition that the weights add up to 1 is:

w
i 1
i  w1  w2  w3  ...............  wN  1 …………………………….……………….[27]

In vector form this becomes:

 w1 
 . 
1 = 1 1 1...........1 1   = 1 W …………………………………………….[28]
 . 
 . 
w 
 N

We can now get the mean of the N-asset portfolio as follows:

N
R p   wi Ri = w1R1  w2 R2  ....................  wn RN ………….……………………[29]
i 1

Recall:
N
R p   wi Ri = WR
i 1
n
E ( R p )   wi E ( Ri ) = w1E( R1 )  w2 E( R2 )  ......................  wN E( RN )
i 1

15
  E ( R1 ) 
= w1 w2 ........... wN  

. 
 = W E(R) = W E……….[30]
 . 
 . 
 E ( R )
 N 
The last equality just simplifies notation. The vector of mean returns shows up so much
that I will call it E instead of carrying E(R) around.

The variance of the portfolio return is:


2
p
  
 E ( Rp  E ( Rp ))2 = EW R  W E  = E (W ( R  E ))2
2

= EW ( R  E )( R  E)W  = WE( R  E)( R  E)W  W W

Where:

  E( R  E )( R  E) and is the variance-covariance matrix of returns.

Please note that w’s are numbers and R’s are random so the numbers can come out of the
expectation sign E.

Now, let’s restate our problem with this notation. Minimizing the variance is the same as
minimizing 1/2 the variance, so we want to choose weights to:

1
min W W s.t. WE   ; W 1  1
W 2

This is a constrained optimization problem. The Lagrangian function can be formed as

follows:

1
L  W W   (W E   )   (W 1  1)
2

The first order conditions from the Lagrangian are:

L
 W  E   1  0 …………………………………………………………….FOC1
W

L
 W E    0 …………………………………………………………………FOC2


L
 W 1  1  0 ………………………………………………………………….FOC3


From FOC1 we get:

16
W  1 (E  1 ) …………………………………………………………..………….[31]

Plugging W into the two constraints yields:

[Note that W E  EW , so EW    E1 ( E  1 )   ]

So from FOC1 we get : E1 ( E  1 )  

Also note that W 1  1W

So from FOC2 1W  1  11 ( E  1 )  1

We want to solve the following two equations for two unknowns,  and . So we can
write them as:

E1E  E11  
11E  111  1

Which can be written in matrix form as follows:

 E 1E E 11     

 1     
 1 E 1 11     1 

Solving the above for  and  yields:

1
   E 1E E 11  
     1   
  1  E 1 11   1 

Which implies that:

1
    E 1   
 
    1   E 1  
 1
      

Now that we know what the multipliers are, we can go back and find the weights. From
[31] we know that:

 
W   1 (E  1 )   1 E 1 
 

But
1
    E 1     
 
    1   E 1   so we can plug
 1   into the weights equation to get:
        

17
 1
  E   
W   E 1  1E 1  
1

  1   1

Now use these weights to find the portfolio variance:

 P2  W W

If you plug in W and its transpose you should be able to get:

1
  E    
 p   1  1  1 E 1  1 
2

 A B    E 1 
Let        E 1
 B C    1  

This implies that variance of the portfolio is:

1
 A B     C  B  
p 
2
 1 
1
 B C   1  AC  B 2  1 B A   1 
      

 C  B  

1
 1 B A   1 
AC  B 2   



1
C  B  B  A 
AC  B 2
1

C 2  2 B  A

AC  B 2

Thus the variance is a quadratic function of the mean. We used the notation μ = E(Rp)
This is the reason why we draw bow-shaped frontiers all the time!!!!

The above derivation is more general and abstract. We now want to present a more
practical approach to solving the Markowitz optimization problem.

