FIN3102/FIN3702

Investment Analysis & Portfolio Management

Lecture 2: Portfolio Theory

Dr. YUE Ling

 FIN3102/3702

Learning Outcomes:
1. Understand portfolio risk, return, and diversification
2. Identify opportunity set
2.a) One risky asset + One risk-free asset
2.b) Two risky assets
2.c) Two risky assets + One risk-free asset
2.d) N risky assets + One risk-free asset
3. Quantify investor’s risk aversion and utility score
4. Optimal asset allocation (optimal complete portfolio)
4.a) One risky asset + One risk-free asset
4.b) Two risky assets
4.c) Two risky assets + One risk-free asset
4.d) N risky assets + One risk-free asset

2
 FIN3102/3702

Modern portfolio theory

• Pioneered by Harry Markowitz, 1952, JF
• Developed by William Sharpe, 1964, JF
• Scientific security selection
• Efficient balance between returns and risks
• Returns measured by expected mean
• Risks measured by variances and covariances

• Portfolio perspective of security selection:

• Each security assessed not as individual prospect
• As a member of larger portfolio of securities
• Judge each security’s value by incremental portfolio returns and risks
• Mean variance analysis

3
 Portfolio diversification

Portfolio risk reduction

• The benefit of constructing a portfolio is to achieve the same level of return with
reduced risk. The level of risk reduction, if any, depends on the correlation between
individual assets.

Correlation (ρ) = 1 Correlation (ρ) = -1

A C Portfolio
A B Portfolio

4
 Portfolio diversification

Portfolio of one risky asset & one risk-free asset

• What is the return of a portfolio that consists of one risky asset A and one risk free
asset B?
• Given: Assets Expected  Risk (standard  Weight
return deviation, SD, σ)
Risky A 5% 9% 50%
Risk free B 2% 0% 50%

• The correlation between any risky asset and risk-free asset is _____.
• Applying the formula for portfolio return and risk, we can get:
• 𝐸 𝑟 𝑤 𝐸 𝑟 𝑤 𝐸 𝑟 ____________________

• 𝜎 w σ w σ 2w w Cov r , r _________________________

5
 Portfolio diversification

Portfolios of one risky asset & one risk-free asset

(various weights)

Risky A

1
𝐸 𝑟 𝜎 2%
3
(50% A, 50% B)

Risk‐free B

• The possible portfolios of one risky asset and one risk-free asset is a straight line in
the return-risk plane.
• There is no risk reduction from diversification.
7
 Portfolio diversification

Portfolio of two risky assets

• Recall:
• Expected return: 𝐸 𝑟 𝑤 𝐸 𝑟 𝑤 𝐸 𝑟

• Risk: 𝜎 w σ w σ 2w w Cov r , r

• Given:
Assets Expected  Risk (standard  Weight
return deviation, SD, σ)
Risky A 5% 9% 50%
Risky B 12% 20% 50%

• The magic of risk reduction:

Correlation 𝜌 1 𝜌 0 𝜌 1
coefficient (A,B)
𝐸 𝑟 8.5% 8.5% 8.5%
𝜎 ____ ____ ____
8
 Portfolio diversification
Directly-correlated
Portfolios of two risky assets with (various weights)

Risky B

(50% A, 50% B)
Risky A

• The possible portfolios of two risky assets with correlation coefficient of one (𝜌 1,
perfectly positive correlation) is a straight line in the return-risk plane.
• There is no risk reduction from diversification.

10
 Portfolio diversification

Portfolios of two risky assets with (various weights)

Risky B

(50% A, 50% B)

Risky A No correlation

• The possible portfolios of two risky assets with correlation coefficient of zero (𝜌 0,
no correlation) is a curve bent toward left in the return-risk plane.
• For the same level of return (8.5%), the portfolio has lower/higher level of risk than
the portfolio with 𝜌 1, i.e., there is risk reduction (diversification benefit).
11
 Direct negative correlation Portfolio diversification
Portfolios of two risky assets with (various
weights)

Risky B

(50% A, 50% B)

