(a)

E (R1) = 0.4(-6%) + 0.1(18%) + 0.2(20%) + 0.3(25%)

= 10.9 %
E (R2) = 0.4(12%) + 0.1(14%) + 0.2(16%) + 0.3(20%)
= 15.4 %
σ(R1) = [.4(-6 –10.9)2 + 0.1 (18 –10.9)2 + 0.2 (20 –10.9)2 +
0.3 (25 –10.9)2]½
= 13.98%
σ(R2) = [.4(12 –15.4)2 + 0.1(14 –15.4)2 + 0.2 (16 – 15.4)2 +
0.3 (20 –15.4)2] ½
= 3.35 %
 State of Probability Return on Deviation of Return on Deviation of Product of
nature asset 1 return on asset asset 2 the return on deviation times
1 from its asset 2 from probability
mean its mean

(1) (2) (3) (4) (5) (6) (2)x(4)x(6)

1 0.4 -6% -16.9% 12% -3.4% 22.98

2 0.1 18% 7.1% 14% -1.4% -0.99

3 0.2 20% 9.1% 16% 0.6% 1.09

4 0.3 25% 14.1% 20% 4.6% 19.45

Sum = 42.53

Thus the covariance between the returns of the two assets is 42.53.
(c) The coefficient of correlation between
the returns on assets 1 and 2 is:
Covariance12/ σ1 x σ2
= 42.53/ (13.98 x 3.35)= 0.91
Expected rates of returns on equity stock A, B, C and D can be computed as follows:

A: 8 + 10 – 6 -1+ 9 = 4%
5

B: 10+ 6- 9+4 + 11 = 4.4%

5

C: 9 + 6 + 3 + 5+ 8 = 6.2%
5

D: 10 + 8 + 13 + 7 + 12 = 10.0%
5
(a) Return on portfolio consisting of stock
A = 4%

Return on portfolio consisting of stock A

(b)
and B in equal proportions
= 0.5 (4) + 0.5 (4.4) = 4.2%
(c) Return on portfolio consisting of stocks A,
B and C in equal proportions
= 1/3(4 ) + 1/3(4.4) + 1/3 (6.2)
= 4.87%
(d) Return on portfolio consisting of stocks A,
B, C and D in equal proportions
=0.25(4) + 0.25(4.4) + 0.25(6.2) +0.25(10)
= 6.15%
Grouping Individual Assets into
Portfolios
 The riskiness of a portfolio that is made of different risky
assets is a function of three different factors:
• the riskiness of the individual assets that make up the portfolio
• the relative weights of the assets in the portfolio
• the degree of comovement of returns of the assets making up the
portfolio
 The standard deviation of a two-asset portfolio may be
measured using the Markowitz model:

 p   w   w  2wA wB  A, B A B
2
A
2
A
2
B
2
B
9
10
11
12
13
14
 Portfolio Construction
 Portfolio- combination of stocks, bonds and
money market instruments
 Portfolio construction- process of combining
broad asset classes to yield maximum return with
minimum risk
 Diversification- spread risk by investing in various
instruments
 Traditional approach and Markowitz efficient
frontier approach
15
 Traditional approach
 Evaluate financial plan
 Analysis of constraints- income need
(current and constant, liquidity, safety, time,
tax, temperament)
 Determine objectives
 Selection of portfolio- asset mix
 Risk return analysis
 Diversification- select industry, select
company, determine size of participation 16
Modern Portfolio Theory

17
Portfolio Theory –history
 Modern portfolio theory
(MPT)—or portfolio theory—
was introduced by Harry
Markowitz with his paper
"Portfolio Selection," which
appeared in the 1952 Journal of
Finance. 38 years later, he
shared a Nobel Prize with
Merton Miller and William
Sharpe for what has become a
broad theory for portfolio
selection

18
 Harry Markowitz
 Modern portfolio theory was initiated by
University of Chicago graduate student, Harry
Markowitz in 1952.
 Markowitz showed how the risk of a portfolio is
NOT just the weighted average sum of the risks of
the individual securities…but rather, also a
function of the degree of co movement of the
returns of those individual assets.

