FINS2624 Lecture 4 T1 2020

UNSW Business School/ Banking & Finance
FINS2624 Lecture 4
Optimal Portfolios
Lecture Outline
❑ Optimal portfolios – no risk-free asset
➢ Minimum Variance Frontier
➢ Efficient Frontier
❑ A Complete Portfolio – introducing the risk-free asset

➢ Risky asset share y
➢ Expected return and risk
❑ Optimal Risky Portfolio (P*)

➢ Capital Allocation Line
❑ Separation Property
➢ Choosing P* - maximizing the Sharpe Ratio
➢ Choosing the optimal risky share y
➢ The Optimal Complete Portfolio
➢ Borrowing Constraints
1
❑ The Market Portfolio M
What is the Optimal Portfolio?
❑ Imagine an investment universe with assets characterized by the risk-return
profile as plotted below:
BKM 7.4
2
Optimal Portfolios Risk-free asset Complete Portfolio Optimal P* Separation Theory
What is the Optimal Portfolio?
❑ By combining the assets in different proportions we can construct portfolios
with risk-return profiles which are on the red line
➢ The red line is known as the minimum variance frontier MVF – the lowest
risk portfolio at each level of return. The procedure to derive it is:
① Set target expected portfolio return, e.g. 10%
② Optimise portfolio weights to minimise variance at this level of return
③ Repeat at different return levels till we have plotted the frontier
In mathematical terms:
N
min (Var(rP ) = Var( wi ri )),
wi
i =1
Subject to the constraint:
g
 N 
E (rP ) = E   wi ri  = 10%
 i =1 
BKM 7.4
3
So What is the Optimal Portfolio?
❑ From the mean-variance criterion, we know that any portfolio or asset
combinations below the MVF will be dominated by a portfolio on the MVF
❑ Similarly, any portfolio below the turning point of the MVF will be dominated
by one above the turning point
➢ The turning point is the portfolio (asset combination) that has the lowest
possible risk level
➢ It is known as the Global Minimum Variance Portfolio (GMVP)
Portfolio
combinations or
individual assets
which are
dominated
g
BKM 7.4
4
Efficient Frontier
❑ As each portfolio on the MVF above the GMVP dominates those below, we
discard the portfolios with Expected Returns below the GMVP
➢ The part of the MVF above the GMVP is called the Efficient Frontier
➢ It is the section of the MVF above the GMVP (to plot it we would need to
identify the GMVP first)
➢ Risk averse investors should only choose portfolios on the efficient
frontier
E(r)
Efficient assets are those

sitting on the Efficient
Frontier (lowest risk at
each level of return)
gmvp
σ
BKM 7.4
5
Optimal Point on the Frontier?
❑ So, where along the efficient frontier should we invest?
❑ Coming back to last week’s discussion on preference and utility – we pick
the point which provides the highest utility
➢ Highest utility is represented by the highest attainable indifference curve
➢ The portfolio marked by the star gives the highest possible utility
➢ This portfolio lies on the tangent point between the efficient frontier and
the highest attainable indifference curve
E(r)
Optimal Risky
Portfolio
σ
BKM 7.4
6
Optimal Point on the Frontier?
❑ Where along the efficient frontier should we invest?
❑ The portfolio marked by the star is the optimal portfolio when we have only
risky assets to invest in
❑ As we will see shortly adding a risk-free asset can improve our allocation
options and enhance our optimal portfolio
❑ See “L4 Deriving the MVF and Efficient Frontier”
➢ Plotting the efficient frontier is a key element of your iLab project (Task 1)
➢ See the iLab instructional videos posted online which will really help you
with the theory
BKM 7.4
7
Optimal Portfolio: No Risk-free Asset
❑ Although all investors face the same efficient frontier, they will each have
different utility functions (due to different risk aversion coefficients A)
➢ They will therefore have different indifference curves
➢ So the optimal risky portfolio may differ between investors
Optimal Risky
Portfolio Optimal Risky
Investor A Portfolio
Investor B
8
Introducing the Risk-free Asset
❑ Now lets add a risk-free asset:
➢ Short-term Government bills (T-bills) are often considered as the risk-free
asset, as they have almost no default risk
➢ Some market practitioners also use the Government bond rate as the
risk-free asset for long-term investments
❑ The return on the risk-free asset (the “risk
free rate”) is denoted rf
➢ Even if we don’t take risk we still want a
positive return
➢ Hence rf is generally positive as shown
rf
Risk-free Rate
BKM 6.3
9
Combining Risky and Risk-free Assets
❑ Now suppose we want to combine some risky portfolio P with the risk free
asset
➢ Denote the fraction invested in the risky asset y
➢ Denote the fraction invested in the risk-free asset (1 – y)
➢ y could be any non-negative constant (it can even be higher than 1)
❑ An important capital allocation decision is determining how much of our

