PORTFOLIO THEORY

A portfolio is a combination of various securities. No investor holds a single asset. Portfolio

theory is a mathematical framework for assembling a portfolio of assets such that the expected
return is maximised for a given level of risk. It is a theory on how risk averse investors can
construct a portfolio to optimise / maximise expected return based on a given level of risk. The
goal of portfolio selection is the construction of portfolios that maximize expected returns
consistent with individually acceptable levels of risk.

Using both historical data and investor expectations of future returns, portfolio theory uses
modelling techniques to quantify “expected portfolio returns” and “acceptable levels of
portfolio risk,” and provides methods to select an optimal portfolio. The theory allows
investment managers to quantify the investment risk and expected return of a portfolio,
providing a scientific and objective complement to the subjective art of investment
management.

More importantly, whereas at one time the focus of portfolio management used to be the risk
of individual assets, the theory of portfolio selection has shifted the focus to the risk of the
entire portfolio. The key insight of portfolio theory is that an asset’s risk and return should not
be assessed singularly, but by how it contributes to the portfolio’s overall risk and return. This
theory shows that it is possible to combine risky assets and produce a portfolio whose expected
return reflects its components, but with the potential for considerably lower risk. In other
words, it is possible to construct a portfolio whose risk is smaller than the sum of all its
individual parts. The theory is built on the concept of diversification: that is; an investor can
reduce portfolio risk by simply holding a combination of assets who returns are not correlated
(that is, assets whose returns do not move together).

Assumptions of Portfolio Theory

 Investors are rational wealth-seeking risk-averters, ie given risk they will maximize
return, and given return they will minimize risk.
 Investors are influenced solely by expected return and standard deviation of securities or
portfolios.
 Investors have homogeneous expectations of returns and risk of securities and portfolios
there from.
 Investors have a single period investment horizon.
 A risk-free asset exists that can be invested in or short sold by all investors
Some Basic Concepts
Portfolio theory draws on concepts from two fields: financial economic theory and
probability and statistical theory. So we will consider some few concepts associated with
portfolio theory

Investment Opportunity set

Because of the existence of risk, there is no single payoff. Rather, there are various choices as
to investment available to an investor. An opportunity set refers to a set of outcomes, each with
associated probability of occurrence called a frequency function or return distribution.
The frequency distribution has two key attributes which are expected return (measure of central
tendency) and risk (measure of risk or dispersion around the mean). The opportunity set
therefore represents the various risk- return combinations which are available to an investor.
This risk depends on whether the returns on individual assets tend to move together or whether
some assets yield good returns while others give bad returns. Under risk the outcome of any
action cannot be known with certainty. Outcomes are usually represented by a frequency
function.

Utility and Indifference curves

In life there are many situations where entities (i.e., individuals and firms) face two or
more choices. The economic “theory of choice” uses the concept of a utility function
developed by von Neumann and Morgenstern (1944), to describe the way entities make
decisions when faced with a set of choices.

A utility function assigns a (numeric) value to all possible choices faced by the entity.
The higher the value of a particular choice, the greater the utility derived from that choice.
The choice that is selected is the one that results in the maximum utility given a set of
(budget) constraints faced by the entity.

In portfolio theory too, entities are faced with a set of choices. Different portfolios have
different levels of expected return and risk. Also, the higher the level of expected return,
the larger the risk. Entities are faced with the decision of choosing a portfolio from the set
of all possible risk-return combinations: where return is a desirable that increases the level
of utility, and risk is an undesirable that decreases the level of utility. Therefore, entities
obtain different levels of utility from different risk-return combinations.

The utility obtained from any possible risk-return combination is expressed by the utility
function. Put simply, the utility function expresses the preferences of entities over
perceived risk and expected return combinations. A utility function can be expressed in
graphical form by a set of indifference curves. Figure 1 shows indifference curves labelled
u1, u2, and u3. By convention, the horizontal axis measures risk and the vertical axis
measures expected return.
 Figure 1: Indifference Curves

Each curve represents a set of portfolios with different combinations of risk and return. All the
points on a given indifference curve indicate combinations of risk and expected return that will
give the same level of utility to a given investor. For example, on utility curve u1, there are two
points u and ú, with u having a higher expected return than ú, but also having a higher risk.
Because the two points lie on the same indifference curve, the investor has an equal preference
for (or is indifferent to) the two points, or, for that matter, any point on the curve.
The (positive) slope of an indifference curve reflects the fact that, to obtain the same level of
utility, the investor requires a higher expected return in order to accept higher risk. For the three
indifference curves shown in Figure 1, the utility the investor receives is greater the further the
indifference curve is from the horizontal axis, because that curve represents a higher level of
return at every level of risk. Thus, for the three indifference curves shown in the exhibit, u3 has
the highest utility and u1 the lowest.

