LectureNote5 Portfolio Theory

Investments (BUS2007)
Spring 2023
Lecture Note 5.
Portfolio theory
(Reference Book Chapter 6)
Da-Hea Kim
Preliminary (1)
 Basics of probability theory
X, Y, Z : a random variable, a, b, c : constant
 Properties of the expected value
1) E(a)=
2) E(aX)=
3) E(X+Y)=
4) E(aX+bY)=
Da-Hea Kim Lecture note 5. Portfolio theory 2

Preliminary (2)
 Properties of covariance
1) Cov(a, X)=
2) Cov(aX, Y)=
3) Cov(aX, bY)=
4) Cov(X+Y, Z)=
5) Cov(aX+bY, cZ)=

Preliminary (3)
 Properties of variance
1) Var(a)=
2) Var(aX)=
3) Var(X+Y)=
4) Var(aX+bY)=
 Var(w1R1+w2R2+⋯+wnRn)=

Preliminary (4)
 Correlation
𝑪𝒐𝒗(𝑿,𝒀)
• 𝑪𝒐𝒓𝒓 𝑿, 𝒀 =
𝑽𝒂𝒓 𝑿 𝑽𝒂𝒓(𝒀)
• 𝑪𝒐𝒓𝒓 𝒂𝑿, 𝒀 =
• −𝟏 ≤ 𝑪𝒐𝒓𝒓 𝑿, 𝒀 ≤ 𝟏
• 𝑪𝒐𝒓𝒓 𝑿, 𝒀 = 𝟏 : a strong positive linear relationship between X and Y
• 𝑪𝒐𝒓𝒓 𝑿, 𝒀 = −𝟏 : a strong negative linear relationship between X and Y

Preliminary (5)
 Correlation

Overview
 How to calculate expected returns and variances for a portfolio
 Portfolio diversification
 Mean-variance portfolio theory

 The efficient frontier
 The importance of asset allocation

Intro
 Investors usually hold not a single asset, but rather multiple assets.
 Portfolio: a group of assets
 How to choose an optimal portfolio

 An extended application of a mean-variance analysis to a portfolio
1. Calculate the expected returns and variances for a portfolio
2. Apply the dominance principle
3. Find a portfolio giving the highest utility by using mean-variance indifference curve

Portfolio
 Portfolio consisting of n-assets
 𝒊: i-th asset return, i =1,2, …, n
 𝒊: portfolio weight of i-th asset, i =1,2, …, n

• The proportion of the total value of the portfolio that is invested into each asset
•
• can have a negative value
• <0 : ______________
 𝒑: portfolio’s returns
𝒏
• 𝒑 𝟏 𝟏 𝟐 𝟐 𝒏 𝒏 𝒊 𝟏 𝒊 𝒊

Expected return of portfolio (1)
Two ways
 Using the probability distribution of the portfolio’s returns
 A weighted average of expected returns of individual assets that compose the portfolio
(using the property of the expected value)

Using the probability distribution of the portfolio’s returns
 Future states of economy s=1,2, …, m

 A portfolio consisting of n assets
1. For each state of economy s, calculate the rate of return for the portfolio
2. Calculate the expected value of the portfolio’s returns

 A weighted average of expected returns of individual assets in the portfolio
 Future states of economy s=1,2, …, m

 A portfolio consisting of n assets
1. Calculate the expected returns for each asset.
2. Calculate a weighted average of individual assets’ expected returns.

 Example) You put half your money in each of stocks X and Y
1) Using the probability distribution of the portfolio’s returns
State of Stock X Stock Y

Probability Portfolio returns
Economy Returns Returns
Poor 0.25 -0.10 0.00

Normal 0.50 0.10 0.05
Good 0.25 0.30 0.10
2) A weighted average of expected returns of individual assets that compose the portfolio

Risk of portfolio (1)
Two ways
• Future states of economy s=1,2, …, m

• A portfolio consisting of n assets
 Using the probability distribution of the portfolio’s returns

1. 𝑟 = 𝑤 𝑟 + 𝑤 𝑟 + ⋯ + 𝑤 𝑟 , 𝑠 = 1,2, … , 𝑚
2. Var 𝑟 =𝐸 𝑟 −𝐸 𝑟 =∑ (𝑟 − 𝐸 𝑟 ) 𝑝
 Using the variance and covariance of individual assets that compose the portfolio
• Var 𝑟 = 𝑉𝑎𝑟 𝑤 𝑟 + 𝑤 𝑟 + ⋯ + 𝑤 𝑟
=∑ ∑ 𝑤𝑤𝜎 =∑ ∑ 𝑤𝑤𝜌 𝜎 𝜎