Risky A

• The possible portfolios of two risky assets with correlation coefficient of -1 (𝜌 1,

perfectly negative correlation) is two straight lines.
• For the same level of return (8.5%), the portfolio has lower/higher level of risk than
the portfolio with 𝜌 0, and there is more risk reduction (diversification benefit).
13
 Portfolio diversification

Portfolio of two risky assets

• The risk-return relation of a two-
security portfolio depends on the

return
correlation coefficient: = ___ 100% risky
• -1.0 ≤ 𝜌 ≤ +1.0 asset A

• The smaller/bigger the correlation,

the greater the risk reduction = ___
potential.
100% risky
= ___
asset B

15
 Portfolio diversification

Correlation and risk reduction

• Correlation = 1
• two prices always move up and down together
• no risk reduction benefit
• Correlation = 0.5
• two prices move up and down together most of the time
• some risk reduction benefit
• Correlation = 0
• two prices move up and down together only about half the time
• substantial risk reduction benefit
• Correlation < 0
• risk can be reduced further
• Correlation = 1
• two prices always move in opposite direction
• risk can be eliminated completely

17
 Portfolio diversification

Investment universe comprises more than 2 securities

• Improvement in efficient frontier
• efficient frontier shifts north north-west direction
• diverse investment securities improves risk risk-return trade trade-off

18
 Intro to portfolio return and risk

Recall: Return and Risk of portfolio (N assets)

• Portfolio return:

𝐸 𝑟 𝑤𝐸 𝑟

• Portfolio risk:

2
1 cov12 cov13 ... cov1n w1
2
N N
cov 21 2 cov 23 ... cov 2 n w2
2 2
port wi w j covij w1 w2 …L wn 1 wn cov31 cov32 3 ... cov3n M
…
i 1 j 1
…M …M …M …M …M wn 1
2
cov n1 cov n 2 cov n 3 ... n
wn
w12 2
1 w22 2
2 w32 2
3
…L wn2 2
n 2 w1w2 cov12 2w1w3 cov13 2 w2 w3 cov 23 L…

(N) variance (N2 ― N)/2 unique covariance

because covariance is symmetric, i.e., Cov12=Cov21

20
 Portfolio diversification

Portfolio Risk Diversification

• Portfolio diversification is the investment in several different asset classes or sectors.
• Diversification is not just holding a lot of assets.
• For example, if you own 50 internet stocks, you are not diversified. However, if you
own 50 stocks that span 20 different industries, then you are clearly much more
diversified.

• Diversification can substantially reduce the variability of returns without an

equivalent reduction in expected returns.

• However, there is a minimum level of risk that cannot be diversified away and that is
the systematic risk.

21
 Portfolio diversification

Diversification with stocks

• How much portfolio risk can we reduce by adding more stocks to the portfolio?

24
 Portfolio diversification

Portfolio Risk Diversification

In a large portfolio, the non-systematic risk are effectively
diversified away, but the systematic risk are not.

Diversifiable Risk;
Non-systematic Risk;
Firm Specific Risk;
Unique Risk

Portfolio risk
Non-diversifiable risk; Systematic
Risk; Market Risk
n

• Diversification can eliminate firm specific risk but not market wide risk.
• There is a reward for bearing risk, but there is no reward for bearing risk unnecessarily.
• The expected return on a risky asset depends only on that asset’s systematic risk since
unsystematic risk can be diversified away
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 FIN3102/3702

Learning Outcomes:
1. Understand portfolio risk, return, and diversification
2. Identify opportunity set
2.a) One risky asset + One risk-free asset
2.b) Two risky assets
2.c) Two risky assets + One risk-free asset
2.d) N risky assets + One risk-free asset
3. Quantify investor’s risk aversion and utility score
4. Optimal asset allocation (optimal complete portfolio)
4.a) One risky asset + One risk-free asset
4.b) Two risky assets
4.c) Two risky assets + One risk-free asset
4.d) N risky assets + One risk-free asset

27
 Opportunity set

2.a) one risky asset + one risk-free asset

Risky A
Capital Allocation Line (CAL)

Risk‐free B

• Opportunity set: a line going through risk-free asset and risky asset.