Measurement of Return and Risk

As already explained previously, no investor holds a single asset and because of the existence
of risk there is no single payoff, rather there is set of choices from which an investor can choose
from. Therefore, it is important to compute the expected returns and risk associated with those
returns. Of concern is; how one can compute the expected return and risk of a portfolio – given
the attributes of the individual assets that comprise the portfolio?
Rates of Returns
A key measure of investors’ success is the rate at which their funds have grown during the
investment period

Historical Rates of Return

They are used by investors to estimate the expected returns.

The Holding Period Return (HPR)

HPR is the rate of return over a given investment period. The total holding-period return (HPR)
of a share of stock depends on the increase (or decrease) in the price of the share over the
investment period as well as on any dividend income the share has provided. The rate of return
is defined as dollars earned over the investment period (price appreciation as well as dividends)
per dollar invested.

𝐸𝑛𝑑 𝑉𝑎𝑙𝑢𝑒
𝐻𝑃𝑅 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

Where end value is Beginning Price + Dividends and Beginning Value is same as beginning
price. Therefore, HPR can also be written as:

𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 + 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑

HPR =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

Exercise

Suppose you are considering investing some of your money, in a stock market index fund. The
price of a share in the fund is currently $100, and your time horizon is one year. You expect
the cash dividend during the year to be $4 and the ending price to be $110. Calculate the HPR.

This definition of the HPR assumes that the dividend is paid at the end of the holding period.
If dividends are received earlier, the definition ignores reinvestment income between the
receipt of the dividend and the end of the holding period. Recall also that the percentage return
from dividends is called the dividend yield, and so the dividend yield plus the capital gains
yield equals the HPR.

Arithmetic Mean/Average
Arithmetic mean is the sum of returns in each period divided by the number of periods.
𝛴 𝐻𝑃𝑌
𝐴𝑀 = 𝑛

Where: ΣHPY = the sum of annual holding period yields and n is the number of periods
Example
Consider the following information about a particular investment,

Period HPY
1 0.15
2 0.2
3 -0.2

Determine the arithmetic mean

Solution

AM uses more data than the HPR(Y), therefore, it provides a better understanding of
investment performance over a long period of time. The disadvantage is that is ignores the
effect of compounded returns.

Geometric Mean/Average

The geometric mean (GM), is the nth root of the product of the HPRs for n years minus one.
The geometric return also is called a time-weighted average return.

GM = [π (1+HPR) ]1/n-1
This formula can be expanded as follows:

[(1 + 𝐻𝑃𝑅1 ) + (1 + 𝐻𝑃𝑅2 ) + ⋯ … … … + (1 +)𝐻𝑃𝑅𝑛 ]1/𝑛 − 1

Example

You are given the following historical returns

Year 1 =15%, Year 2 =20% and Year 3 =-20%. Calculate the geometric mean.

Solution

Investors are typically concerned with long-term performance when comparing alternative
investments. GM is considered a superior measure of the long-term mean rate of return
because it indicates the compound annual rate of return based on the ending value of the
investment versus its beginning value.
Historical Return of Portfolio

The actual return on a portfolio of assets over some specific time period is a weighted average
of the returns on the individual assets in the portfolio and is given by

𝑅𝑝 = 𝑊1 𝑅1 + 𝑊2 𝑅2 … … … . +𝑊𝑛 𝑊𝑛

Where Rp is rate of return of the portfolio over the period

𝑊𝑛 = the weight of asset n in the portfolio (i.e. market value of asset n as a proportion of the
market value of the total portfolio) at the beginning of the period
𝑅1 = the rate of return of asset n over the period.
n= number of assets in the portfolio.
Example

Consider the following portfolio consisting of three assets

Asset Market Value at the Beginning of Rates of Return over the Holding
Holding Period Period
1 6 million 12%
2 8 million 10%
3 11 million 5%

What is the holding period return of the portfolio?

Solution

NB: Although analysis of historical returns is useful; selecting investments requires one to
predict the rate of return they expect to prevail in the future holding period.

Expected Return
Expected return is the return that an individual expects a stock to earn over the next period.
When analysing securities, we estimate possible HPRs, devise a list of possible economic
outcomes or scenarios and specify both the likelihood (i.e., the probability) of each scenario
and the HPY the asset will realize in that scenario. The list of possible HPRs with associated
probabilities is called the probability distribution of HPYs Therefore, this approach is called
scenario and probability distribution analysis.
Expected Return of a Single Asset

The expected return from an investment is therefore defined as

𝑛

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 = ∑(𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦) 𝑥(𝑃𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑅𝑒𝑡𝑢𝑟𝑛)

𝑖=1

𝐸(𝑅𝑖 ) = 𝑃1 𝑅1 + 𝑃2 𝑃2 +. . . +𝑃𝑛 𝑅𝑛

= 𝐸 (𝑅𝑖 ) = ∑(𝑃𝑖 )(𝑅𝑖 )

𝑖=1

Pi = probability of observing the ith rate of return.

