Lecture 5

Portfolio Analyses and

the Markowitz Portfolio Selection Model
 Recap from Last Lecture
• Utility Indifference

• Risk & Return for Security Portfolios

• Mean-Variance Criterion

• Complete Portfolio Return & Risk

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 Outline of Today’s Lecture
• Risk Tolerance & Portfolio Choice

• Portfolios of Two Risky Assets

• Minimum Variance & Optimal Portfolio

• Optimal Complete Portfolio

3
Risk Tolerance & Asset Allocation
• Given that:
E(rC) = rf + y[E(rP) – rf]
σC = yσP
UC = E[rC] – ½AσC2

• UC = rf + y[E(rP) – rf] – ½A y2σP2

• What is the Optimal Asset Allocation, y* = ?

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 Finding the Optimal Allocation
• How? Maximize Investor Utility (A=4)
Max UC = rf + y[E(rP) – rf] – ½A y2σP2

• Find y at ∂UC/∂y = 0 (First order condition)

i.e., [E(rP) – rf] – AyσP2 = 0

• Hence: y*= [E(rP) – rf] ÷ AσP2

• Numerically: y* = [0.15 – 0.07] ÷ 4(0.22)2
y* = 0.08 ÷ 4(0.0484) = 41.32%
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 Optimal Allocation: Graphically
UC = rf + y[E(rP) – rf] – ½A y2σP2
10%

U(y*)
8.65% •
C*
8%
Utility
U(y)
6%

4%
y* = [E(rP) – rf] ÷ AσP2
U(y*) = rf + y*[E(rP) – rf] – ½A y*2σP2
2%

y* = 0.4132 y
0%
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
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 Optimal Allocation: Graphically
Return The Optimal Portfolio, C*, Utility Indifference
E(r) Curves (A=4)
involves y* = 41.32%. Capital
Its expected return, Allocation
E(rC*) = 10.28% and Line (CAL)
standard deviation,
σC* = 9.02%
E(rP)
•
15% P with utility of 8.65%
E(rC*)
•
10.28% C*
rf •
7% •F Suboptimal Utility, U = 4.653%
Optimal Utility, U = 8.653%
Unfeasible Utility, U = 12.653% Risk
σC* = 9.02% σP = 22% σ
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 Some more details about CAL
• Can y* be smaller than zero?
• No, because the expected return of the complete portfolio
would be lower than the riskfree rate
• What is the optimal complete portfolio if the borrowing rate is
higher than the riskfree rate (rb > rf)?
• Use rf to solve for y* first
Case 1: Unlevered (y* ≤ 1): not affected
Case 2: Buying on margin (y* > 1): replace rf with rb and solve
for a new y* (call this y**)
• If y** > 1 you are fine (you buy on margin, borrowing at rb)
• But what if y* > 1 and y** < 1? That is, you want to buy on
margin if borrowing at rf (but can’t), and you don’t want to
buy on margin if borrowing at rb 8
 Outline of Today’s Lecture
 Risk Tolerance & Portfolio Choice

• Portfolios of Two Risky Assets

• Minimum Variance & Optimal Portfolio

• Optimal Complete Portfolio

9
 Allocation Decision Levels

Complete Portfolio

Risky Assets Security

Optimal Selection
Weights
Stocks Optimal
between
Weights
Risky &
Bonds within
Riskfree Risky
Assets Assets
(Chapter 6) Others (Chapter 7)
Asset Riskfree Assets
Allocation
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Portfolios of Two Risky Assets
• Say you can invest in two risky assets:

A bond fund (D) and a stock fund (E) with the

following annual expected return and risk
(standard deviation):

D E
E(r ) 0.08 0.13
σ 0.12 0.20
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 Portfolios of Two Risky Assets
wD = bond fund weight, with E(rD) and σD2
wE = stock fund weight, with E(rE) and σE2
σDE = covariance between these funds, thus:

E(rP) = wDE(rD) + wEE(rE)

σP2 = wD2σD2 + wE2σE2 + 2wDwEσDE
or: σP = [wD2σD2 + wE2σE2 + 2wDwEρDEσDσE]½
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 Portfolio Risk vs. Security Risk

• Let’s see how expected portfolio return, E(r),

and risk, σP, behave as we vary the portfolio
weights (wD, wE) from 0 to 1
i.e., (all stock/no bond → all bond/no stock)

