2.

1- 1

Investments

Cover image

Lesson 2
Portfolio Theory &
Risk-Return Models

Cover
image Thanh Truc – TCNH – UEL
 2.1- 2
Lesson 2 Portfolio Theory & Risk-
Return Models

 Portfolio theory & practice (chapter 6,

7)
 Risk-Return Models
• Index Model (chapter 8)
• Capital Assets Pricing Model (chapter 9)
• Arbitrage Pricing Theory & Multifactor
Model (chapter 10)

Cover
image Thanh Truc – TCNH – UEL
 2.1- 3

Portfolio Theory and practice

Cover
image Thanh Truc – TCNH – UEL
 2.1- 4

Content
Capital allocation across risky and risk
free asset
– Risk aversion and utility value
– Portfolios of a risky asset and one risk free asset
– Risk Tolerance and Asset Allocation
Optimal risky portfolios
– Portfolios of two risky assets
– Optimal risky portfolio (Asset allocation with
stocks, bonds, and bills)
– The Markowitz portfolio optimization model
Cover
image Thanh Truc – TCNH – UEL
 2.1- 5

The optimal risky portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 6

Portfolio return and risk

Cover
image Thanh Truc – TCNH – UEL
 2.1- 7

Diversification & Portfolio risk

There are two broad sources of uncertainty

associated with one stock:
− Firm specific risk: unexpected events affecting
to only one company, can be diversified away.
− Market risk: comes from conditions in the
general economy, such as the business cycle,
inflation, interest rates, and exchange rates.
Because all securities are affected by the
common macroeconomic factors, market risk
cannot be diversified away.
Cover
image Thanh Truc – TCNH – UEL
 2.1- 8
Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 9

Figure 7.2 Portfolio Diversification

Cover
image Thanh Truc – TCNH – UEL
 2.1- 10
Return of the portfolio of two
risky assets

rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2

Cover
image Thanh Truc – TCNH – UEL
 2.1- 11
Risk of the portfolio of two
risky assets

p2 = w1212 + w2222 + 2w1w2 Cov(r1r2)

12 = Variance of Security 1

22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for
Security 1 and Security 2
Cover
image Thanh Truc – TCNH – UEL
 2.1- 12

Covariance

Cov(r1r2) = r1,212
r1,2= Correlation coefficient of
returns
1 = Standard deviation of
returns for Security 1
2 = Standard deviation of
returns for Security 2

p2 = w1212 + w2222 + 2w1w2σ1σ2ρ1,2

Cover
image Thanh Truc – TCNH – UEL
 2.1- 13
Correlation Coefficients:
Possible Values

Range of values for r1,2

+ 1.0 > r > -1.0
If r= 1.0, the securities would be perfectly
positively correlated
If r= - 1.0, the securities would be
perfectly negatively correlated

Cover
image Thanh Truc – TCNH – UEL
 2.1- 14
Risk of the portfolio of two
risky assets
ρ=1
p2 = w1212 + w2222 + 2w1w2σ1σ2

ρ=0
p2 = w1212 + w2222

ρ = -1
p2 = w1212 + w2222 – 2w1w2σ1σ2
Cover
image Thanh Truc – TCNH – UEL
 2.1- 15

when ρ < 1, the standard deviation of

portfolio return is always smaller than
the average of standard deviations of
return of stocks in the portfolio.
When ρ =1, the standard deviation of
portfolio return is equal to the average
of standard deviations of return of
stocks in the portfolio.

Cover
image Thanh Truc – TCNH – UEL
 2.1- 16

Portfolio of three stocks

rp = W1r1 + W2r2 + W3r3

2p = W1212 + W2212 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
Cover
image Thanh Truc – TCNH – UEL
 2.1- 17

Table 7.2 Computation of Portfolio Variance

from the Covariance Matrix

Cover
image Thanh Truc – TCNH – UEL
 2.1- 18

Table 7.1 Descriptive Statistics for Two Mutual

Funds

E(rP) = WE E(rE) + (1 – WE)E(rD)

σP= [WE2σE2 + (1 – WE)σD2 + 2σEσDρ]0.5

Cover
image Thanh Truc – TCNH – UEL
 2.1- 19
Table 7.3 Expected Return and Standard
Deviation with Various Correlation Coefficients