Ri = the ith rate of return
N = number of possible outcomes

NB: Where probabilities are not given, assume equal chances for all outcomes.

Example

Calculate the expected return of an asset that offers the following possible rates of returns.

Economic Condition Possible Rate of Return Probability

(%)
Horrid 8 0.35
Bad 10 0.30
Average 12 0.20
Good 14 0.15

Solution

E (Ri) =(8 x 0.35) +(10 x 0.3) + (12 x 0.2) +(14 x0.15)

= 2.8 +3 +2.4 +2.1
=10.3%
Expected Return of a Portfolio of Assets
Portfolio return is simply a weighted average of the expected returns on the individual
securities/assets in the portfolio as shown below:

𝐸(𝑅𝑝 ) = 𝑊1 𝐸(𝑅1 ) + 𝑊2 𝐸(𝑅2 )+. . . +𝑊𝑛 𝐸(𝑅𝑛 )

Where

Wn the weight or proportion of security n in the portfolio and

E (Rn) is the expected return of security n
𝑛

𝐸 (𝑅𝑖 ) = ∑(𝑊𝑖 )(𝑅𝑖 )

𝑖=1

Example

Consider a portfolio consisting of assets A and B. E (RA) is 22% while E (RB) is 12%. Assume
an investor has $1 000 and decides to invest $700 of his wealth in asset A and the remainder in
asset B. Calculate E[R] of the portfolio.

Solution

WA = 700/1000 =0.7

WB = 1-WA = 1-0.7 =0.3

Therefore, the expected portfolio return will be

E (Rp) =0.7(22) + 0.3(12)

=15.4 +3.6
= 19%

Measurement of risk
The expected rates of return are uncertain; they are just expectations. Because this is only an
expectation, it may be either higher or lower than the actual return. For instance, the investor
may estimate an expected return of 10% under normal conditions. However, they have to admit
that in bad market conditions, this return may be as low as -15% or be as high as 20% in good
market conditions. The larger the range of possible outcomes and economic scenarios, the
greater the uncertainty regarding the actual return. The uncertainty surrounding the outcomes
(returns) is referred to risk. It can also be defined as the potential for variability in returns. It
is important to measure the risks associated with the expected rates of returns.

Measures of Risk

There are many measures of risk but the most common are variance of returns and standard
deviation. These measure the dispersion of returns around the expected value. The greater the
dispersion, the greater the uncertainty.
The Risk of a Single Asset

Variance = 𝜎𝑖 = 𝑃𝑖 [𝑅𝑖 − 𝐸(𝑅𝑖 )]2

Standard Deviation = 𝜎𝑖 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒

Example
Use the information use to calculate return of a single asset, calculate the variance and standard
deviation.

Solution
Ri E(Ri) Ri –E(Ri) [Ri-E(Ri)]2 Pi [Ri-E(Ri)]2 Pi
8 10.3 8-10.3 = -2.3 2.32 =5.29 0.35 1.8515
10 10.3 10-10.3 =-0.3 -0.32=0.09 0.3 0.027
12 10.3 12-10.3 =1.7 1.72 =2.89 0.2 0.578
14 10.3 14-10.3 =3.7 3.72=13.69 0.15 2.0535
2 4.51

Standard Deviation = 4.51 = 2.12%

Why do we have to square the deviations?

We square the deviations because if we did not, negative deviations would offset positive
deviations, with the result that the expected deviation from the mean return would necessarily
be zero. Squared deviations are necessarily positive. Of course, squaring (a nonlinear
transformation) exaggerates large (positive or negative) deviations and relatively deemphasizes
small deviations. To give the measure of risk the same dimension as expected return (%), we
use the standard deviation.
A potential drawback to the use of variance and standard deviation as measures of risk is that
they treat positive deviations and negative deviations from the expected return symmetrically.
In practice, of course, investors welcome positive surprises, and a natural measure of risk would
focus only on bad outcomes. However, if the distribution of returns is symmetric (meaning that
the likelihood of negative surprises is roughly equal to the probability of positive surprises of
the same magnitude), then standard deviation will approximate risk measures that concentrate
solely on negative deviations.

The Coefficient of Variation (CV)

In some cases, an unadjusted variance or standard deviation can be misleading. If conditions
for two or more investment alternatives are not similar, that is, if there are major differences in
the expected rates of return— it is necessary to use a measure of relative variability to indicate
risk per unit of expected return. A widely used relative measure of risk is the coefficient of
variation (CV), calculated as follows:
𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏𝒔
𝑪𝒐𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒕 𝒐𝒇 𝑽𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏 =
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏𝒔
𝝈
= 𝑬(𝑹𝒊
𝒊)

CV is a measure of relative variability and risk is used by financial analysts to compare

alternative investments with widely different rates of return and standard deviations of returns.