19
 Harry Markowitz: Founder of
Portfolio Theory

• The first major publication indicating the importance of

security return correlation in the construction of stock
portfolios

• Markowitz showed that for a given level of expected

return and for a given security universe, knowledge of
the covariance and correlation matrices are required

20
 MPT
 Detailing a mathematics of diversification, he
proposed that investors focus on selecting
portfolios based on their overall risk-reward
characteristics instead of merely compiling
portfolios from securities that each individually
have attractive risk-reward characteristics.
 In a nutshell, investors should select portfolios not
individual securities.

21
 MPT
 With MPT, investors had a tool that they could use
to dramatically reduce the risk of the portfolio
without a significant reduction in the expected
return of the portfolio.
 Markowitz demonstrated that the variance of the
rate of return is a meaningful measure of portfolio
risk under reasonable assumptions
 The portfolio variance formula shows how to
effectively diversify a portfolio
22
 Markowitz Portfolio Theory
Assumptions
 Investors consider each investment alternative as
being presented by a probability distribution of
expected returns over some holding period.
 Investors are risk averse and try to minimise the
risk and maximise return, and their utility curves
demonstrate diminishing marginal utility of
wealth.
 Investors estimate the risk of the portfolio on the
basis of the variability of expected returns.
23
 Markowitz Portfolio Theory
Assumptions
 Investors base decisions solely on expected return
and risk, so their utility curves are a function of
expected return and the expected variance (or
standard deviation) of returns only.
 For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given
level of expected returns, investors prefer less risk
to more risk.

24
 Markowitz Portfolio Theory
 Under these five assumptions, a single asset
or portfolio of assets is efficient if no other
asset or portfolio of assets offers higher
expected return with the same (or lower)
risk, or lower risk with the same (or higher)
expected return.

25
 Terminology
 Security Universe
 Efficient frontier
 Capital market line and the market portfolio
 Corner portfolio

26
 Security Universe
 Thesecurity universe is the collection of all
possible investments
• For some institutions, only certain investments
may be eligible

– E.g., the manager of a small cap stock mutual fund

would not include large cap stocks

27
Grouping Individual Assets into
Portfolios
 The riskiness of a portfolio that is made of different risky
assets is a function of three different factors:
• the riskiness of the individual assets that make up the portfolio
• the relative weights of the assets in the portfolio
• the degree of comovement of returns of the assets making up the
portfolio
 The standard deviation of a two-asset portfolio may be
measured using the Markowitz model:

 p   w   w  2wA wB  A, B A B
2
A
2
A
2
B
2
B
28
 Correlation
 The degree to which the returns of two
stocks co-move is measured by the
correlation coefficient.
 The correlation coefficient between the
returns on two securities will lie in the
range of +1 through - 1.
 +1 is perfect positive correlation.
 -1 is perfect negative correlation.
29
10
 Perfect Negatively Correlated Returns
over Time
Returns
%
A two-asset portfolio
made up of equal parts
of Stock A and B would
be riskless. There
would be no variability
of the portfolios returns
10%
over time.

Returns on Stock A
Returns on Stock B
Returns on Portfolio
1994 1995 30
1996 Time 11
 Markowitz Diversification
 Portfolio Return of AB will always be on
line AB depending on the relative fractions
invested in assets A and B.
 Calculating the risk of the portfolio
• Consider 3 possible relationships between A
and B
– Perfect Positive Correlation
– Zero Correlation
– Perfect Negative Correlation

31
 Perfect Positive Correlation
(continued)
 Therefore, the risk of portfolio AB is simply
the weighted value of the two assets’ .
• In this case:

p = xA2 A2 + xB2 B2 + 2 xAxBABAB

p = .25(.10)2+.25(.20)2+2(.5)(.5)(.10)(.20)

p = .15 or 15%
32
 Graphically

E(Rp)
B
15%

10% Portfolio AB

5% A

5 10 15 20 25 

33
 Perfect Positive Correlation
A and B returns vary in identical pattern.
Hence, there is a linear risk-return
relationship between the two assets.