Cover
image Thanh Truc – TCNH – UEL
 2.1- 20

Figure 7.3 Portfolio Expected Return as a

Function of Investment Proportions

Cover
image Thanh Truc – TCNH – UEL
 2.1- 21

Figure 7.4 Portfolio Standard Deviation as a

Function of Investment Proportions

Cover
image Thanh Truc – TCNH – UEL
 2.1- 22
Figure 7.5 Portfolio Expected Return as a
function of Standard Deviation

Cover
image Thanh Truc – TCNH – UEL
 2.1- 23

− Figure7.5 shows all combinations of portfolio

expected return and standard deviation that
can be constructed from the two available
assets using different correlation coefficient. It
plots portfolio expected return as a function of
standard deviation.
− The solid colored curve in Figure 7.5 shows
the portfolio opportunity set for ρ = .30.
− The other lines show the portfolio opportunity
set for other values of the correlation
coefficient
Cover
image Thanh Truc – TCNH – UEL
 2.1- 24

− The solid black line connecting the two

funds shows that there is no benefit from
diversification when the correlation between the
two is perfectly positive (ρ = 1)
− The dashed colored line demonstrates the
greater benefit from diversification when the
correlation coefficient is lower than .30.
− For ρ = -1, the portfolio opportunity
set is linear, but now it offers a perfect hedging
opportunity and the maximum advantage from
diversification. For ρ = -1, it is possible to
construct a risk-free portfolio
Cover
image Thanh Truc – TCNH – UEL
 2.1- 25
The importance of correlation
coefficient
− The extent to which portfolio risk is reduced by
diversification depends on the correlation among
stocks.
− The lower the correlation, the greater the
potential benefit from diversification
− -1.0 < r < +1.0
− For r = +1.0, diversification gives no benefit.
− In the extreme case of perfect negative
correlation, we have a perfect hedging
opportunity and can construct a zero -variance
portfolio.

Cover
image Thanh Truc – TCNH – UEL
 2.1- 26

Determination of the
optimal risky portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 27

Figure 7.6 The Opportunity Set of the Debt and

Equity Funds and Two Feasible CALs

Cover
image Thanh Truc – TCNH – UEL
 2.1- 28

Assets allocation: Stocks, Bonds, and Bills

If choosing the portfolios P at A, B, E, or P to combine with

the risk-free asset F, then the properties of portfolios as
below
A B E P

E(rP) 8.90% 9.50% 13.00% 11.00%

σP 11.45% 11.70% 20.00% 14.20%

WE 0.18 0.30 1.00 0.60

WD 0.82 0.70 0.00 0.40

S 0.34 0.38 0.40 0.42

= [E(rP) – rf]/σP
Cover
image Thanh Truc – TCNH – UEL
 2.1- 29
How to choose the optimal
portfolio P?
− Investors naturally will want to work with the risky
portfolio that offers the highest reward-to-
volatility or Sharpe ratio. The higher the Sharpe
ratio, the greater the expected return
corresponding to any level of volatility.
− The best risky portfolio is the one that results in
the steepest capital allocation (CAL) line.
− Therefore, our next step is the construction of a
risky portfolio combining the major asset classes
(here a bond and a stock fund) that provides the
highest possible Sharpe ratio.
Cover
image Thanh Truc – TCNH – UEL
 2.1- 30
How to choose the optimal
portfolio P?

− The objective is to find the weights wD and wE

that result in the highest slope of the CAL. Thus
our objective function is the Sharpe ratio:

SP = (E(rp) – rf)/σP

Cover
image Thanh Truc – TCNH – UEL
 2.1- 31
How to choose the optimal
portfolio P?
Max S = [E(rP) – rf]/σP (*)

E(rP) = WE E(rE) + (1 – WE)E(rD)

σP= [WE2σE2 + (1 – WE)σD2 + 2σEσDρ]0.5

Calculate E(rP) and σP

with the following values and then put the results in
equation (*):
E(rE) = 13%; E(rD) = 8%; rf = 5%
σE = 20%; σD = 12%, ρ = 0.3
Take the derivative of S, set the derivative to zero,
solve for WE
Cover
image Thanh Truc – TCNH – UEL
 2.1- 32
Figure 7.7 The Opportunity Set of the Debt and Equity Funds with
the Optimal CAL and the Optimal Risky Portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 33

The complete portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 34

Where is investors’ complete portfolio in the

CAL?