Example
Consider the two following investments and evaluate their attractiveness

Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07

CVA =0.05/0.07 =0.714

CVB = 0.07/0.12 =0.587

Comparing absolute measures of risk, investment B appears to be riskier because it has a

standard deviation of 7 percent versus 5 percent for investment A. In contrast, the CV figures
show that investment B has less relative variability or lower risk per unit of expected return
because it has a substantially higher expected rate of return:

RISK OF A PORTFOLIO

Risk of a portfolio is not a simple weighted average of risks associated with individual assets
comprising it, but a product of many factors including the weight of each asset in the portfolio,
covariance of assets, correlation of assets, risk associated with each asset etc. This means the
riskiness inherent in any single asset held in a portfolio is different from the riskiness of that
asset held in isolation.

Covariance
In forming a portfolio, the investor’s aim is to diversify or spread risk. In order for this to be
effective, the assets comprising the portfolio should be of different types or industries or
classes. This is necessary so that returns of assets will move differently, which a requirement
for effective risk is spreading. To realize this, the covariance of each pair of assets should be
determined before forming the portfolio.

Covariance is a measure of the degree to which two variables move together over time. A
positive covariance implies that the rates of return for the investments move in the same
direction over time while a negative covariance implies movement in different directions over
time. A covariance of zero implies independence in movement of returns of two assets. Given
asset X and Y, covariance can be calculated as follows:

𝑪𝒐𝒗𝒙𝒚 = 𝝈𝒙𝒚 = ∑[{𝑿𝒊 − 𝑬(𝑿𝒊 )}{𝒀𝒊 − 𝑬(𝒀𝒊 )}] 𝑷𝒊

Example

From the following information, calculate COVxy

Event Probability Xi Yi
A 0.25 29 20
B 0.50 20 24
C 0.25 15 32

Solution

First step is to determine E (Xi) and E (Yi)

E (Xi) = (0.25x29) + (0.5x20) + (0.25x15) = 21%

E (Yi) = 0.25x20) + (0.5x24) + (0.25x32) = 25%

Step 2 is to find the covariance

Probability Xi – E(Xi ) Yi – E(Yi ) Pi [Xi – E(Xi ][Yi – E(Yi )]
0.25 29-21 = 8 20-25 = -5 0.25x8x-5 = -10
0.50 20-21 = -1 24-25 = -1 0.5x-1x-1 = 0.5
0.25 15-21 = -6 32-25 = 7 0.25x-6x7 = -10.5
COVxy = -20

Thus the returns of X and Y move in opposite directions.

Correlation Coefficient
Is an adjusted covariance in that it relates covariance between two assets to the  of each asset.
It is therefore a relative measure of co-movement as opposed to an absolute measure (COV).

𝑪𝑶𝑽𝒙𝒚 𝝈𝒙𝒚
Correlation Coefficient between X and Y = 𝝆𝒙𝒚 = =
𝝈𝒙 𝝈𝒚 𝝈𝒙 𝝈𝒚

Therefore, 𝝈𝒙𝒚 = 𝝆𝒙𝒚 𝝈𝒙 𝝈𝒚

Example

Given that x= 0.134; y= 0.1 and xy = 0.011, find the correlation coefficient between X
and Y.
Solution

Correlation coefficient can vary only in the range –1 to +1. xy = -1 indicates a perfect negative
relationship between two assets. xy = +1 indicates perfect positive relationship between two
assets. xy = 0 indicates no relationship at all.

Risk of Two-Asset Portfolio

The variance of a two asset portfolio is given by the following formula:

𝜎𝑝2 = 𝑊𝐴 2 𝜎𝐴 2 + 𝑊𝐵 2 𝜎𝐵 2 + 2𝑊𝐴 𝑊𝐵 𝜎𝐴𝐵

OR

𝜎𝑝2 = 𝑊𝐴 2 𝜎𝐴 2 + 𝑊𝐵 2 𝜎𝐵 2 + 2𝑊𝐴 𝑊𝐵 𝜎𝐴 𝜎𝐵 𝜌𝐴𝐵

The standard deviation of a portfolio = 𝜎𝑝 = √𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒

Risk of a portfolio depends on both the variances of individual assets and covariance between
them. A positive covariance between assets increases risk whereas negative covariance reduces
risk. In the latter case, diversification takes place.

Example

Calculate the expected return, variance and standard deviation of a portfolio comprising assets
X and Y (in the preceding example). Value of total portfolio is $1000 of which $800 is invested
in asset X.