1) Using the probability distribution of the portfolio’s returns
State of Stock X Stock Y Portfolio returns

Probability
Economy Returns Returns
Poor 0.25 -0.10 0.00

Normal 0.50 0.10 0.05
Good 0.25 0.30 0.10

2) Using the variance and covariance of individual assets that compose the portfolio
State of Economy Probability Stock X Returns Stock Y Returns
Poor 0.25 -0.10 0.00
Normal 0.50 0.10 0.05
Good 0.25 0.30 0.10

The Sharpe Ratio
 Reward-to-Volatility ratio
 Ratio of risk premium to standard deviation

𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝑹𝒊𝒔𝒌 𝑷𝒓𝒆𝒎𝒊𝒖𝒎 𝑬 𝒓𝑷 𝒓𝒇
 𝑺𝑷 = 𝑺𝒕𝒂𝒏𝒅𝒂𝒓𝒅 𝑫𝒆𝒗𝒊𝒂𝒕𝒊𝒐𝒏 𝒐𝒇 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝒓𝒆𝒕𝒖𝒓𝒏𝒔 = 𝝈𝑷
where 𝑬 𝒓𝑷 =Expected return of the portfolio

𝒓𝒇 = Risk free rate of return; Rate of return that can be earned with certainty
𝝈𝑷 = Standard deviation of portfolio returns
 The Sharpe ratio quantifies the incremental reward for each increase of 1% in the standard deviation.
 The higher the Sharpe ratio, the better reward per unit of the standard deviation.
 A higher Sharpe ratio indicates a more efficient portfolio.

Portfolio Diversification (1)
 Don’t put all your eggs in one basket.
Don’t put all your money in one asset.
: If you put all your money in one asset, a disaster

befalling that asset will make you go bankrupt.
With your money spread out across a variety of
assets, you are not hurt as badly when any one
asset does poorly.
 Diversification: The process of spreading an investment across assets (and thus forming a portfolio)
 The principle of diversification: The diversification reduces the risk.

How diversification works?
Example) Stocks A, B, and C.
State of Economy Probability 𝒓𝑨 (%) 𝒓𝑩 (%) 𝒓𝑪 (%) 𝒓𝑷 = 𝟎. 𝟓𝒓𝑩 + 𝟎. 𝟓𝒓𝑪
1 0.5 10 20 0
2 0.5 10 0 20
 Statistics
A 𝐁 𝐂 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 (𝑩: 𝟓𝟎%, 𝑪: 𝟓𝟎%)
Expected return
Standard deviation
Correlation
 Standard deviation of the portfolio with 𝒘𝑩 = 𝒘𝑪 = 𝟎. 𝟓

Why diversification works?
 Key: Correlation

 Example) Correlation and the risk reduction
Stock A Stock B
Expected return 30% 10%
Standard deviation 30% 10%
Portfolio weights 0.6 0.4
 When ρ=+1
 When ρ=0
 When ρ=-1

 The relationship between portfolio size and portfolio risk
 For equally weighted portfolios that contain different numbers of randomly selected NYSE securities
Q) If you randomly select a single NYSE stocks and put all your money
into it, what would be your typical standard deviation of returns?
A) ______________
 The portfolio standard deviation declines as the number of securities

increases.
• Diversification effect
• What if securities are not randomly selected?
 The portfolio standard deviation is not reduced to zero.

• Even extensive diversification cannot eliminate all risk.

 The relationship between portfolio size and portfolio risk
 Some of riskiness associated with individual assets can be eliminated by forming portfolios.
 There is a minimum level of risk that cannot be eliminated by simply diversifying.

Diversifiable Risk and Systematic Risk
 Diversifiable risk
 The risk that can be eliminated by diversification
 Risk from firm-specific factors (success in R&D, management style, philosophy, …)
 Systematic risk
 The risk that remains even after diversification
 Risk attributable to market-wide risk sources, general economic conditions (business cycles, inflation, exchange rate, ...)