With the set of all possible portfolios that can

be constructed from a risk-free asset and the
optimal risky portfolio (P) as presented on the
CAL, what is the complete portfolio for a
given investor?
Depending on the investor’s degree of risk
aversion and with the goal of maximizing the
utility value of U = E(r ) - 0.5 A σ2
The proportion in the optimal risky portfolio :
y = [E(rP) – rf]/AσP2
Cover
image Thanh Truc – TCNH – UEL
 2.1- 35
Figure 7.8 Determination of the Optimal Overall
Portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 36
Where is investors’ complete portfolio in the
CAL?

Portfolio P: E(rP) = 11%, σP = 14.2%;

WE = 0.6 and WD = 0.4
Risk-free asset F: rf = 5%
A given investor with risk aversion degree of A = 4
Investment proportion allocated to P:
y = (11% - 5%)/(4x 0.1422) = 0.7439.
The complete portfolio (C) includes risk-free asset F, long
term bond portfolio (D) and stock portfolio (E) with
proportions:
WF = 1- 0.7439 = 0.2561 (25.61%)
WE = 0.6 x 0.7439 = 0.4463 (44.63%)
WD = 0.4 x 0.7439 = 0.2976 (29.76%)

Cover
image Thanh Truc – TCNH – UEL
 2.1- 37
Figure 7.9 The Proportions of the Optimal
Overall Portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 38

The Markowitz Portfolio

Optimization Model

Cover
image Thanh Truc – TCNH – UEL
 The Markowitz Portfolio 2.1- 39

Optimization Model
Portfolio construction has three parts:
− Identify the risk–return combinations available
from the set of risky assets.
− Identify the optimal portfolio of risky assets by
finding the portfolio weights that result in the
steepest CAL
− Investors choose an appropriate complete
portfolio by mixing the risk-free asset with the
optimal risky portfolio

Cover
image Thanh Truc – TCNH – UEL
 2.1- 40
Identify the risk–return combinations
available from the set of risky assets
- Risk-return analysis, the portfolio manager needs
as inputs a set of estimates for the expected returns
of each security and a set of estimates for the
covariance matrix
- Calculation of the expected return and variance
of risky portfolios with weights in each security, wi
and estimates of expected return and covariance
(using equation 7.15 and 7.16).
- Identification of the efficient set of portfolios, that
is the set of portfolios that minimizes the variance for
any expected return or portfolios that has the highest
expected return for any risk level
Cover
image Thanh Truc – TCNH – UEL
 2.1- 41

Determination of the optimal risky portfolio

− The optimal portfolio is the one that results in the

steepest CAL when combine with the risk-free
asset. P is the tangency point of a line from F to the
efficient frontier. Portfolio P maximizes the Sharpe
ratio.
− The CAL tangent to the efficient frontier is the one
with highest slope
− The optimal portfolio is the same for all investors
who are the manager’s clients, regardless of risk
aversion.

Cover
image Thanh Truc – TCNH – UEL
 2.1- 42
Figure 7.10 The Minimum-Variance Frontier of
Risky Assets

Cover
image Thanh Truc – TCNH – UEL
 2.1- 43

Figure 7.11 The Efficient Frontier of Risky

Assets with the Optimal CAL

Cover
image Thanh Truc – TCNH – UEL
 2.1- 44

Figure 7.12 The Efficient Portfolio Set

Cover
image Thanh Truc – TCNH – UEL
 2.1- 45

Figure 7.13 Capital Allocation Lines with

Various Portfolios from the Efficient Set

Cover
image Thanh Truc – TCNH – UEL
 2.1- 46
Table 7.4 Risk Reduction of Equally Weighted Portfolios
in Correlated and Uncorrelated Universes

Cover
image Thanh Truc – TCNH – UEL