Solution

Risk of a 3-Asset Portfolio

The variance of a three asset portfolio is given by the following formula
2
𝜎𝑝2 = 𝑊𝐴 𝜎𝐴 2 + 𝑊𝐵 2 𝜎𝐵 2 + 𝑊𝐶 2 𝜎𝐶 2 + 2𝑊𝐴 𝑊𝐵 𝜎𝐴𝐵 + 2𝑊𝐴 𝑊𝐶 𝜎𝐴𝐶 + 2𝑊𝐵 𝑊𝐶 𝜎𝐵𝐶

Example
A portfolio consists of 3 assets, A, B and C. The portfolio proportions are 0.25; 0.25 and 0.5
for assets A, B and C respectively. Variances of the returns on individual assets are 16; 25 and
36 for assets A, B and C respectively. Correlation coefficients between the returns are 𝜌𝐴𝐵 =
0.5; 𝜌𝐵𝐶 = 0.25 and 𝜌𝐴𝐶 = -0.75. Determine the variance and standard deviation of the
portfolio.

Solution
Capital Allocation
The most fundamental decision in investment is deciding how much of the investable funds
should be allocated to a particular asset so that portfolio risk is reduced or return is maximised
or utility is maximised. Before looking at how we allocate assets to minimise risk or maximise
return, we will consider some key concepts which are fundamental in asset allocation.

Risk Premiums and Risk Aversion

It is essential that one understands the concept of risk premium and risk aversion in portfolio
construction. Risk premium is an expected return in excess of the return on risk-free securities.
It is given by the following formula

𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = 𝐸(𝑅𝑝 ) − 𝑅𝑓

Where E (Rp) is the expected return on the portfolio and Rf is the rate of return on risk free
securities. Rf is the rate of return that can be earned with certainty.
Because investors are risk averse, they will invest in the risk free asset. In order for them to
invest in the risky asset/portfolio), the risk premium must be positive. Portfolios with risk
premium =zero are considered fair games while portfolios with negative risk premiums are
considered a gamble. Therefore, no risk averse investor will choose such portfolios . (Recall
one assumption of portfolio theory is that all investors are risk averse)
The level of risk premium demanded by an investor will depend on their degree of risk aversion
(risk tolerance) which is computed as follows :

𝐸(𝑅𝑝) − 𝑅𝑓
𝐴=
1⁄ 𝜎 2
2 𝑝

Where A denotes the degree of risk aversion and ½ is merely a scale factor chosen for
convenience and has no real bearing on the analysis. The above equation applies only to the
variance of an investor’s overall portfolio, not to individual assets held in that portfolio.
NB: The investor’s degree of risk aversion is quantified based on the assumption that investors
choose portfolios based on both expected return, E(RP), and the volatility of returns as
measured by the variance, σP2. Therefore, if we quantify the degree of risk aversion with the
parameter A, it makes sense to assert that the risk premium an investor demands on a portfolio
will be dependent on both risk aversion, A and the risk of the portfolio, σ P2.

In practice, we cannot observe the risk premium investors expect to earn. We can observe only
actual returns after the fact. Moreover, different investors may have different expectations
about the risk and return of various assets. We cannot observe an investor’s total portfolio of
assets. While the exact relationship between risk and return in capital markets cannot be known
exactly, many studies conclude that investors’ risk aversion is likely in the range of 2–4.
Exercise
A respected analyst forecasts that the return of the S&P 500 index portfolio over the coming
year will be 10% and the one-year T-bill rate is 5%. Examination of recent returns of the S&P
500 Index suggest that the standard deviation of returns will be 18%. What does this
information suggest about the degree of risk aversion of the average investor, assuming that
the average portfolio resembles the S&P 500?

Solution

A = (0.1-0.05)/ (0.5x0.182)
= 3.09

Asset Allocation Across Risky Assets

This is relatively easy to analyse. The main objective when allocating capital among risky
assets is to minimise risk for a given level of return. So the question is, considering the risk,
covariance of assets and the correlation of the assets, how much should we invest in a particular
risky asset in order to minimise portfolio risk. Portfolio risk can be reduced through
diversification. Therefore, when allocating assets, one must take into account the extent of co-
movements of returns of assets and in particular, the correlation coefficient.

Case 1 𝝆𝒙𝒚 =+1

When correlation coefficient is positive 1, Returns on the assets are always rising or falling in
unison. Diversification provides only risk averaging and no risk reduction because the portfolio
risk cannot be reduced below the individual security risk. In this case diversification is not a
productive activity.
Example
Consider a portfolio made up of security A and B. The standard deviation of A and B is 50 and
30respectively and the expected returns of are 15% and 12% respectively. Tabulate and draw
the investment opportunity set of the two risky securities. Use investment proportions, i.e.
weights, for security A of zero to 100 % in increments of 10 %. What are your observations
about the risk of the portfolio?

Case 2 𝝆𝒙𝒚 =-1

An increase in the return of one asset is met by a reduction in the return of the other asset.
Diversification becomes highly productive because portfolio risk can be considerably reduced
and sometimes even eliminated. Using the example in case 1, Tabulate and draw the investment
opportunity set of the two risky securities. Use investment proportions, i.e. weights, for security
A of zero to 100 % in increments of 10 %. What are your observations about the risk of the
portfolio?
Since the portfolio risk can be eliminated when the returns of assets are perfectly negatively
correlated. We must determine the weights of asset A and B which minimise the risk of the
portfolio.