34
 Zero Correlation
 A’sreturn is completely unrelated to B’s
return. With zero correlation, a substantial
amount of risk reduction can be obtained
through diversification.

35
 Zero Correlation
E(Rp)
B
15%

10% AB
5%
A

10 11.2 20 p
p = .25(.10)2+.25(.20)2
p  11.2% 36
 Negative Correlation
 A’s and B’s returns vary perfectly inversely.
The portfolio variance is always at the
lowest risk level regardless of proportions
in each asset.

37
 Negative Correlation
E(Rp)
B
15%
AB
10%

5%
A

5 10 20 p
p = .25(.10)+.25(.20)+2(.5)(.10)(.20)(-1)

p = .05 or 5%
38
 Negative correlation isn’t essential
 Assets don’t need to be negatively correlated to have
some volatility smoothing.
 As long as the correlation is less than +1 the assets will
be at least a little bit different and at least some volatility
will be cancelled.
 Most real world assets are positively correlated because
most prices are related somehow to important “macro”
factors like global economic growth, interest rates, oil
prices etc.
 Even if negative correlations are rare, substantial
volatility reduction is possible by using assets with a low
positive correlation.
39
 Interference and correlation
If asset B tends to move in the opposite direction to asset A then these
two assets are said to have “negative correlation”, and they can be highly
effective at cancelling out each other’s volatility. If the assets both trend
upwards over the longer term a combination of them will have a return
equal to the average of the two assets’ returns but with substantially
reduced volatility.

Negatively correlated assets cancel the greatest

amount of each other’s volatility.
40
41
 Risk of a Three-asset Portfolio
The data requirements for a three-asset portfolio grows
dramatically if we are using Markowitz Portfolio selection formulae.

We need 3 (three) correlation coefficients between A and B; A and

C; and B and C.
A
ρa,b ρa,c
B C
ρb,c

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A, B A B  2wB wC  B,C B C  2wA wC  A,C A C

42
Risk of a Four-asset Portfolio
The data requirements for a four-asset portfolio grows dramatically
if we are using Markowitz Portfolio selection formulae.

We need 6 correlation coefficients between A and B; A and C; A

and D; B and C; C and D; and B and D.

A
ρa,b ρa,d
ρa,c
B D
ρb,d
ρb,c ρc,d
C

43
 Diversification
 Superfluous or Naive Diversification
• Occurs when the investor diversifies in more
than 20-30 assets. Diversification for
diversification’s sake.
• a. Results in difficulty in managing such a
large portfolio
• b. Increased costs
– Search and transaction

44
 Markowitz Diversification
 This type of diversification considers the
correlation between individual securities. It
is the combination of assets in a portfolio
that are less than perfectly positively
correlated.

45
 Markowitz Diversification
 Although there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
 Therefore, one can reduce total risk (p)
through diversification.
 By considering many assets at various
weights, one can generate the efficient
frontier.
46
 Probability X Y
Return 0.5 7% 13%
0.5 11% 5%
E(R) 9% 9%
Variance 4% 16%
Correlation -1
Covariance -8 47
 Covariance= 0.5(7-9)(13-9)+ 0.5(11-9)(5-9)
 = -4-4= -8
 Correlation= Cov / (SD1*SD2)=-8 / 2*4= -1

 Ifrisk should be zero when ρ is -1, allocation

should be, Wx= σy/ σx + σy
 = 4/6= 0.666
 Wx= 2/3; Wy= 1/3
48
 Minimum risk portfolio
 Wmin= σy2- Cov (rx, ry)
σ x2 + σy2- 2 Cov (rx, ry)
If correlation coefficient is not -1

If correlation coefficient is less than ratio of smaller SD to

larger SD, a combination of 2 securities provides lower SD
than either of security
-1<2/4
49
 Concept of Dominance
 Dominance is a situation in which investors
universally prefer one alternative over
another
• All rational investors will clearly prefer one
alternative
Among all investments with a given return, the
one with the least risk is desirable; or given the
same level of risk, the one with the highest
return is most desirable
50
 Concept of Dominance
A portfolio dominates all others if:
• For its level of expected return, there is no
other portfolio with less risk