18
Markowitz Optimization Problem: A More Practical Approach
The Case of N-risky Assets

The Markowitz optimization problem can be stated as follows:

k k
Min w w C n m mn s.t.  wn  1 and  wn rn  r
n 1 n 1

Where wm is the weight of the mth asset in the portfolio, wn is the weight of the nth asset in
the portfolio and Cmn is the covariance between the returns of assets m and n.

Minimizing  wn wmCmn and 1 2  wn wmCmn yield the same results, we therefore

multiply the objective function by 0.5 to make the calculations simpler. The Markowitz
optimization problem can therefore be restated as:

k k k
Min
w
 wn wmCnm s.t.  wn  1 and  wnrn  r
n,m1 n 1 n 1

Before going any further we need clarity on how to differentiate the following term of the
objective function:
1 k
 wn wmCmn
2 n,m1

Please note that:

k n n

 wn wmCmn   p   wi w j ij
2

n ,m 1 i 1 i  j

It is just different notation being used in the two expressions.

Let us start with the case of a portfolio with three assets and then generalize from there.

3 3

 p   wi w j ij
2

i 1 i  j
3
  wi w1 i1  wi w2 i 2  wi w3 i 3 
i 1
3 3 3
  wi w1 i1   wi w2 i 2   wi w3 i 3
i 1 i 1 i 1

 w1w1 11  w2 w1 21  w3 w1 31  w1w2 12  w2 w2 22  w2 w3 32  w1w3 13  w2 w3 23  w3 w3 33

 w12 11  2w2 w1 21  2w3 w1 31  w22 22  2w2 w3 23  w32 33
 w12 11  w22 22  w32 33  2w2 w1 21  2w3 w1 31  2w2 w3 23

So in a 3-asset portfolio the variance-covariance or total risk is given by:

19
 n n

 p   wi w j ij
2

i 1 i  j

 w  11  w22 22  w32 33  2 w2 w1 21  2 w3 w1 31  2 w2 w3 23

2
1

Differenti ating the above function yields :

 p2
 2 w1 11  2 w2 21  2 w3 31
w1

M ore generally we have :

 p2 n
  2 w j 1 j
w1 j 1

Now, going back our optimization problem. First, we formulate the Lagrange function
and then calculate the first order conditions as follows:

1 k k  k 
L 
2 n ,m1
w w C
n m mn    
 n1
wn  1

   
 n 1
wn rn  r 

L k
  wnC1n    r1  0
w1 n 1
L k
  wnC2 n    r2  0
w2 n 1
.
.
.
L k
  wnCkn    rk  0
wk n 1
L k 
   wn  1  0
  n 1 
L  k

   wn rn  r   0
  n 1 

To help see how the above system can be transformed into matrix notation we rewrite the
above first order conditions as follows:

20
w1C11  w2C12  w3C13  .......  wk C1k    r1  0
w1C21  w2C22  w3C23  .......  wk C2 k    r2  0
.
.
w1Ck1  w2Ck 2  w3Ck 3  .......  wk Ckk    rk  0
w1  w2  w3  ......................  wk 1
w1r1  w2 r2  .........................  wk rk r

The above system can then be restated in matrix notation as follows:

C11 C12 C13 C1k  r1   w1  0

1
  0
C
 21 C22 C23... C2 k  1  r2   w2   
.
 . . .... . . .  .   
 . . .... . . .  .  . 
     
 . . .... . . .  .  . 
Ck1 Ck 2 Ck 3 ... Ckk  1  rk   wk  0 
    
1 1 1... 1 0 0    1 
r1 r2 r3 ... rk 0 0     r 
 

Call this matrix A

If A is invertible then the unique solution to our optimization problem would be:

 w1  0 
 w2  0 
  . 
.   
.  . 
   A 1  
.  . 
w  0 
 k  
  1 
  r 
   

21
Case 2: MVF - Many risky assets (with a risk free)
In the presence of any risk-free asset and any number of risky assets the set of efficient
portfolios is a straight line. The minimization problem in the presence of a risk-free asset
is a little bit different. The objective function is as in equation (24). The constraint that
portfolio expected return must be equal to a certain return can now be expressed as
follows:

E ( R p )  w1 E ( R1 )  w2 E ( R2 )  .....  wn E ( Rn )  r f w0
n
 r f w0   E ( Ri )
i 1

Where w0 is the weight of the risk-free asset. And rf is the return on the risk-free asset.
The constraint that the sum of the weights must equal 1 is now given as follows:

n
w0   wi  1
i 1 .