When 𝜌𝑥𝑦 =-1, the risk of a two asset portfolio becomes:

𝜎𝑝2 = (𝑊𝐷 𝑊𝐷 − 𝑊𝐸 𝑊𝐸 )2

and the standard deviation becomes:

𝜎𝑝 = 𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝑉𝑎𝑙𝑢𝑒 = (𝑊𝐷 𝑊𝐷 − 𝑊𝐸 𝑊𝐸 )

Then we must find the weights of equity and debt which minimises risk, that is, which result
in
𝜎𝑝 = 𝑜𝑟 (𝑊𝐷 𝑊𝐷 − 𝑊𝐸 𝑊𝐸 ) = 0

Weight of debt (D) in the riskless portfolio is given by:

𝜎𝐸
𝑊𝐷 =
𝜎𝐷 + 𝜎𝐸
:
And the weight of equity in the riskless portfolio is given by:

𝜎𝐷
𝑊𝐸 =
𝜎𝐷 + 𝜎𝐸
or 1- 𝑊𝐷

NB: Now use the formula above to determine the riskless portfolio.

Case 3 −𝟏 < 𝝆𝒙𝒚 < +𝟏

When the correlation coefficient is greater than -1 but less than +1 one, there are some
benefits of diversification, that is, portfolio risk can be reduced to some extent. So we are
interested in the weights of debt and equity which result in minimum risk.
The weight of debt (D) in the minimum variance portfolio is given by:
𝜎𝐸 − 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
𝑊min(𝐷) =
𝜎𝐷 + 𝜎𝐸 − 2𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )

And the weight of equity (E) is 1- 𝑊min(𝐷)

Example
Using the example in case 1, Tabulate and draw the investment opportunity set of the two risky
securities. Use investment proportions, i.e. weights, for security A of zero to 100 % in
increments of 10 %. Assume the correlation coefficients are -0.5 and +0.5 What are your
observations about the risk of the portfolio? If you apply the above formula, what are the
weights of A and B in the minimum variance portfolio?

Asset Allocation Across Risky and Risk Free Asset Portfolios

Investors construct their portfolios using securities from all asset classes. Some of the portfolio
may be in risk-free Treasury bills and some in high-risk stocks. Risky investments often offer
higher than average returns but with high risk. The most straightforward way to control risk of
the portfolio is to allocate /invest some of your funds in TBs and other safer money market
securities (risk free portfolios). The portfolio which contains the risk free asset and risky assets
is called the complete portfolio.
Asset allocation entails choice of how much of the investable funds should be put in risky assets
and the risk free. Shifting wealth from the risky assets to the risk free asset does not change the
relative proportions of the various risky assets within the risky portfolio, rather the relative
weight of the risky portfolio is reduced.
To demonstrate the concept, consider the following scenario

Example

An individual has $600 they want to invest to fund their retirement income in 15 years’ time.
According to current retirement funding rules, the investor can only invest 40% or less of their
assets in TBs and the rest in long term securities. The investor decides to invest $226 800 in
equities and $193 200 in bonds. The remaining amount is put in money markets and the only
available security is a T-bill with an expected return of 7%. Determine:
a) The weights of assets in the risky portfolio
b) The weights of the equities, bonds, risky portfolio and the T-bills in the complete
portfolio
c) Dollar amount invested in T-Bills

Solution

Let P denote the portfolio of risky assets, F denote the portfolio of the risk free assets,  denote
the weight of portfolio P; (1-) denote the weight of the risk free asset; WE denote the weight
of equities and WB denote the weight of bonds
a) Weights of assets in the risky portfolio
WE = 226 800/ 420 000 =0.54

WB = 193 200/ 420 000 = 0.46

b) Weights of assets in the complete portfolio

WE = 226 800 /600 000 =0.378

WB =193 200 /600 000 =0.322

 = (226 800 +193 200) /600 000 =0.7

1 -  = 1-0.7 =0.3
c) Dollar amount invested in T-bills
= 600 000 – (226 800 +193 200) = $180 000

Suppose the investor decides to decrease risk by reducing exposure to the risky portfolio from
 = 0.7 to  =0.6

d) Determine the dollar value positions of E, B, P and F

e) Determine the new weights of E, B, P and F in the complete portfolio and the weights of
E and B in P.
f) How much equities and bonds should be sold to invest in the risk free asset?