Portfolio Combination Line (1)
 A line describing the possible risk-return combinations available to investors
 Portfolio weights determine the risk-return combinations.
<The case of perfect positive correlation>
Stock A Stock B WA WB E[RP] σP

2.00 -1.00 0.50 0.50 Portfolio combination line
ρ=+1
Weight w 1-w
1.75 -0.75 0.45 0.45 ρ=+1
1.50 -0.50 0.40 0.40
Expected return 30% 10% 0.60
1.25 -0.25 0.35 0.35
Standard deviation 30% 10% 0.50
1.00 0.00 0.30 0.30
0.40
0.75 0.25 0.25 0.25
E[rP]
0.50 0.50 0.20 0.20 0.30
0.25 0.75 0.15 0.15 0.20

0.00 1.00 0.10 0.10 0.10
-0.25 1.25 0.05 0.05 0.00
-0.50 1.50 0.00 0.00 0.00 0.10 0.20 0.30 0.40 0.50 0.60
-0.75 1.75 -0.05 0.05 σP
-1.00 2.00 -0.10 0.10

<The case of perfect negative correlation>
Stock A Stock B WA WB E[RP] σP Portfolio combination line

2.00 -1.00 0.50 0.70
ρ=-1 ρ=-1
1.75 -0.75 0.45 0.60
Weight w 1-w 0.60
1.50 -0.50 0.40 0.50
Expected return 30% 10% 0.50
1.25 -0.25 0.35 0.40
Standard deviation 30% 10% 1.00 0.00 0.30 0.30 0.40
0.75 0.25 0.25 0.20 0.30

0.50 0.50 0.20 0.10 0.20
0.25 0.75 0.15 0.00
E[rP]
0.10
0.00 1.00 0.10 0.10
0.00
-0.25 1.25 0.05 0.20 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
-0.10
-0.50 1.50 0.00 0.30
-0.20
-0.75 1.75 -0.05 0.40
-1.00 2.00 -0.10 0.50 -0.30
-0.40
σP

<The case of imperfect correlation>
Stock A Stock B WA WB E[RP] σP Portfolio combination line

ρ=0 2.00 -1.00 0.50 0.61
ρ=0
1.75 -0.75 0.45 0.53
Weight w 1-w
1.50 -0.50 0.40 0.45 0.60
1.25 -0.25 0.35 0.38 0.50
Standard deviation 30% 10% 1.00 0.00 0.30 0.30 0.40
0.75 0.25 0.25 0.23 0.30
0.50 0.50 0.20 0.16
0.20
0.25 0.75 0.15 0.11
E[rP]
0.10
0.00 1.00 0.10 0.10
0.00
-0.25 1.25 0.05 0.15
0.00 0.20 0.40 0.60 0.80
-0.50 1.50 0.00 0.21 -0.10
-0.75 1.75 -0.05 0.29 -0.20
-1.00 2.00 -0.10 0.36 -0.30
-0.40
σP

Portfolio combination line
rho=-1 rho=0 rho=1
0.60
0.50
0.40
0.30
0.20
E[rP]
0.10
0.00
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
-0.10
-0.20
-0.30
-0.40
σP

Minimum variance portfolio (1)
 The portfolio having the least variance (or standard deviation) in the portfolio combination line
rho=-1 rho=0 rho=1
0.60
0.50
0.40
0.30
0.20
E[rP]
0.10
0.00
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
-0.10
-0.20
-0.30
-0.40
σP

 Determining weights in the minimum variance portfolio
Stock A Stock B
ρ
Weight w 1-w
Variance 𝝈𝟐𝑨 𝝈𝟐𝑩
Covariance 𝝈𝑨𝑩
 Variance of the portfolio
𝝈𝟐𝑷 = 𝒘𝟐 𝝈𝟐𝑨 + (𝟏 − 𝒘)𝟐 𝝈𝟐𝑩 + 𝟐𝒘(𝟏 − 𝒘)𝝈𝑨𝑩
 Objective
min 𝝈𝟐𝑷 = 𝒘𝟐 𝝈𝟐𝑨 + (𝟏 − 𝒘)𝟐 𝝈𝟐𝑩 + 𝟐𝒘(𝟏 − 𝒘)𝝈𝑨𝑩
𝒘
 Weights in the minimum variance portfolio
𝒘∗ =

