IME611 Class workbook

Suman Saurabh
September 2022

1 Portfolio theory

1.1 Mean, Variance and Covariance

µ = aX + bY (1)

σ 2 = (a2 σX
2
+ b2 σY2 + 2abρσX σY ) (2)

σ 2 = (a2 σX
2
+ b2 σY2 + 2abCov(X, Y )) (3)

Cov(X, Y )
ρ= (4)
σX σY

1.2 Risk and Return with two assets

E(rp ) = w1 E(r1 ) + w2 E(r2 ) (5)

σp2 = (w12 σ12 + w22 σ22 + 2w1 w2 ρσ1 σ2 ) (6)

1.3 Portfolio risk for different values of ρ

1. Now, for ρ = +1

σp2 = (w1 σ1 + w2 σ2 )2 (7)

σp = (w1 σ1 + w2 σ2 ) (8)

2. Now, for ρ = 0

σp2 = (w12 σ12 + w22 σ22 ) (9)

1
 3. Now, for ρ = −1

σp2 = (w1 σ1 − w2 σ2 )2 (10)

σp = (w1 σ1 − w2 σ2 ) (11)

1.4 Diversification and the correlation coefficient

• For ρ = +1: No diversification
• For ρ = 0: Some level of diversification
• For ρ = −1: Perfect hedge (diversification)
σ2
w1 = (12)
σ1 + σ2
As, w1 + w2 = 1

2 An example of portfolio construction

2.1 Input
Two risky assets with returns as follows:

Returns: E(r1 ) = 8% and E(r2 ) = 13%

Risk: σ1 = 12%, σ2 = 20%, and Correlation (ρ) = 0.3

2.2 Solution approach

Use the formula and obtain a set of values for

E(rp ) = 8w1 + 13w2 (13)

σp2 = (122 w12 + 202 w22 + 2 ∗ 0.3 ∗ 12 ∗ 20 ∗ w1 w2 ) (14)

Try to obtain values for risk and return for different values of ρ, such
as 0.3, 0, +1, −1

2
 w1 w2 E(rp ) ρ = −1 ρ=0 ρ = 0.3 ρ = +1
0.00 1.00 0.13 0.20 0.20 0.20 0.20
0.10 0.90 0.125 0.168 0.180 0.184 0.192
0.20 0.80
... ...
0.9 0.1 0.085 0.088 0.1098 0.1155 0.128
1.00 0.00