Solution

Expected Return and risk of a complete portfolio

The expected return of a portfolio that consist of risky assets and the risk free asset is given by:

𝐸(𝑟𝑐 ) = γ[𝐸(𝑅𝑝 ) − 𝑅𝑓 ]

and the variance of a complete portfolio is given by:

𝜎𝑐2 = 𝛾 2 𝜎𝑝2

And the standard deviation is given by:

𝜎𝑐 = 𝛾𝜎𝑝

Example

Let’s assume the expected return of the risky portfolio is 15%, standard deviation is 22% and
the risk free rate is 7%.
a) Calculate the risk premium
 b) What would be the portfolio’s expected return and standard deviation if you invest
100% in the risky portfolio? What if you invest 100% in the risk free asset?
c) Assume you invest 65% in the risky asset and the rest in the risk free asset, what would
be the return and standard deviation?

Solution

The Investment Opportunity Set of a Risky Asset and Risk Free Asset

The Capital Allocation Line (CAL)

It depicts the risk-return combinations available by varying asset allocation, that is, by choosing
different values of y. When you invest all your investable funds in the risk free asset, your
portfolio will behave like the risk free asset F. When you invest all your investable funds in the
risky asset, your portfolio will behave like the risky portfolio (asset), P. When you invest part
of your funds in P, and another portion in F, your portfolio will plot/lie between F and P. the
risk premium, standard deviation and return of the complete portfolio increase in proportion to
the investment in the risky portfolio.

Portfolio of the right of P on CAL

For portfolios on the right of CAL, 𝛾 is greater than 1. Investors are borrowing at the risk free
rate to finance investments in risky assets (margin trading).
Example
Assume in the above example, the investor has $300 000 and they borrow an additional $120
000 and invest the total available funds in the risky asset.
i) Determine the proportion of the risky asset/portfolio and the risk free asset in the
complete portfolio
ii) What is the portfolio’s expected return and standard deviation and the reward to
volatility ratio?
NB: Recall that modern portfolio theory is built on the assumption that there is a risk free asset
in the market, and all investors can lend or borrow at the risk free rate. But in reality, non-
government investors cannot borrowers at a risk free rate, lenders would demand a higher
interest rate on loans because non-government borrowers have a higher risk of default.
Therefore, the CAL will be kinked at point P as shown below:

The investment opportunity with different lending and borrowing rates.

The reward to volatility ratio

The slope, S, of the CAL equals the increase in expected return that an investor can obtain per
unit of additional standard deviation. In other words, it shows extra return per extra risk. For
this reason, the slope also is called the reward-to-variability ratio and is given by the
following formula:
𝐸(𝑅𝑝 ) − 𝑅𝑓
𝑆=
𝜎𝑝

Notice that the reward-to-variability ratio is the same for risky portfolio P and the complete
portfolio that was formed by mixing P and the risk-free asset in equal proportions. In fact, the
reward-to-variability ratio is the same for all complete portfolios that plot on the capital
allocation line. While the risk-return combinations differ, the ratio of reward to risk is constant.

Risk Tolerance and Asset Allocation

The CAL shows all feasible risk-return combinations available from allocating the complete
portfolio between a risky portfolio and a risk-free asset. The investor confronting the CAL
now must choose one optimal combination from the set of feasible choices (optimal complete
portfolio). Because of differences in risk aversion, given an identical capital allocation line,
investors will choose different positions in the risky asset. Specifically, the more risk-averse
investors will choose to hold less of the risky asset and more of the risk-free asset.

Graphically, more risk-averse investors will choose portfolios near point F on the capital
allocation line while more risk-tolerant investors will choose points closer to P, with higher
expected return and higher risk. If the reward-to-variability ratio increases, then investors might
well decide to take on riskier positions The most risk-tolerant investors will choose portfolios
to the right of point P. These levered portfolios (those on the right hand of P) provide even
higher expected returns, but even greater risk.

Apart from attitude to risk, an investor’s asset allocation choice also will depend on the utility
derived by the investor for holding a certain portfolio. Thus the choice of portfolios
combinations will be influenced by utility derived from holding the portfolio. The utility that
an investor derives from a portfolio with a given expected return and standard deviation can be
described by the following utility function:

𝑈 = 𝐸 (𝑟) = 1⁄2 𝐴𝜎 2

Where U is the utility score

E(r) is the expected return of a portfolio
A is the degree or coefficient of risk aversion
𝜎 2 is the variance of the portfolio
0.5 is merely a scaling factor

This expression implies that the utility from a portfolio increases as the expected rate of return
increases, and it decreases when the variance increases. The relative magnitude of these
changes is governed by the coefficient of risk aversion, A.

A portfolio is desirable if it has a higher utility than others.

Evaluating Investments by Using Utility Scores

Sometimes portfolios offer progressively higher levels if risk premium, how do we choose
among them? The answer may be rank them according to higher expected returns. But what if
the risk increases with return. The alternative is to them according to utility scores
Example
Consider the following portfolios /investments
Portfolio Expected Return Standard Deviation
A 7% 5%
B 9% 10%
C 13% 20%

As a potential investor, which portfolio will you choose and why?