28
 Opportunity set

2.b) two risky assets

Risky E Efficient frontier

Minimum‐Variance 
Portfolio (MVP) big red dot
Risky D

• Opportunity set: efficient frontier of D and E, which is the part of the curve above the
minimum-variance portfolio (MVP). The portfolio on efficient frontier gives the
highest return for any given level of risk.

29
 Opportunity set

Minimum variance portfolio (MVP) for two risky assets

• What is the MVP if correlation is 𝜌 for any 2 risky assets D and E? The proportion of
MVP invested in the risky asset D is 𝑤 .

𝜎 𝐶𝑜𝑣 𝑟 , 𝑟
𝑤
𝜎 𝜎 2𝐶𝑜𝑣 𝑟 , 𝑟
𝑤 1 𝑤

• If two risky assets are perfectly negatively correlated (𝜌 1), then the MVP may
be risk free.

Minimum‐Variance 
Portfolio (MVP)

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 Opportunity set

Example: MVP for two risky assets with

• The expected return and risk of Asset D and Asset E are summarized below.
E(r) σ(r)
Risky Asset D 5% 15%
Risky Asset E 7% 20%
• Let the correlation between the two assets be -1 (𝜌 1). Calculate the portfolio
weights of the MVP.
,
• 𝑤 ______________
0.571428571
,
• 𝑤 1 𝑤 ______________
0.428571429

• The risk of the MVP: 𝜎 0

𝑤 𝜎 𝑤 𝜎 2∗𝑤 ∗𝑤 ∗𝜎 ∗𝜎 ∗ 1 |𝑤 ∗ 15% 𝑤 ∗
20% | _______ 0

• Thus, the MPV of risky assets D and E is risky / risky-free.

31
 Opportunity set

2.c) two risky assets + one risk-free asset

Capital Allocation Line (CAL)
return (new efficient frontier)

Tangency  Asset E
Portfolio P

(previous efficient frontier)

Proportion of P invested in D:
,
𝑤
Risk‐free  Asset D ,
asset 𝑤 1 𝑤

sharpe ratio : return per unit of risk

• Optimal risky asset: tangency portfolio P which has the highest the Sharpe Ratio
(gradient) on DE curve. The proportion of portfolio P invested in the risky asset D is
𝑤 .
• Opportunity set: Capital Allocation Line (CAL), which is a straight line going
through risk-free asset and tangency portfolio P. CAL is the new efficient frontier.
y-intercept
33
 Opportunity set

2.d) N risky assets + one risk-free asset (part 1)

Markowitz Efficient Frontier
13.50
13.00 2
12.50
Expected Return

12.00
11.50
11.00
Individual
10.50 MVP 3
4 Assets
10.00
9.50
9.00 1
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00
Risk (Standard Deviation)
• Efficient frontier of N risky assets: the portfolio on efficient frontier gives the lowest
risk for any given level of return and the highest return for any given level of risk.

34
 Opportunity set

2.d) N risky assets + one risk-free asset (part 2)

Markowitz Efficient Frontier
14.00
2
12.00
Tangency
portfolio P
3 4
Expected Return

10.00
1
8.00
Capital Allocation Line (CAL)
(new efficient frontier)
6.00

4.00

2.00 Rf

0.00
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00
Risk (Standard Deviation) sharpe ratio is the gradient of the curve,
= return / risk (std)

• N risky assets + one risk-free asset (in practice, we use the yield on the 1-month, 3
month or 1-year government bond as the risk-free rate).
^ in risk-free asset and portfolio allocation

• Optimal risky asset: tangency portfolio P which maximizes the Sharpe Ratio.
• Opportunity set: Capital Allocation Line (CAL), the new efficient frontier.

35
 Opportunity set

Assumptions when using historical data

• “While results vary from asset class to asset class and from time period to time
period, experience suggests that for predicting future values, historical data appear to
be quite useful with respect to standard deviations, reasonably useful for correlations,
and virtually useless for expected returns.”

• -- William F. Sharpe, winner of 1990 Nobel Prize in Economics. Managing

Investment Portfolios: A Dynamic Process.

