FIN3102/FIN3702

Investment Analysis & Portfolio Management

Lecture 2: Portfolio Theory

Dr. YUE Ling

 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 covariance between any risky asset and risk-free asset is zero. (Loosely speaking,
the correlation is zero).
• Applying the formula for portfolio return and risk, we can get:
• 𝐸 𝑟 𝑤 𝐸 𝑟 𝑤 𝐸 𝑟 .5 ∗ 5% .5 ∗ 2% 3.5%

• 𝜎 w σ w σ 2w w Cov r , r .5 ∗ 9% 0 0 .5 ∗
9% 4.5%

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 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
• Covariance: Cov r , r 𝜎 𝜎 𝜌
• 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 14.5% 11% 5.5%
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 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 zero (𝜌
0) is a curve bent toward left in the return-risk plane.
• For the same level of return (8.5%), the portfolio has lower level of risk than the
portfolio with 𝜌 1, i.e., there is risk reduction (diversification benefit).
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 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 level of risk than the
portfolio with 𝜌 0, and there is more risk reduction (diversification benefit).
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 Portfolio diversification

Portfolio of two risky assets

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

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

• The smaller the correlation, the

greater the risk reduction potential.  = 1.0
100% risky
=0
asset B

0


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 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

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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 0.5714
,
• 𝑤 1 𝑤 0.4286

• The risk of the MVP: 𝜎 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 risk free.

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 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: B < C < A (risk free) < D

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 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 = .07-(.5*2*0)=.07

• What if the investor has A = 4?

• A=4, risky portfolio I: U = .14-(.5*4*.20^2)=.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 .1, we get: 𝐸 𝑟 = .19 or 19%.

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 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 P and (1-𝑤 ∗ ) in risk-free asset:

∗
𝐸 𝑟 𝐸 𝑟
𝑤
𝐴𝜎
• Thus:
• An investor who can tolerate risk (low 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 allocation in the risky portfolio.

• An increase in risk premium will increase allocation in the risky portfolio

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 Optimal asset allocation

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

Proportion of C 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.
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 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?

rp = (- 0.5) (.07) + (1.5) (.15) = .19

σp = 1.5*0.22 = 0.33

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 Optimal asset allocation

Example: Invest with leverage

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

Return (‐50% risk free, 
150% risky A)

15%
A

7% Invest with lending Invest by borrowing

22%
Risk (Standard Deviation) 66
 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 and the

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