So the minimization problem is now given as follows:

n n
min var (Rp) s.t. r f w0   E ( Ri )   and w0   wi  1 …………………..…[24]
i 1 i 1

That is, for a given expected return μ you carry out a separate minimization problem so
that as μ changes the efficient set is traced out.

You can do it as follows:

1. First construct the minimum variance frontier (see the GG frontier in the
following figure) for risky assets alone.

2. Next draw a ray to any point on the GG frontier.

Points along this ray show the expected return and risk for portfolios comprising the risk
free asset and the portfolio of risk assets given by the chosen point on the GG frontier.
For a given level of risk, high levels of expected return can be attained by pivoting the
ray through rf to higher points along the GG frontier. This can be done until the ray is
tangent to GG (at point Z).

Beyond Z no further increases in E(Rp) is possible.

The set of efficient portfolios for all assets including the risk free asset is then the ray
formed from rf to E, that is rfZE.

22
 Efficient Portfolios with Risk-Free Asset
E( Rp ) E
G
Z
rZ

rf

G
0 Z  p

So introducing a risk-free asset in the optimization problem implies that we have a

portfolio made up of K risky assets plus one risk free asset. So we seek to minimize:

k k k


n , m0
wnCov(rn , rn ) wm s.t  wn  1 and  wn rn  r
n 0 n 0

But since variance of the risk-free asset is zero and the covariance of the returns between
the risk-free asset and other asset returns is also zero the objective function becomes:

 w Cov(r , r )w
n , m 1
n n n m

So we seek to solve the following optimization problem:

k k k


n ,m1
wnCov(rn , rn ) wm s.t  wn  1 and  wnrn  r
n 0 n 0

23
 1 k k  k 
L 
2 n ,m1
w w C
n m mn    
 n 0
wn  1

   
 n 0
wn rn  r 

L
   r0  0
w0
L k
  wnC1n    r1  0
w1 n 1
L k
  wnC2 n    r2  0
w2 n 1
.
.
.
L k
  wnCkn    rk  0
wk n 1
L k 
   wn  1  0
  n 1 
L k 
   wn rn  r   0
  n 1 

   r0  0
w1C11  w2C12  w3C13  .......  wk C1k    r1  0
w1C21  w2C22  w3C23  .......  wk C2 k    r2  0
.
.
w1Ck1  w2Ck 2  w3Ck 3  .......  wk Ckk    rk  0
w1  w2  w3  ...........................  wk 1
w1r1  w2 r2  w3r3  .............  wk rk r

24
 0 0 0 0... 0  1  r0   w0  0
  0
0
 C11 C12 C13... C1k  1  r1   w1   
.
 . . .... . . .  .   
 . . .... . . .  .  . 
     
 . . .... . . .  .  . 
0 Ck 1 Ck 2 Ck 3 ... Ckk  1  rk   wk  0 
    
1 1 1 1... 1 0 0    1 
r0 r1 r2 r3 ... rk 0 0     r 
 

Call this matrix A

 w0  0 
 w1  0 
   
.  .
   A 1  
 wk  0 
  0 
   
  1
 

This provides the unique solution to the optimization problem.