William F. Sharpe

36
 FIN3102/3702

Learning Outcomes:
1. Understand portfolio risk, return, and diversification
2. Identify opportunity set
2.a) One risky asset + One risk-free asset
2.b) Two risky assets
2.c) Two risky assets + One risk-free asset
2.d) N risky assets + One risk-free asset
3. Quantify investor’s risk aversion and utility score
4. Optimal asset allocation (optimal complete portfolio)
4.a) One risky asset + One risk-free asset
4.b) Two risky assets
4.c) Two risky assets + One risk-free asset
4.d) N risky assets + One risk-free asset

37
 Risk aversion

Risk Aversion
• Initial Investment: $100.

State Probability A B C D

Good 0.5 105 110 115 130

Bad 0.5 105 85 95 90

E(Value) 105 97.5 105 110

Risk Premium 0 ‐7.5 0 5
(excess return)

• Ranking of 4 assets: _______________________

D, A, C, B

usually expected return effects trumps risk aversion, but with same expected returns,
prefers investment with higher worst case returns

38
 Risk aversion

Assessing Risk Tolerance

• Standard assumptions about risk preference:
• Prefer more wealth than less wealth.
• Prefer less risk to more risk.
• Derive less satisfaction with each unit of incremental wealth.
• More tolerant to risk as we become wealthier.
• Experience more disutility from a decline in wealth than from an equal increase
in wealth.
• Prefer a certain outcome to an uncertain outcome of equal value.

40
 Risk aversion

Quantify Risk Tolerance

• Link the risk tolerance to utility if we only consider risk and return of financial assets.
• A simple quadratic utility function of a specific individual:
utility from expected returns - disutility

𝑼 𝑬 𝒓 𝟎. 𝟓𝑨𝝈𝟐 from bearing risk, manifested by the

individual investor’s degree of risk aversion

where:
• E(r): expected return
• σ: standard deviation
• A: the degree of risk aversion
Note: the parameter 0.5 in the utility function here is to 
simplify the mathematical solution for the optimal portfolio 
weight as the quadratic term needs to take first order 
differentiation using calculus shown in later slide.

• Investor’s view of risk

• Risk Lover: A < 0
• Risk Neutral: A = 0
• Risk Averse: A > 0
• What is your “A?”
• Score<=14, A >=5
• Score between 15 to 21, score = 18
A = 3 or 4
• Score >=22, A<=2
41
 Risk aversion

Example: Risk Aversion and Utility Score

• Risky portfolio I has an expected rate of return of 14% and standard deviation of
20%. T-bills offer a safe rate of return of 7%. Would an investor with a risk-aversion
parameter A = 2 prefer to invest in T-bills or the risky portfolio?

• Calculate the utility from each security:

• A=2, risky portfolio I: U = .14-(.5*2*.20^2)=.1
• A=2, T-bill: U = __________
0.07

• What if the investor has A = 4?

• A=4, risky portfolio I: U = ___________
0.06

• If A=2, risky portfolio J has standard deviation of 30%. What should be J’s expected
return that would make the investor indifferent between I and J?
• To be indifferent, the investor would expect the same level of utility from I and
J. portfolio J, i.e., 𝑈 𝑈 ____.
0.1

• Since 𝑈 𝐸 𝑟 .5 ∗ 2 ∗.3 ____,0.1 we get: 𝐸 𝑟 = ____

0.19

42
 Risk aversion

𝟐
Indifference Curve:
• Given the degree of risk aversion (A) of a specific investor, which portfolios would
result in the same level of utility (e.g., U=0.05) for this investor?
• A higher level of utility or happiness is represented by a higher curve
• For the same individual, his indifference curves are 'parallel'

A=2
U=0.05 U=0.1 U=0.15
σ E(r) E(r) E(r)
0.00 0.05 0.10 0.15
0.05 0.05 0.10 0.15
0.10 0.06 0.11 0.16
0.15 0.07 0.12 0.17
0.20 0.09 0.14 0.19
0.25 0.11 0.16 0.21
0.30 0.14 0.19 0.24
0.35 0.17 0.22 0.27
0.40 0.21 0.26 0.31
0.45 0.25 0.30 0.35
0.50 0.30 0.35 0.40