• Consider correlations of ρDE = 1, 0.3, 0, -1

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 Portfolio Risk vs. Security Risk
(wD2σD2 + wE2σE2 + 2wDwE ρDE σDσE )½ ρ DE ρ DE ρ DE ρ DE
1 0.3 0 -1
wD wE E(r P) σP σP σP σP
All E/No D 0.00 1.00 13% 20% 20% 20% 20%
0.10 0.90 13% 19% 18% 18% 17%
0.20 0.80 12% 18% 17% 16% 14%
0.30 0.70 12% 18% 15% 14% 10%
0.40 0.60 11% 17% 14% 13% 7%
0.50 0.50 11% 16% 13% 12% 4%
0.60 0.40 10% 15% 12% 11% 1%
0.70 0.30 10% 14% 12% 10% 2%
0.80 0.20 9% 14% 11% 10% 6%
0.90 0.10 9% 13% 12% 11% 9%
All D/No E 1.00 0.00 8% 12% 12% 12% 12%
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 Portfolio Risk vs. Security Risk
35% ρ = -1
(wD2σD2 + wE2σE2
σP Portfolio
30% Standard
+ 2wDwE ρDE σDσE )½ ρ=0
Deviation ρ = 0.3

25%
ρ=1

20% •E

15%

• Minimum Variance
11.5% D
10.3% 10%

5%
Weight in
Stock Fund
0.0% 0%
-0.50 -0.25 0.00 0.25 0.50 0.75 1.00 1.25 1.50 wE
0.18 0.26 0.38 15
 Outline of Today’s Lecture
 Risk Tolerance & Portfolio Choice

 Portfolios of Two Risky Assets

• Minimum Variance & Optimal Risky Portfolio

• Optimal Complete Portfolio

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 Minimum Variance Portfolio

σP2 = wD2σD2 + wE2σE2 + 2wDwEσDE

σP2 = w2σD2 + (1 – w)2σE2 + 2w(1 – w)σDE

Min σP2 by finding w such that ∂σP2/∂ w = 0

 w = (σE2 – σDE) ÷ (σD2 + σE2 – 2σDE)

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Portfolio Return vs. Portfolio Risk
14%
Portfolio
E(rP) Expected
13%
Return
•E
12%
ρ = -1
11%
ρ=0 Portfolio
10% ρ=1
ρ = 0.3 Opportunity Set
9%
= All Possible
Risky Portfolios
D (for ρ = 0.3)
8% •
7%

6%

σP Portfolio
5% Standard
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Deviation

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 Find Optimal Risky Portfolio, P*
• Find the Optimal Risky
14%
Portfolio Portfolio, P*, with Highest
E(rP) Expected CAL(P*)
13%
Return
Reward-to-Variability, SP •E
12%
CAL(A)
11.0%11% •P* (Not
optimal)
10% SP* = [E(rP*) – rf] ÷ σP*
= (11-5)/14.2 = 0.42
A
8.9% 9% •
SP* D Portfolio
8% •
Minimum Opportunity
7% Riskfree Variance Set
Portfolio Portfolio
6% SA = [E(rA) – rf] ÷ σA

•
F = (8.9-5)/11.45 = 0.34 σP Portfolio
5% Standard
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Deviation
11.45% 14.20%
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 Optimal Risky Portfolio, P*
Portfolio
E(rP) Expected CAL(P*)
Return
•E

•P* Efficient
Frontier
(Above A)
A
•
D Portfolio
•
Minimum Opportunity
Riskfree Variance Set
Portfolio Portfolio

•
F σP Portfolio
Standard
Deviation
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 Optimal Risky Portfolio Weights

• Maxw Sp = [E(rp) – rf] ÷ σp such that Σwi = 1

• First Order Condition:

Let rDf ≡ E(rD) – rf and rEf ≡ E(rE) – rf

wD* = [rDf σE2 – rEf σDE ] ÷

[ rDf σE2 + rEf σD2 – (rDf + rEf ) σDE ]

wE* = 1 – wD*

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Optimal Risky Portfolio Weights

• rf = 5%, E(rD) = 8%, E(rE) = 13%

σD = 12%, σE = 20%, σDE = 0.72%

• wD* = [0.03(0.0400) – 0.08(0.0072)] ÷

[ 0.0012 + 0.08(0.0144) – 0.11( 0.0072)]
wD* = 40% in bond, and wE* = 60% in stock

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 Outline of Today’s Lecture
 Risk Tolerance & Portfolio Choice

 Portfolios of Two Risky Assets

 Minimum Variance & Optimal Risky Portfolio

• Optimal Complete Portfolio

23
 Optimal Complete Portfolio, C*
Utility Indifference Curve (A = 4)
14%
Portfolio
E(rP) Expected CAL(P*)
13%
Return
•E
12%
Optimal
11% Complete •P*
Optimal Risky
Portfolio
10% Portfolio:
C*
9.46% • wD = 40% in bond
9%
wE = 60% in stock
D
8% •
7%

6%
F
•
σP Portfolio
5% Standard
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Deviation
10.56%
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 Reference
• Investments book
• Chapters 7

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