• For its level of risk, there is no other portfolio

with a higher expected return

51
 Concept of Dominance
0.14
0.12
Expected Return

0.1
0.08
0.06
0.04
0.02
0
0 0.005 0.01 0.015 0.02 0.025 0.03

Risk
52
 Dominance Principle Example
 Security E(Ri) 
ATW 7% 3%
GAC 7% 4%
YTC 15% 15%
FTR 3% 3%
HTC 8% 12%
ABC 6% 9%
XYZ 11% 10%
 ATW dominates GAC
 ATW dominates FTR

53
Expected Return

4
2 3
1

Standard Deviation

• 2 dominates 1; has a higher return

• 2 dominates 3; has a lower risk
• 4 dominates 3; has a higher return 54
 Diversification
Proposition: portfolio of less than perfectly
correlated assets always offer better risk-
return opportunities than the individual
component assets on their own.
 In the early 1950s, professor Harry
Markowitz was the first to examine the role
and impact of diversification.

55
 Efficient Frontier
 Assume there are 20 assets.
 With the help of the computer, calculate all
possible portfolio combinations.
 The Efficient Frontier will consist of those
portfolios with the highest return given the
same level of risk or minimum risk given
the same return (Dominance Rule)

56
 The various combinations of risk and return
available all fall on a smooth curve.
 This curve is called an investment opportunity set
because it shows the possible combinations of risk
and return available from portfolios of these two
assets.
 A portfolio that offers the highest return for its
level of risk is said to be an efficient portfolio.
 The undesirable portfolios are said to be
dominated or inefficient.
57
 The Efficient Frontier
 The efficient frontier represents that set of
portfolios with the maximum rate of return
for every given level of risk, or the
minimum risk for every level of return
 Frontier will be portfolios of investments
rather than individual securities

58
 2 Risky Assets
Equity 1 Equity 2

Mean 8.75% 21.25%

SD 10.83% 19.80%

Correlation -0.9549

Covariance -204.688

59
 The feasible set of portfolios represents all
portfolios that can be constructed from a given
set of stocks.
 An efficient portfolio is one that offers:
• the most return for a given amount of risk, or
• the least risk for a give amount of return.
 The collection of efficient portfolios is called
the efficient set or efficient frontier.

60
 Portfolio Risk and Return
Share of wealth in Portfolio
w1 w2 ERp p
1 1 0 8.75% 10.83%

2 0.75 0.25 11.88% 3.70%

3 0.5 0.5 15% 5%

4 0 1 21.25% 19.80%

61
Efficient Frontier
25

20
Expected return (%)

15

10

0
0 5 10 15 20 25
Standard deviation
62
 Efficient and Inefficient
Portfolios
ERp
U A
mp* = 10% x
x
x x
L
mp** = 9% x
x x P1
B x x
x x
x
x x
P1 x
x
x C

p** p* p

63
Min-Variance opportunity set with
E(r ) the Many risky assets
p

Efficient
frontier

Individual risky assets

Min-variance opp. set

σp 64
Min-Variance opportunity set
Min-Variance Opportunity set – the locus of risk & return
combinations offered by portfolios of risky assets that yields
E(rp) the minimum variance for a given rate of return

σp
65
66
 Efficient Frontier
Expected Return
100% investment in security
No points plot above with highest E(R)
the line

Points below the efficient

All portfolios frontier are dominated
on the line
are efficient
100% investment in minimum
variance portfolio

Standard Deviation

67
 Expected
Portfolio
Return, rp Efficient Set

Feasible Set

Risk, p
Feasible and Efficient Portfolios
68
 Correlation is -1

69
70
 If risk should be zero when ρ is -1,
allocation should be, Wx= σy/ σx + σy

 Wmin= σy2- Cov (rx, ry)

σ x2 + σy2- 2 Cov (rx, ry)