portfolio to allocate to the risk-free asset vs risky assets P
❑ We can create a complete portfolio C where our capital is fully allocated
into a combination of risky and risk-free assets
❑ The return on our complete portfolio C is:
rC = (1 − y )r f + yrP
BKM 6.4
10
A Note on Return
❑ If the market is in equilibrium ie demand equals supply, then expected
return should equal the required rate of return determined by the market
➢ If an investment is viewed as “unattractive”, investors will require a
higher return to buy it, which results in a lower price
❑ All else being equal, a low price implies a higher required return (and
therefore a higher expected return)
❑ So counter-intuitively less attractive investments have higher expected
returns on average
➢ In finance, less attractive generally means more risky
➢  Required Return (eg higher risk) →  Price →  Expected Return
❑ In finance, the central subject of most asset pricing models is the

required/expected rate of returns
➢ Effectively equivalent to studying asset prices
11
Complete Portfolio Expected Return
❑ As usual, we want to determine the risk and expected return of the
complete portfolio C
❑ To induce risk averse investors to take risky investments, we need to give
them an incentive – a risk premium in terms of higher expected return
➢ The liquidity premium (from Lecture 2) is an example of a risk premium
❑ In other words, risk averse investors would only invest in riskier assets if it
compensated them with higher expected return
❑ Last week we discussed the concept of expected return
❑ Example: If a stock i has a 75 % chance of giving a 20 % return and a 25 %
chance of giving a –10 % return, our expected return would be:
E (ri ) =  ps ri s = 0.75  0.2 + 0.25  (− 0.1) = 12.5%

s
BKM 6.4
12
Complete Portfolio Expected Return
❑ The Expected Return on the Complete Portfolio C is given by:
E(rC) = E[(1-y)rf + yrp]
E(rC) = (1-y)rf + yE(rp)
❑ As we saw in the last lecture, the portfolio expected return is a weighted
average of the component asset expected returns
❑ It is often convenient to express this equation in terms of a risk premium
➢ Rearranging the above equation:
E(rC) = rf + y[E(rp) - rf ]
➢ [E(rp) - rf ] is often referred to as the risk premium
BKM 6.4
13
Complete Portfolio Risk
❑ Applying our equation for a 2-asset portfolio risk/variance to the Complete
Portfolio C gives:
𝜎2𝐶 = 𝑉𝑎𝑟 𝑦𝑟𝑝 + 1 − 𝑦 𝑟𝑓
= 𝑦2𝜎2𝑃 + (1 − 𝑦)2𝜎2𝑟𝑓 + 2𝑦(1 − 𝑦)𝐶𝑜𝑣(𝑟P , 𝑟𝑓)
❑ Since the risk-free asset’s return is known (a constant), it has no variance
Therefore: 𝜎2𝑟𝑓 = 0 and Cov(rP, rf) = 0
❑ So the portfolio variance equation simplifies to:

𝜎2𝐶 = 𝑦2𝜎2𝑃
𝜎𝐶 = 𝑦2𝜎2𝑃
𝜎𝐶 = 𝑦𝜎𝑃
BKM 6.4
14
Possible Values for y
❑ y represents the fraction invested in risky assets
❑ So graphically, if we drew a straight line connecting the risk-free rate rf to
the risky asset P, y would tell us where along the line we sit
❑ If y > 1, it means borrowing at the risk free rate (instead of investing in the
risk-free asset) and investing the proceeds into risky assets. In this case,
we are taking a levered position in the risky asset
E(r) ❑ Let’s label the line
rf is on the y- y=1
associated with
C(y=0.75)
intercept as
CALP
C(y=0.25)
𝜎=0 the risky portfolio

P
P CALP (for
C(y=1.25)
rf reasons that will

C(y=0.5)
become clear
later)
σ
BKM 6.4
15
Risk-free Asset and Efficient Frontier
❑ You will recall the efficient frontier from earlier
❑ Now we can invest in the risk-free asset too, we have widened the
investment opportunity set of complete portfolios
❑ CALP dominates CALPI
BKM 7.4
16
Why Add the Risk-free Asset?
C1 offers the same
return as P1 but lower
risk: C1 dominates P1
C3 dominates P3
❑ Both efficient risky portfolios, P1 and P3, are dominated by Complete