Note: the utility level is computed in decimal place using return and risk in decimal places. 
There is no unit attached to it. 46
 Risk aversion

Risk aversion and Indifference curve

• Conservative investor
• less tolerant of risk (i.e. more risk averse)
• indifference curves steeper than those of an aggressive investor
• requires much more return to compensate risk
• prefers portfolios along lower segment of efficient frontier

48
 FIN3102/3702

Learning Outcomes:
1. Understand portfolio risk, return, and diversification
2. Identify opportunity set
2.a) One risky asset + One risk-free asset
2.b) Two risky assets
2.c) Two risky assets + One risk-free asset
2.d) N risky assets + One risk-free asset
3. Quantify investor’s risk aversion and utility score
4. Optimal asset allocation (optimal complete portfolio)
4.a) One risky asset + One risk-free asset
4.b) Two risky assets
4.c) Two risky assets + One risk-free asset
4.d) N risky assets + One risk-free asset

49
 Optimal asset allocation

4.a) one risky asset + one risk-free asset

Indifference Curve

Proportion of C invested in P: 
∗
𝐸 𝑟 𝐸 𝑟
𝑤
𝐴𝜎

• Optimal complete portfolio: the tangent point C between investor’s indifference

curve and the Capital Allocation Line (CAL). It maximizes investor’s utility and it’s
the final portfolio choice of an investor. 50
 Optimal asset allocation

Key Economic Takeaways:

• Given 1 risky asset and 1 risk free asset, an investor with risk aversion of A will
choose to invest 𝑤 ∗ in the risky asset A and (1-𝑤 ∗ ) in risk-free asset:
Wp* P Wp*
∗
𝐸 𝑟 𝐸 𝑟
𝑤
𝐴𝜎
• Thus:
• An investor who can tolerate risk (low/high value of A) will optimally invest a
larger proportion in the portfolio of risky assets (higher 𝑤 ∗ ).

• An increase in risky portfolio’s volatility (e.g., higher σ next month) will

decrease/increase allocation in the risky portfolio.

• An increase in risk premium will decrease/increase allocation in the risky

portfolio

51
 Optimal asset allocation

4.b) two risky assets (D and E)

E(r) U(1) U(2) U(3)

Asset E

P Proportion of P invested in D:
,
𝑤
,
𝑤 1 𝑤
Asset D
St. Dev
• Optimal complete portfolio: the risky portfolio (P) on the opportunity set of risky
assets that maximizes the investor’s utility.
53
 Optimal asset allocation

4.b) two risky assets (D and E)

E(r) U(1) U(2) U(3)

Q2
P
Less risk-averse
Q1 investor

More risk-averse
investor
St. Dev
• Optimal complete portfolio: the risky portfolio (P) on the opportunity set of risky
assets that maximizes the investor’s utility.
54
 Optimal asset allocation

4.c) two risky assets + one risk-free asset

E(r) Capital Allocation Line (CAL)
(new efficient frontier)
E

Investor 1
P
Proportion of A invested in P: 
Q1
A ∗
𝐸 𝑟 𝐸 𝑟
𝑤
𝐴𝜎
D
rf F

• CAL is the new efficient frontier. Now the individual chooses the appropriate mix
between the tangency portfolio P (formed by D and E) and risk-free asset.
• Optimal complete portfolio: the tangent point A between investor’s indifference curve
and the CAL. It maximizes the investor’s utility.
optional complete portfolio factors into account invertors’ risk-aversion, resulting portfolio may not have least variance.
* minimum variance does not take risk-aversion into account, simply finds portfolio with least variance and its associated return 55
 Optimal asset allocation

4.c) two risky assets + one risk-free asset

Investor 2 Capital Allocation Line (CAL)
E(r)
Aggressive (new efficient frontier)
B E
Q2
Investor 1
Conservative P
Q1
A

D
rf F

• CAL is the new efficient frontier. Now the individual chooses the appropriate mix
between the tangency portfolio P (formed by D and E) and risk-free asset.
• Optimal complete portfolio: the tangent point A between investor’s indifference curve
and the CAL. It maximizes the investor’s utility.
56
 Optimal asset allocation