71
 1. minimum risk portfolio, weight for
Dew=30/50= 0.6; raindrop=0.4
 2. minimum risk portfolio, weight for
Rock= 625-275/ (484+625)-550=
350/559=0.626
 Reed=0.374

72
73
Calculate correlation
coefficient; if it is high, don’t
combine.
74
75
76
 The Efficient Frontier and
Investor Utility
 An individual investor’s utility curve specifies the
trade-offs he/she is willing to make between
expected return and risk
 Each utility curve represent equal utility; curves
higher and to the left represent greater utility
(more return with lower risk)
 The interaction of the individual’s utility and the
efficient frontier should jointly determine portfolio
selection
77
 The Efficient Frontier and
Investor Utility
 The optimal portfolio has the highest utility
for a given investor
 It lies at the point of tangency between the
efficient frontier and the utility curve with
the highest possible utility

78
 Indifference curves reflect an investor’s attitude toward
risk as reflected in his or her risk/return tradeoff
function.
 They differ among investors because of differences in
risk aversion.
 An investor’s optimal portfolio is defined by the
tangency point between the efficient set and the
investor’s indifference curve.

79
 Individual’s decision making with 2
risky assets, no risk-free asset
E(rp)
U’’’ U’’ U’

Efficient set
S
P
Q
Less
risk-averse
More investor
risk-averse
investor
σp 80
81
82
83
 Introducing risk-free assets
 Assume borrowing rate = lending rate
 Then the investment opp. set will involve any
straight line from the point of risk-free assets to
any risky portfolio on the min-variance opp. set
 However, only one line will be chosen because it
dominates all the other possible lines.
 The dominating line = linear efficient set
 The line through risk-free asset point tangent to
the min-variance opp. set.
 The tangency point = portfolio M (the market)
84
 Efficient Frontier
 Borrowing and lending investment funds at
Rf to expand the Efficient Frontier.
• a. We keep part of our funds in a saving
account
– Lending, OR
• b. We can borrow funds for a greater
investment in the market portfolio

85
 Borrowing Possibilities
 Investors are no longer restricted to their initial
wealth when investing in risky assets.
 Investors can:
 Buy stock on margin
 Borrow at the risk-free rate
 Borrowing additional funds for investment
purposes allows investors to seek higher expected
returns while assuming more risk
87
 Risk-Free Lending
 The expected return on a combined portfolio of
risk-free and risky assets would be:

E( Rp )  wrf Rf  (1  wrf ) E( Rx )
 Since the of risk-free assets is equal to 0 than
the  of the portfolio would be:

 p  (1  wRF ) x
 Rf 20% 0
Ri 12.5% 15

Rp= 12.5*0.5 + 20*0.5= 16.25% if equal weight

Rp=0 +20%=20% no Rf
Rp= (12.5*-0.5)+ 20*1.5= 23.75% if borrow 50% and
invest 150% in risky asset
Variance
Weight in Ri Portfolio risk
0.5 7.5 (=0.5*0+0.5*15)
1 15
1.5 22.5 (=1.5*15) 89
90
 Efficient Frontier
Expected Return
C

Rf
A

Standard Deviation
91
 Borrowing and Lending
Possibilities
The Markowitz Efficient Frontier and the Possibilities
Resulting from Introducing a Risk-Free Asset
 Efficient Frontier
 By using RF, the Efficient Frontier is now
dominated by the capital market line
(CML).
 Each portfolio on the capital market line
dominates all portfolios on the Efficient
Frontier at every point except M.