Getting the Minimum Variance Portfolio

k
To get the Minimum Variance Portfolio we minimize  wn wmCmn s.t.  wn  1 . Note that
n 1
in this case we do not specify a constraint of the targeted portfolio return since we are
simply trying to get a portfolio with minimum variance and not one that meets a
particular return target. So we state our optimization problem as:

k
1
Min
2
 wn wmCmn s.t.  wn  1
n 1

We formulate the Lagrangean function and calculate the first order conditions as follows:

25
 1 k  k 
L 
2 n ,m1
w w C
n m mn    
 n1
wn  1

L k
  wnC1n    0
w1 n 1
L k
  wnC2 n    0
w2 n 1
.
.
.
L k
  wnCkn    0
wk n 1
L k 
   wn  1  0
  n 1 

As done previously, to help see how we can transform the above system into matrix
notation we rewrite the above first order conditions as follows:

w1C11  w2C12  w3C13  .......  wk C1k    0

w1C21  w2C22  w3C23  .......  wk C2 k    0
.
.
w1Ck1  w2Ck 2  w3Ck 3  .......  wk Ckk    0
w1  w2  w3  ...........................  wk 0

The above system can be restated in matrix notation as follows:

 C11 C12....... C1K  1  w1  0

C  
 21 C22........ C2 K  1  w2  0
 
. . . .  .   . 
 
. . . .    . 
  w 
CK 1 CK 2 ...... CKK  1  k  0
 1 1 1 0    1
 

Call this matrix A

If A is invertible then the unique solution to our optimization problem would be:

26
 w1  0 
 w2  0 
   
   A  . 
. 1
  .
 wk  0 
   
  1

Example: Calculating expected return and variance for a minimum variance

portfolio
Consider a portfolio with 3 assets (A, B and C) with expected returns rA=0.5, rB=1,
rC=1.5, respectively. Their covariance matrix is given by:

C AA C AB C AC   1 1 4 1 2 
C  CBA CBB CBC   1 4 2 3 4
CCA CCB CCC  1 2 1 4 3 

Calculate the expected return and variance for the minimum variance portfolio.

So we seek to solve the following optimization problem:

k
1
Min  wn wmCmn s.t.  wn  1
2 n 1
Note that we do not specify a constraint of the targeted portfolio return since we are
simply trying to get a portfolio with minimum variance and not one that meets a
particular return target.

1 3  3 
L 
2 n ,m1
w w C
n m mn    
 n 1
wn  1

L k
  wnC1n    0...................( FOC1)
w1 n 1
L k
  wnC2 n    0...................( FOC 2)
w2 n 1
L k
  wnC 33n    0..................( FOC 3)
w3 n 1
L k 
   wn  1  0..................( FOC 4)
  n 1 

As done previously, to help see how the above system can be transformed into matrix
notation we rewrite the above first order conditions as follows:

27
w1C11  w2C12  w3C13    0
w1C21  w2C22  w3C23    0
w1C31  w2C32  w3C33    0
w1  w2  w3  1

The above system can be restated in matrix notation as follows:

C11 C12 C13  1  1  0

w
C   w2  0

 21 C 22 C 23 1  w3   0
C31 C32 C33  1    
     1
 1 1 1 0     

BUT

C AA C AB C AC   1 1 4 1 2 
C  CBA CBB CBC   1 4 2 3 4
CCA CCB CCC  1 2 1 4 3 

So:
 1 1 4 1 2  1  1  0
w
1 4 2 3 4  1 w2  0

   w3   0
1 2 3 4 3  1    
     1
 1 1 1 0     

 w1  0 
w  0 
 2 1  
 w3   A 0
  1 
   
   

Therefore, w1 = 0.6538, w2 = 0.2692, w3 = 0.0769, lambda = 0.7596

Now we need to calculate the expected return and the variance for the MVP.