4.d) N risky assets + one risk-free asset

57
 Optimal asset allocation

4.d) N risky assets + one risk-free asset

Proportion of A invested in P: 
Return
∗
𝐸 𝑟 𝐸 𝑟
𝑤 Capital Allocation Line (CAL)
𝐴𝜎

Opportunity set of N 
rP risky assets
Indifference Curve P
C Optimal risky portfolio
F Optimal  (tangency portfolio, 
rf Complete  max Sharpe Ratio)
Portfolio

σP Risk (Standard Deviation)
• Optimal complete portfolio: the tangent point C between investor’s indifference
curve and the CAL. It maximizes the investor’s utility.
58
 Optimal asset allocation

Markowitz Portfolio Selection Model

(1952, Journal of Finance)

IF (key assumptions)
• If all investors have the same perception regarding the probability distribution of
risky securities (homogeneous expectations)
and
• if they can borrow and lend at the same rate (same 𝑟 )

Then
• Then they will agree on the same risky portfolio P, i.e., all investors have the same
capital allocation line (going through 𝑟 and risky portfolio P).

59
 Optimal asset allocation

Markowitz Portfolio Selection Model

(1952, Journal of Finance)

Two funds separation theorem

• First task: All investors regardless of their degree of risk aversion will invest only in
the same risky portfolio P.
• Determination of the optimal risky portfolio P is purely technical
market portfolio intersect CAL/CML

• Second task: Consider three investors with different risk profiles – conservative,
moderate, and aggressive.
• Allocation of the optimal complete portfolio on T-bills (𝑟 ) versus the risky
portfolio depends on personal preference. Investors will select the desired point
along CAL based on their degree of risk aversion.
A affects investor position on CAL

60
 Optimal asset allocation

Markowitz Portfolio Theory

Capital Market • The Separation Property states that
Line (CML) the market portfolio, M, is the
Indifference  optimal risky portfolio for all
return

Curve investors— that is, the choice of the

market portfolio is separate from the
investors’ risk tolerance.
M
• All investors have the same capital
allocation line. This line is the
Optimal Risky  Capital Market Line (CML).
rf Portfolio
• Where a specific investor chooses to
invest along the CML depends on
his risk tolerance.

61
 Optimal asset allocation

Example: Invest with leverage

Given:
E(rA) = 15% A = 22%
E(rB) = 7% B = 0%

• If you can borrow additional 50% of capital from the risk-free rate asset B and invest
in risky asset A, what is the level of risk and return of this portfolio?
borrow at 7% to buy risky expecting 15% returns

rp = _______________________
-0.5 (7%) + 1.5 (15%) = 24%

σp = _______________________
√1.5^2 x 0.22^2 = 1.5 * 0.22 = 0.33

63
 Optimal asset allocation

Example: Invest with leverage

• If you can borrow at 7%. Where is your portfolio on CAL?

Return

15%
A

7% Invest with borrowing/lending Invest by borrowing/lending

22%
Risk (Standard Deviation) 65
 FIN3102/3702

Investors with different risk profiles

• More averse to risk: allocate
J more wealth in risk-free
security, less in tangency
portfolio;

Market • More tolerant of risk: allocate

less in risk-free security,
more in tangency portfolio;
may borrow to invest more
I than net worth in tangency
portfolio.

𝛽𝜎 𝜎 𝛽𝜎

• Point I is achieved by investing a proportion 𝛽 of available funds in portfolio M / risk-

free asset and the rest in a portfolio M / risk-free asset.
• Point J is achieved by borrowing / lending 𝛽 1 of available funds at the risk-free rate
and investing everything in portfolio M.
67
 FIN3102/3702

Simple Investment Advice

• Two-fund separation theorem
• Risk aversion determines the
fraction of wealth invested in:
• Risk-free asset
• Tangency Portfolio

• Passive Investment: Don’t try to beat

the market. Invest in index funds or
ETFs that track performance of broad
asset categories, e.g., stock, bond,
commodity, real estate.

Jack Bogle created The Vanguard

500 index fund, which tracks the
Standard and Poor's 500 Index, the
first low-cost index mutual fund
designed for the retail investor.