93
 Optimal risky portfolio
 Wx= (Rx-Rf)* y 2 - (Ry-Rf)*Cov xy

(Rx-Rf)*  y 2+ (Ry-Rf)* x2 -

[(Rx-Rf)+(Ry-Rf)*cov xy]

94
 Capital Market Line (CML)

 Depicts the equilibrium conditions that

prevail in the market for efficient portfolios
consisting of the optimal portfolio of risk-
free and risky assets

 All combinations of assets are bound by the

CML and at equilibrium all investors end up
with efficient portfolios
 Capital Market Line (CML)
 Slope of the CML is the market price of risk for
efficient portfolios

 Slope of the CML = E ( RM )  RF

M
 The CML is always upward sloping because the
price of risk is always positive
Capital Market Line (CML)
The CML and the Components of Its Slope
 Efficient Frontier
CML
E(Rp) Borrowing B
Efficient
Frontier
Lending
M

RF A

p
Portfolio A: 80% of funds in RF, 20% of funds in M
Portfolio B: 80% of funds borrowed to buy more of M,
100% or own funds to buy M
98
 The Portfolio Investment
CML
E(Rp)
Efficient
Frontier
M

Mutual Fund Portfolios

RF with a cash position

p
Investors’ indifference curves are based on their degree
of risk aversion and investment objectives and goals. 99
Expected
Capital Market LineN
rate of
return %

Rm M

Rf

Risk (sd)
100
Individual’s decision making with 2
risky assets, with risk-free asset
E(rp) CML

B
Q
M

rf

σp 101
The Security Market Line (SML)
 The SML is the key contribution of the CAPM to
asset pricing theory
 The SML equation is:

E ( Ri )  RF  E ( RM )  RF  i
 The SML represents the trade-off between
systematic (as measured by beta) and expected
returns for all assets
The Security Market Line (SML)
 Investor Differences and
Portfolio Selection
Arelatively more conservative investor
would perhaps choose Portfolio A
• On the efficient frontier and on the highest
attainable utility curve
A relatively more aggressive investor would
perhaps choose Portfolio B
• On the efficient frontier and on the highest
attainable utility curve
104
 Beta
 Beta – the measure of the systematic risk of a
security that cannot be avoided through
diversification
 Beta measures a security’s volatility in price
relative to a benchmark
• Beta – risk-free asset = 0
– market portfolio = 1.0
• Stocks -  betas are higher risk securities
 betas are lower risk securities
 Portfolio Betas

 Are weighted averages of the betas for

individual securities in the portfolio

 The equation is:

 p  w11  w2  2  ...wn  n
Over- and Undervalued Securities

• Securities plotted above the SML are

undervalued because they offer more
expected return given its beta
• Securities plotted below the SML are
overvalued because they offer less expected
return given its beta
 Summary
1. An efficient portfolio has the highest expected
return for a given level of risk or the lowest level
of risk for a given level of expected return.
2. Capital market theory, based on the concept of
efficient diversification, describes the pricing of
capital assets in the market place. The new
efficient frontier is called the capital market line
(CML), and its slope indicates the equilibrium
price of risk in the market.
 Summary
3. Based on the separation of risk into its
systematic and non-systematic components, the
security market line (SML) can be constructed
for individual securities (and portfolios).
4. Beta is a relative measure of risk, which
indicates the volatility of a stock relative to a
market index. While all betas change through
time, betas for large portfolios are much more
stable than those for individuals stocks
 Implication
 Allan investor needs to know is the
combination of assets that makes up
portfolio M as well as risk-free asset. This is
true for any investor, regardless of his
degree of risk aversion.

110
A simple rule of portfolio construction
 If there are two assets with roughly equal expected returns,
putting 50% into each is a way to hedge one’s bets (and spread
the risk) without compromising expected return.
 The lower the correlation of those assets, the more the risk will
be reduced while not reducing expected returns at all.
 Actually, this holds true with a greater number of investments as
well.
 For example, if there are five equally attractive assets, invest
one fifth in each.

111
 Corner Portfolio
A corner portfolio occurs every time a new
security enters an efficient portfolio or an
old security leaves
• Moving along the risky efficient frontier from
right to left, securities are added and deleted
until you arrive at the minimum variance
portfolio

112
Year Stock A Stock B Stock C
1 8 10 9
2 10 6 6
3 -6 -9 3

Calculate portfolio return of 2 stocks at a time

Portfolio return of 3 stocks
Assume equal weights

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Year Stock A Stock B
1 12 14
2 18 12

Calculate portfolio return and risk, weight of A 60%, weight of B 40%.

Identify minimum risk portfolio.

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