NB: The attractive portfolio is not obvious, the investor must assign each portfolio a utility
score on the basis of expected return and standard deviation. The portfolio with highest utility
will be chosen.
Now let’s assume there are three investors with A =2; 3.5 and 5. Show how each of these
investors will rank the three portfolios using utility scores. N (Convert all expected returns and
standard deviation into decimals)

What if there is another investor who is risk neutral (A=0) and a risk seeker (A  0), how would
they rank the above portfolios?
Risk neutral investors judge prospective investments solely on expected returns, the level of
risk is irrelevant. Risk lovers on the other hand, usually engage in fair games and gambles, that
is, investments with risk premium =0.

The Optimal Complete Portfolio

This is the portfolio that maximises the utility of the investor. So we must determine the
combination of the risk free asset and risky asset which maximises the utility of a particular
investor given their level of risk aversion. The investor attempts to maximize utility, U, by
choosing the best allocation to the risky asset 𝛾. To solve the utility maximization problem
more generally, we write the problem as follows:
1
𝑀𝑎𝑥 𝑈 = 𝐸 (𝑟𝐶 ) − 𝐴𝜎 2
2

Or
1 2 2
𝑀𝑎𝑥 𝑈 = R 𝐹 + y[E(R 𝑃 ) − R 𝐹 ] − 𝐴𝑦 𝜎𝑝
2
The maximization problem is solved by setting the derivative of this expression to zero. If we
solve for y, the optimal position for risk-averse investors in the risky asset, y* is given by:

E(R 𝑃 ) − R 𝐹
𝑦∗ =
𝐴𝜎𝑝2
Example
Let’s assume the expected return of the risky portfolio is 15%, standard deviation is 22% and
the risk free rate is 7%. How much should an investor with a degree of risk aversion A=2
invest in the risky asset and risk free asset in order to maximise utility? What if their risk
aversion was A=2? Also calculate the expected returns and risk of these portfolios.

The Optimal Risky Portfolio

This is an efficient risky portfolio, P (combination of risky assets), that that maximises the
reward to volatility ratio or slope of CAL or results in the highest possible CAL.
When allocating assets within the risky portfolio, the objective is to find the weights debt (𝑊𝐷)
and equity (𝑊𝐸) that result in the highest slope of the CAL (i.e., the weights that result in the
risky portfolio with the highest reward-to-variability ratio). This problem is solved by
maximising the following objective function:
𝐸(𝑅𝑝 ) − 𝑅𝑓
𝑆=
𝜎𝑝
1/2
Recall the 𝐸(𝑅𝑝 ) = 𝑊𝐷 𝐸(𝑅𝐷 ) + 𝑊𝐸 𝐸(𝑅𝐸 ) and 𝜎𝑝 = [𝑊𝐴 2 𝜎𝐴 2 + 𝑊𝐵 2 𝜎𝐵 2 + 2𝑊𝐴 𝑊𝐵 𝜎𝐴𝐵 ]

The weights of the optimal risky portfolio are then given by:

[𝐸(𝑅𝐷 ) − 𝑅𝑓 ]𝜎𝐸2 − [𝐸(𝑅𝐸 ) − 𝑅𝑓 ]𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )

𝑊𝐷 =
[𝐸(𝑅𝐷 ) − 𝑅𝑓 ]𝜎𝐸2 + [𝐸(𝑅𝐸 ) − 𝑅𝑓 ]𝜎𝐷2 − [𝐸(𝑅𝐷 ) − 𝑅𝑓 + 𝐸 (𝑅𝐸 ) − 𝑅𝑓 ]𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )

And 𝑊𝐸 = 1 − 𝑊𝐷

Example
The universe consists of the following securities:
Security Expected Return Standard Deviation
Debt 15% 30%
Equity 20% 50%
Treasury Bills 7%

If the correlation coefficient between debt and equity is 0.3, determine the optimal risky
portfolio, its expected return and standard deviation and the slope of the capital allocation line.
Summary of Asset Allocation between the risky asset and the risk free asset
1. Specify the characteristics of all assets, that is expected returns, variances and the
covariance.
2. Establish the weights of the assets in the optimal risky portfolio, P (𝑤𝐷 and 𝑤𝐸 ).
3. Calculate the properties of the optimal risky portfolio (expected return and variance)
using the weights determined above.
4. Determine the weights of the optimal risky portfolio, P, and the risk-free asset in the
complete portfolio (𝑦 ∗ and 1-𝑦 ∗ ).
5. Calculate the expected return and standard deviation of the complete portfolio using
these 2 new weights.
6. The proportion of the complete portfolio invested in each asset is given by:
a) 𝑦 ∗ 𝑥 𝑤𝐷 in debt/bonds
b) 𝑦 ∗ 𝑥 𝑤𝐸 in equity/stocks
c) 1 − 𝑦 ∗ in the risk-free asset