Portfolios of the risk-free asset and the (inefficient) risky portfolio, PI
❑ Hence, efficient risky portfolios are no longer efficient if we further consider
complete portfolios that include the risk-free asset
❑ The risk-free asset has significantly increased our investment opportunities
BKM 7.4
17
Which Risky Portfolio?
CALPE
PE
E(r)
CPE CALPI
PI
CPI
rf
σ
❑ Clearly it is not optimal to combine the risk-free asset with an interior
(inefficient) risky portfolio, PI (ie a portfolio underneath the efficient frontier)
❑ For any portfolio of the risk-free asset and an interior portfolio, we can
always find a portfolio of the risk-free asset and an efficient portfolio that
dominates (same return but lower risk, or same risk but higher return)
BKM 7.3
18
Which Risky Portfolio?
Note these principles:
❑ The higher the slope of CAL to an efficient risky portfolio (ie the steeper the
CAL), the better the risky portfolio is to form a complete portfolio
❑ For any complete portfolio on a lower-slope CAL, you can always find a
dominating complete portfolio on the higher-slope CAL
❑ We are interested in drawing CAL to risky portfolio P where:
① The complete portfolios along the CAL dominate all other portfolios (the
steepest possible CAL)
② The investment opportunity is attainable
BKM 7.3
19
The Optimal Risky Portfolio P*
❑ This turns out to be the CAL which is tangent to the efficient frontier
❑ The point of tangency is called the Optimal Risky Portfolio, P*
❑ The associated line CALP* is often simply denoted CAL. This is called the
Capital Allocation Line
CALP* = CAL
E(r)
P*
rf
σ
BKM 7.3
20
The Optimal Risky Portfolio P*
❑ Only risky portfolios on the efficient frontier should be considered
❑ The CAL links the risk-free asset to a portfolio on the efficient frontier
❑ The steeper the CAL the better eg CAL2 clearly dominates CAL1
❑ The optimal risky portfolio P* is on the steepest possible CAL and the
efficient frontier – it is the point of tangency from rf to the efficient frontier
❑ We call this tangent portfolio (P*) the Optimal Risky Portfolio, and the
tangent line is the Capital Allocation Line (CAL)
CALP* = CAL
Any CAL above CALP*
is not attainable
CAL2
E(r)
P*
CAL1
rf
σ
21
Separation Theorem
❑ CALP* caters to all risk tolerances and provides the highest possible return
for each level of risk
❑ Therefore regardless of an individual investors’ level of risk aversion –
measured by their risk aversion coefficient A - EVERY investor will invest
along CALP*
➢ Because for EVERY level of risk aversion, CALP* gives the highest return
❑ CALP* is the Capital Allocation Line (CAL) for ALL investors

❑ ALL investors will form a Complete Portfolio along the CAL
BKM 7.4
22
Separation Theorem
❑ Different portfolios on CAL correspond to different allocations (y) in the
optimal risky portfolio (P*), and so carry different amounts of risk: σc = yσP*.
❑ An investor will choose their optimal portfolio on CAL (and therefore their
optimal risk allocation y), depending on their risk preference
❑ Therefore the Separation Theorem states portfolio optimisation can be
derived in two separate steps:
① Find the optimal risky portfolio, P* (common to all investors)
② Determine the share of our wealth we invest in the optimal risky portfolio
P* (ie the “optimal risky share” y*) based on our individual risk tolerance
(specific to the individual investor)
❑ See file “L4 Deriving the EF, CAL and Optimal Complete Portfolio”
BKM 7.4
23
Step 1: Choosing P* (and therefore CAL)
❑ The slope of the CAL SP tells us the incremental return/reward we get - E(r)
- for taking on incremental risk 𝜎. We can calculate this slope from our two
known points on the line:
y E (rP ) − E (rf ) E (rP ) − rf
SP = = =
x P −0 P
❑ This is known as the Sharpe Ratio
❑ In other words, the slope of the CAL is its Sharpe ratio
❑ So we find P* by choosing its portfolio weights, wP which maximises SP:
E (rP ) − rf
max S P =
wP P
❑ For > 2 assets this optimization gets tricky – we often use Excel Solver
(iLab)
BKM 7.4
24
Step 2: Choosing the risky share y*
❑ We choose y based on our individual risk preferences
➢ The risk aversion coefficient A is different for different investors
➢ Therefore different investors have different utility functions
➢ Therefore different investors have different indifference curves:
E(r)
C* is the Optimal P*
Complete Portfolio
– tangent between C* is specific to this investor
the CAL and C* based on their indifference
highest attainable curves (ie their individual risk
indifference curve rf aversion coefficient A)
σ
BKM 6.5
25
❑ Remember from earlier we derived the return and risk on a Complete
Portfolio C:
E(rC) = rf + y[E(rp*) - rf ]
and 𝜎𝐶 = 𝑦𝜎𝑃*
Now recall the utility function:∗
U = E (r ) − 1 2 A 2
Lets combine these equations:
 