 Example) Weights in the minimum variance portfolio
Stock A Stock B
ρ=-1
Weight w 1-w ρ=-1
0.60
Standard deviation 30% 10% 0.40
WA WB E[RP] σP 0.20
E[rP]
2.00 -1.00 0.50 0.70
1.75 -0.75 0.45 0.60 0.00
1.50 -0.50 0.40 0.50 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
1.25 -0.25 0.35 0.40 -0.20

1.00 0.00 0.30 0.30
0.75 0.25 0.25 0.20 -0.40 σP
0.50 0.50 0.20 0.10
0.25 0.75 0.15 0.00
0.00 1.00 0.10 0.10
-0.25 1.25 0.05 0.20
-0.50 1.50 0.00 0.30
-0.75 1.75 -0.05 0.40
-1.00 2.00 -0.10 0.50

Mean-Variance Portfolio Theory (1)
 Optimal risky portfolio
 Investment opportunity set
Expected return
• A set of available portfolio risk-return combinations Efficient frontier
• Formed using the available assets in differing proportions.
 Efficient frontier
Investment opportunity set
• A set of portfolios satisfying the dominance principle.
• Rational investors should choose portfolios on the efficient frontier
 Optimal portfolio
Standard deviation
• Apply mean-variance indifference curve

Mean-Variance Portfolio Theory (2)
 Optimal risky portfolio
𝑬[𝒓]
Q1) Who is more risk-averse?
Efficient frontier Q2) Whose optimal portfolio is

of risky assets less risky?

Allocation to risk-free and risky assets (1)
 Risk-free asset
 Asset giving a certain fixed payoff.
 Proxy
• Ex) T-bill, money market instruments
 Expected return from the risk-free asset: risk-free rate 𝒓𝒇
 Variance: ___________
 Covariance with other assets’ returns: ___________

 Investment opportunity set for a risky asset and a risk-free asset
Risky asset i Risk-free asset
Return 𝒓𝒊 𝒓𝒇
Weight w 1-w
Variance 𝝈𝟐𝒊 𝟎
Covariance 𝟎
Expected return
Finding risk-return combination and risk by

varying portfolio weights
w 1-w 𝒓𝑷 𝐄[𝐫𝐏 ] 𝛔𝐏
1 0 1
2 0.5 0.5
3 1 0
▶ When we have the risk-free asset and a risky portfolio, the

Standard deviation resulting opportunity set is the straight line!

 Investment opportunity set for a risky asset and a risk-free asset
Risky asset i Risk-free asset
Return 𝒓𝒊 𝒓𝒇
Weight w 1-w
Variance 𝝈𝟐𝒊 𝟎
Covariance 𝟎
𝒓𝒑 = 𝒘𝒓𝒊 + (𝟏 − 𝒘)𝒓𝒇
 Expected return
 Risk (Variance, Standard deviation)

 Capital allocation line: CAL
𝑬 𝒓𝒊 − 𝒓𝒇
𝑬 𝒓𝒑 = 𝒓𝒇 + 𝝈𝑷
𝝈𝒊
𝑬[𝒓𝑷 ]  When we have the risk-free asset and a risky

portfolio, the resulting opportunity set is the
straight line called CAL.
 The CAL represents the relation between the

expected return and risk of the portfolio
consisting of the risk-free asset and risky
𝝈𝑷 assets.

 Example)
 Stock A: Expected return=18%, Standard deviation=12%

 Risk-free rate: 6%
• Find the expected return and standard deviation of the portfolio, 60% of which is held in stock A
and 40% in the risk-free asset.
• Find the capital allocation line.

 Efficient frontier in the existence of risk-free asset
𝑬[𝒓]

 Optimal portfolio with risky and risk-free assets
 In the presence of a risk-free asset, an optimal portfolio should be chosen among a straight line
liking the risk-free asset and tangent portfolio.
𝑬[𝒓]
Efficient frontier with
risk-free asset
𝑻𝒂𝒏𝒈𝒆𝒏𝒕 𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐
𝒓𝒇

Homework (1)
 Stocks offer an expected rate of return of 10% with a standard deviation of 20%, and gold
offers an expected return of 5% with a standard deviation of 25%.
(a) In light of the apparent inferiority of gold to stocks with respect to both mean return and
volatility, would anyone hold gold? If so, demonstrate graphically why one would do so.
(b) How would you answer (a) if the correlation coefficient between gold and stocks were 1?
Could these expected returns, standard deviations, and correlation represent an equilibrium
for the security market?