69
 FIN3102/3702

Summary
• Understand portfolio risk, return, and diversification
• Identify opportunity set
• Quantify investor’s risk aversion and utility score
• Optimal asset allocation (optimal complete portfolio)

• Readings: BKM Chapter 6 (excluding appendices); Chapter 7.

71
Excel worksheet steps

72
 Opportunity set

EXCEL: find MVP of two risky assets

• If there are two risky assets, how to find the portfolio with minimum variance among
all possible portfolios?
• The Add-in “Solver” in Excel can help achieve this.

• Input: Expected Returns, Standard Deviations, and Correlations of Risky Assets.

• Output: Weights in individual assets that minimize the portfolio risk.
• Steps:
• Run “Solver” in Excel > Data.
• Objective: minimize portfolio risk;
• Constraints: sum of weights = 1.

73
 Opportunity set

EXCEL: find Tangency Portfolio for two risky assets

and one risk-free asset risk-free asset
• If there are two risky assets and one risk-free asset, how to find the tangency
portfolio, i.e., the portfolio of two risky assets which has the maximum Sharpe Ratio?
• The Add-in “Solver” in Excel can help achieve this.

• Input:
• Expected Returns, Standard Deviations, and Correlations of Risky Assets.
• Risk-free rate.
• Output: Weights in individual assets that maximize the portfolio Sharpe Ratio.
• Steps:
• Run “Solver” in Excel > Data.
• Objective: maximize the portfolio Sharpe Ratio;
• Constraints: sum of weights = 1.

74
 Opportunity set

EXCEL: find efficient frontier of N risky assets

• If there are three risky assets, how to find the allocated weights such that the portfolio risk
is minimized given a certain desired return?
• The Add-in “Solver” in Excel can help achieve this.

• Input:
• Expected Returns, Standard Deviations, and Correlations of Risky Assets;
• Risk-free rate
• Output: Weights in individual assets that minimize the portfolio risk.
• Steps:
1) Key in any reasonable “Desired return” (e.g., 10%);
2) Run “Solver” in Excel > Data.
• Objective: minimize portfolio risk;
• Constraints: (1) sum of weights = 1; (2) portfolio expected return = Desired
return (e.g., 10%).
3) Copy and save the resulted portfolio risk and return to a table;
4) Repeat the above steps with different desired returns;
5) Sort the data in step 3) by portfolio risk and then plot.
75
Appendix:
Formula derivation for math gurus…
(self reading)

76
 Opportunity set

For math gurus… MVP for two risky assets

Objective function: minimize portfolio variance:

• Minimize 𝜎 𝑤 𝜎 𝑤 𝜎 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
𝜎 𝑤 𝜎 𝑤 𝜎 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
• Subject to: 
𝑤 𝑤 1

Unknown: portfolio weights 𝑤 and 𝑤

Hence: mathematically, it is equivalent to taking first order differentiation with 
respect to the above objective function with respect to the weight 𝑤 , whereas 
𝑤 1 𝑤 .
2 2 2
d p / dwD 2wD D 2(1 wD ) E 2(1 2 wD )Cov( rD , rE ) 0
2 2 2
wD ( D E 2Cov(rD , rE )) E Cov(rD , rE )
2
Cov(rD , rE )
wD 2
E
2
D E 2Cov(rD , rE )
77
 Opportunity set

Math for Finding the Tangency Portfolio “P” for two

risky assets and one risk-free asset
• Intuition:
• Objective: Choose 𝑤 and 𝑤 such that they maximize Reward-to-variability
ratio (i.e. Sharpe Ratio)
• Subject to: available investment option

• Mathematically: Choose 𝑤 and 𝑤 to:

• Maximize 𝑆
𝑟 𝑤 𝑟 𝑤 𝑟
• Subject to: 𝜎 𝑤 𝜎 𝑤 𝜎 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
𝑤 𝑤 1
• Then we get:
2
(rD rf ) E (rE rf )Cov(rD, rE )
wD 2 2
(rD rf ) E (rE rf ) D (rE rf rD rf )Cov(rD, rE )
wE 1 wD