28
  E (rA ) 
E (rp )  wA E (rA )  wB E (rB )  wC E (rC )  wA wB wC  E (rB ) 
 E (rC )
1 2 
 0.6538 0.2692 0.0769 1 
3 2
 0.7115

 1 1 4 1 2  0.6538
  W CW  0.6538 0.2692 0.07691 4 2 3 4 0.2692  0.7595
2
p
T

1 2 3 4 3  0.0769
 P2  0.875

Portfolio Diversification Benefits

We want to prove that as the number of assets in a portfolio increases the risk or the
portfolio variance decreases. To simplify our calculations we shall assume that the assets
have equal weights. That is if we have N assets in the portfolio then the weight is wi =
1/N. We shall also start by assuming that all assets in question are uncorrelated (that
is,  ij  0 ). The variance of the portfolio given the above assumptions is:

  w12 12  w22 22  ..............  w2 n N2

2
p

But wi = 1/N and 1   2  .......   N  

1 2 1 2 1 1 1 1
    2  2  ..............  2  N2  2  2  2  2  ..............  2  2
2
p 2 1
N N N N N N

1
  N 2
2
p
N2

1 2
  
2
p
N

1 2 1
 p
N
 

N
Thus as N increases the portfolio standard deviation or risk goes down.

29
This is because as more and more uncorrelated risks are pooled together, total risk is
reduced. This is known as the insurance principle: insurance companies like to take on
more and more uncorrelated risk.

If we assume that the following still holds:

1   2  .......   N  
And that assets are equally weighted: wi = 1/N

And also that 12   32  .......   jn  Cov

Then:

   
n n
1 1
 p   wi w j ij  N 2  2 N 2  N Cov
2
2
i 1 i  j N N


1 2
N
  1
N
N  1Cov
 2 ( N  1)
  Cov
N N
2 1
  Cov  Cov
N N

Lim  Cov
2
p
N 

Thus as N increases portfolio variance approaches covariance. The risk associated with
each asset comes from unique/diversifiable risk and market/systematic risk. As N
increases diversifiable risk is eliminated and the risk of the portfolio is only explained by
market risk, which in this case comes from the covariance term. If the asset returns for a
given portfolio are perfectly unrelated then Cov = 0 and so the risk for that portfolio
would be zero.

Relaxing some of the above assumptions:

The above proof is based on a number of simplifying assumptions. Let us relax some of
the assumptions and show that the conclusion does not change.

n n

 p   wi w j ij
2

i 1 i  j

Note that variance is a special type of covariance. Variance is the covariance of an asset
with itself. That is,  ii   i .
2

Separating the above expression into variance and covariance terms yields:

30
 n n n

 p   wi2 i2   w w 
2
i j ij
i 1 i 1 i  j , j i

Note that a 2-asset portfolio has 2 variance and 2 covariance terms. A 3-asset portfolio
has 3 variance and 6 covariance terms. An N-asset portfolio has N variance terms and
N2-N covariance terms. We shall assume that the portfolio is equally weighted:
wi = wj = 1/N.

2
1 2 1 n n
n

 p i1  N   i  N 2 
   ij
2

i 1 i  j , j i

n n n
1 1
p   i2   
2
ij
N2 i 1 N2 i 1 i  j , j i

Suppose that the largest individual asset variance is L. The first term (the variance terms)
is less than or equal to:
1 n 1 N 1 L
2  2 
 i
2
 L  2 NL 
N i 1 N i 1 N N
So as the number of assets in the portfolio increases this term approaches zero. That is;

L
Lim N  0
N 

Now let us look at the covariance term:

Let the average covariance of the N 2 - N terms be  ij . So there are N2 - N covariance
terms each equal to  ij . Therefore,

1 n n 1 
2   ij
  2 ( N 2  N ) ij   ij  ij
N i 1 i  j , j i N N

Thus as N increases portfolio variance goes down:

 1 
lim  2 ( N 2  N ) ij    ij

N  N


As we increase the number of assets in a portfolio the covariance terms become more
important (see handouts and the different textbooks on this).

31
Required Reading
1. Markowitz, H. (1952). Portfolio selection, Journal of Finance 7, 77-91.

2. Tobin, J. (1958). Liquidity preference as behaviour towards risk. Review of Economic

Studies, February 1958, 65–86.

3. Markowitz, H. (1991). Foundations of portfolio theory, The Journal of Finance 46

(2), 469-477.

32