Homework (2)
 Assume that you manage a risky portfolio with an expected rate of return of 17% and a
standard deviation of 27%. The T-bill rate is 7%. Your client choose to invest 70% of a
portfolio in your fund and 30% in a T-bill money market fund.
(a) What is the expected return and standard deviation of your client’s portfolio?
(b) What is the Sharpe ratio of your risky portfolio and your client’s overall portfolio?
(c) Draw the CAL of your portfolio on an expected return/standard deviation diagram. What
is the slop of the CAL? Show the position of your client on your fund’s CAL.

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Investments (BUS2007)

X, Y, Z : a random variable, a, b, c : constant

 Properties of the expected value

Da-Hea Kim Lecture note 5. Portfolio theory 2

X, Y, Z : a random variable, a, b, c : constant

Da-Hea Kim Lecture note 5. Portfolio theory 3

X, Y, Z : a random variable, a, b, c : constant

Da-Hea Kim Lecture note 5. Portfolio theory 4

X, Y, Z : a random variable, a, b, c : constant

• 𝑪𝒐𝒓𝒓 𝑿, 𝒀 = 𝟏 : a strong positive linear relationship between X and Y

• 𝑪𝒐𝒓𝒓 𝑿, 𝒀 = −𝟏 : a strong negative linear relationship between X and Y

Da-Hea Kim Lecture note 5. Portfolio theory 5

Da-Hea Kim Lecture note 5. Portfolio theory 6

 Mean-variance portfolio theory

Da-Hea Kim Lecture note 5. Portfolio theory 7

 Portfolio: a group of assets

 How to choose an optimal portfolio

2. Apply the dominance principle

Da-Hea Kim Lecture note 5. Portfolio theory 8

 𝒊: i-th asset return, i =1,2, …, n

 𝒊: portfolio weight of i-th asset, i =1,2, …, n

Da-Hea Kim Lecture note 5. Portfolio theory 9

 Using the probability distribution of the portfolio’s returns

Da-Hea Kim Lecture note 5. Portfolio theory 10

 Future states of economy s=1,2, …, m

2. Calculate the expected value of the portfolio’s returns

Da-Hea Kim Lecture note 5. Portfolio theory 11

 Future states of economy s=1,2, …, m

1. Calculate the expected returns for each asset.

2. Calculate a weighted average of individual assets’ expected returns.

Da-Hea Kim Lecture note 5. Portfolio theory 12

1) Using the probability distribution of the portfolio’s returns

State of Stock X Stock Y

Poor 0.25 -0.10 0.00

Da-Hea Kim Lecture note 5. Portfolio theory 13

• Future states of economy s=1,2, …, m

 Using the probability distribution of the portfolio’s returns

Da-Hea Kim Lecture note 5. Portfolio theory 14

1) Using the probability distribution of the portfolio’s returns

State of Stock X Stock Y Portfolio returns

Poor 0.25 -0.10 0.00

Da-Hea Kim Lecture note 5. Portfolio theory 15

Da-Hea Kim Lecture note 5. Portfolio theory 16

 Ratio of risk premium to standard deviation

where 𝑬 𝒓𝑷 =Expected return of the portfolio

 A higher Sharpe ratio indicates a more efficient portfolio.

Da-Hea Kim Lecture note 5. Portfolio theory 17

Don’t put all your money in one asset.

: If you put all your money in one asset, a disaster

 The principle of diversification: The diversification reduces the risk.

Da-Hea Kim Lecture note 5. Portfolio theory 18

 Standard deviation of the portfolio with 𝒘𝑩 = 𝒘𝑪 = 𝟎. 𝟓

Da-Hea Kim Lecture note 5. Portfolio theory 19

Da-Hea Kim Lecture note 5. Portfolio theory 20

Da-Hea Kim Lecture note 5. Portfolio theory 21

 The portfolio standard deviation declines as the number of securities

 The portfolio standard deviation is not reduced to zero.

Da-Hea Kim Lecture note 5. Portfolio theory 22

Da-Hea Kim Lecture note 5. Portfolio theory 23

Da-Hea Kim Lecture note 5. Portfolio theory 24

 Portfolio weights determine the risk-return combinations.

<The case of perfect positive correlation>

Stock A Stock B WA WB E[RP] σP

0.25 0.75 0.15 0.15 0.20