78
 Opportunity set

For Math gurus…Tangency Portfolio “P” for two risky

assets and one risk-free asset
wD rD wE rE rf wD rD wE rE rf wD rD (1 wD )rE rf
Sp
p wD2 2
D wE2 2
E 2 wD wE cov(rD , rE ) wD2 2
D (1 wD ) 2 2
E 2 wD (1 wD ) cov(rD , rE )
let
h wD2 2
D (1 wD ) 2 2
E 2 wD (1 wD ) cov(rD , rE )
FOC with respect to wD
Sp (rD rE )h ( wD rD (1 wD )rE rf ) h '
0
wD h2
Hence, you get the following equation (1)
1
(rD rE )h 2 ( wD rD (1 wD )rE rf )[2 wD 2
D 2(1 wD ) 2
E 2(1 2 wD ) cov(rD , rE )]
2
where
11
h' [2 wD D2 2(1 wD ) E2 2(1 2 wD ) cov( rD , rE )]
2h
Then you substitute function h back and solve for wD .
You can therefore get the term for wD from equation (1)
(rD rE )[ wD2 2
D (1 wD ) 2 2
E 2 wD (1 wD ) cov(rD , rE )] ( wD rD (1 wD ) rE rf )[ wD 2
D (1 wD ) 2
E (1 2 wD ) cov(rD , rE )]
The good thing is that the term of wD2 drops out. Hence, with a bit of patience, you can get the below expression for wD :
2
(rD rf ) E (rE rf )Cov(rD , rE )
wD 2 2
(rD rf ) E (rE rf ) D (rE rf rD rf )Cov(rD , rE )
wE 1 wD 79
 Optimal asset allocation

Math of Optimal Complete Portfolio Allocation of

One Risky Asset and One Risk-free Asset
• Suppose: Investor’s risk aversion = A

• Objective: Choose 𝑤 (proportion invested in the risky asset P) to maximize the

utility in investing in portfolio C.
• Maximize: 𝑈 𝐸 𝑟 0.5 ∗ 𝐴 ∗ 𝜎
𝐸 𝑟 𝑤 𝐸 𝑟 1 𝑤 𝐸 𝑟
• Subject to:
𝜎 𝑤 𝜎

• Mathematical Derivation:
• Max. 𝐸 𝑟 0.5 ∗ 𝐴 ∗ 𝜎 𝑤 𝐸 𝑟 1 𝑤 𝐸 𝑟 0.5 ∗ 𝐴 ∗ 𝑤 𝜎
• First order differentiation with respect to 𝑤 (unknown)
𝑑𝑈
𝐸 𝑟 𝐸 𝑟 𝜎 𝐴𝑤 0
𝑑𝑤

∗
𝐸 𝑟 𝐸 𝑟
• Solution: 𝑤
𝐴𝜎
80
 Optimal asset allocation

Math of Optimal Complete Portfolio Allocation of

Two Risky Assets
• Objective: Choose 𝑤 and 𝑤 such that they maximize Investor Utility subject to the
available investment opportunity curve

• Objective: Choose 𝑤 and 𝑤 such that they

• Maximize: 𝑈 𝐸 𝑟 0.5 ∗ 𝐴 ∗ 𝜎
𝑟 𝑤 𝑟 𝑤 𝑟
• Subject to: 𝜎 𝑤 𝜎 𝑤 𝜎 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
𝑤 𝑤 1

• Solution:
rD rE A( E2 Cov(rD, rE ))
wD
A( D2 E2 2Cov(rD, rE ))
wE 1 wD

81
 Optimal asset allocation

Math of Optimal Complete Portfolio Allocation for

N Risky Assets and One Risk-Free Asset
Intuition:
• Objective: Choose 𝑤 (the proportion invested in Tangency Portfolio P) which
maximizes Investor Utility
• Subject to: New CAL (P)

Mathematically:
• Maximize: 𝑈 𝐸 𝑟 0.5 ∗ 𝐴 ∗ 𝜎
𝐸 𝑟 𝑤 𝐸 𝑟 1 𝑦 𝐸 𝑟
• Subject to:
𝜎 𝑤 𝜎

• Solution:
∗
𝐸 𝑟 𝐸 𝑟
𝑤
𝐴𝜎

82