U = rf + y E (rP* ) − rf − 1 2 A( y P* ) = rf + y E
2

 
= rf + y E (rP* ) − rf − 1 2 A( y P* ) = rf
2
+ yE (r ) − r −
P* f
1
2 Ay  P*
2 2
BKM 6.5
26
❑ Let’s choose y so as to maximize our utility:

max U = rf + y E (rP* ) − rf − 1 2 Ay2 P2*
y

❑ Setting the first derivative equal to zero and solving for y gives:
E(rp) – rf – A yσ2p = 0 y* is positively correlated
to the risk premium –
E (rp ) − rf more reward for risk →
y* is negatively y= *
invest more in risky assets
correlated risk and A p2
risk aversion
❑ y* identifies the optimal proportion an individual investor should place in

risky assets to achieve their Optimal Complete Portfolio C*
E (rP* ) − r f
Note:  P2*
is known as the reward-to-risk ratio (similar interpretation to the Sharpe ratio, but
the denominator is the variance not 𝜎)
BKM 6.5
27
❑ Let’s verify the separation theorem
➢ Investors with different risk aversion (A) have different complete portfolios
➢ But they invest in the same risky portfolio P*
➢ They only differ in terms of the fraction (y*) of their investments in the
risky portfolio P*
CA* is the Optimal
Complete Portfolio
for investor A CB *
E(r)
P* CB* is the Optimal
Complete Portfolio
for investor B
CA*
rf
σ
BKM 6.5
28
Borrowing Constraints
❑ The optimal risky allocation y* can be >1 for (less risk averse) investors
❑ From earlier slides, this means investors take a levered position in the
optimal risky portfolio, ie borrowing to invest
❑ In reality, although we can invest at the risk-free rate (by buying
government bonds) we generally can’t borrow at the risk-free rate
❑ Let’s assume that we are able to borrow at some higher interest rate than
the risk-free rate rb > rf
❑ Then it means that for those (less risk averse) investors who would like to
borrow to invest, the section of CAL above P* is not obtainable, as those
levered positions are based on rf
BKM 6.4
29
Borrowing Constraints
❑ A new optimal risky portfolio (Pb*) and associated CAL should be derived
for the borrowing rate rb
➢ Only the section of CAL above Pb* is relevant, as this is the CAL for
borrowing to take a levered position in the optimal risky asset
❑ Graphically the CAL has a kink where y = 1 (at P*)
❑ Unless explicitly asked, we assume no borrowing constraints
E(r)
P* Pb*
rb
rf
σ
BKM 6.4
30
Separation Theorem Implications
❑ In market equilibrium all investors hold the same optimal risky portfolio P*
❑ If, in equilibrium, all investors are holding the same risky portfolio, this must
be the market portfolio M which comprises all assets
➢ The weight of each asset in M is the asset’s total market value divided by
the total value of M
➢ Each investor holds a small fraction of this portfolio
❑ Since P* is the market portfolio M, M has the highest possible Sharpe ratio
❑ The rational way to increase risk (and return) is to increase leverage and
invest more in M (rather than deviating from M and buying risky assets in
different weightings to their weightings in M)
BKM 7.4
31
The Market Portfolio M
❑ Since every investor holds M for their risky asset allocation, the
attractiveness of a stock is determined by how it contributes to the return
and risk of this portfolio
❑ We know from Lecture 3 that:
➢ The contribution an individual asset makes to portfolio return is simply
proportional to its weight
➢ However, its contribution to portfolio risk depends on its covariance
with the other stocks in the portfolio
❑ So the risk of an individual asset is no longer measured just by its own
variance or volatility, but rather its covariance with all other assets in the
market portfolio M – in equilibrium this is now our key measure of risk
❑ This is the key insight of the Capital Asset Pricing Model (CAPM) for next
week’s lecture
32
Next Lecture
❑ CAPM
Key Concepts
➢ The Capital Market Line
➢ Assumptions of the CAPM
➢ Derivation of the CAPM
➢ Systematic and unsystematic risk
➢ The Security Market Line
Readings
➢ BKM 9 Capital Asset Pricing Model: 9.1
33

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UNSW Business School/ Banking & Finance

❑ A Complete Portfolio – introducing the risk-free asset

❑ Optimal Risky Portfolio (P*)

Efficient assets are those

❑ An important capital allocation decision is determining how much of our

❑ In finance, the central subject of most asset pricing models is the

E (ri ) =  ps ri s = 0.75  0.2 + 0.25  (− 0.1) = 12.5%

❑ So the portfolio variance equation simplifies to:

𝜎=0 the risky portfolio

rf reasons that will

❑ Both efficient risky portfolios, P1 and P3, are dominated by Complete

❑ CALP* is the Capital Allocation Line (CAL) for ALL investors

① Find the optimal risky portfolio, P* (common to all investors)

❑ y* identifies the optimal proportion an individual investor should place in

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