FIN 301 – Exercise 8

Mean-Variance Efficient Portfolios

annabelle.broestl@students.uni-mannheim.de
True/False Statements

• The covariance between the returns on two stocks equals the correlation
coefficient multiplied by the standard deviations of the two stocks.
• A risk premium is the difference between a security's return and short-term
government bonds like the Treasury bill return.
• Investors will always prefer the investment with the highest return.

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True/False Statements

• Diversification eliminates both firm-specific and systematic risk.

• The portfolio risk that cannot be eliminated by diversification is called
idiosyncratic (=unique, diversifiable) risk.
• Stocks in the same industry tend to have more highly correlated returns than
stocks among different industries.
• Investors require a risk premium for bearing idiosyncratic risk.
• If two stocks have a correlation coefficient of -1, the risk of a portfolio with
those two stocks is always zero.

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Recap from last week

• Portfolios = combinations of several stocks

• The portfolio return is the weighted average of the individual stocks‘ returns:
μ= N j=1(wi ∗ ri )
N N
• Portfolio variance: i=1 j=1 wi wj cov(ri , rj )
• Combining stocks with not perfectly positively correlated returns (r < 1) reduces
the portfolio variance at no cost (portfolio still yields the weighted average
return, variance is lower than weighted average of variances).
• Portfolio investments can be combined with either borrowing or lending money
at the risk-free rate.

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Key concepts of todays exercise

(1) Which portfolio combination of several stocks minimizes the variance? ->
Minimum variance portfolio (MVP)
– Derivation
– Calculation
– Usage + Implications

(2) Which portfolio is the “best” portfolio in terms of its return/risk ratio? ->
Tangency portfolio (market portfolio)
– Derivation (MVP and capital allocation line)
– Implications

(3) How can diversification be achieved in practice?

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Exercise 8 a – Mean-Variance Efficient Portfolios

Minimum Variance Portfolio

• μMVP = 1 − 0.265 ∗ 0.09 + 0.265 ∗ 0.13 = 0.1006 = 10.06%

• σ2 MVP = 0.7352 ∗ 0.04 + 0.2652 ∗ 0.09 + 2 ∗ 0.735 ∗ 0.265 ∗ 0.012 =
0.0326
• σMVP = 0.0326 = 0.1806 = 18.06%

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Exercise 8 a – Mean-Variance Efficient Portfolios

How would you derive the stock combination of the minimum

variance portfolio?
Two stock example:
Question: What is the minimum of the portfolio variance function?
Solution: Express both weights in terms of wA, set the first derivative of the
expected portfolio variance equal to zero and solve for the weights.

var wA = wA 2 ∗ σ2A + 1 − wA 2 ∗ σ2B + 2 ∗ wA ∗ 1 − wA ∗ σAB

var wA = wA 2 ∗ 0.04 + 1 − wA 2 ∗ 0.09 + 2 ∗ wA ∗ 1 − wA ∗ 0.012
var wA = 0.04wA 2 + 1 − 2wA + wA 2 ∗ 0.09 + 1 − wA ∗ 0.024wA
var wA = 0.04wA 2 + 0.09 − 0.18wA + 0.09wA 2 + 0.024wA − 0.024wA 2
var wA = 0.106wA 2 + 0.09 − 0.156wA

var ′ wA = 0.212wA − 0.156 = 0

wA = 0.7358
wB = 1 − wA = 1 − 0.7358 = 0.2642
FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 7
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Exercise 8 b – Mean-Variance Efficient Portfolios

Minimum Variance Portfolio

• All points on the curve are feasible

combinations of the two stocks if
you invest your whole money
• Combinations are efficient if
there is no other possible feasible
combination that yields a higher
return at the same standard
deviation
• Only combinations „above“ the
MVP are efficient

How could you even

further decrease the
variance of your portfolio?
FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 8
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Exercise 8 b – Mean-Variance Efficient Portfolios

Minimum Variance Portfolio

Suppose you express the

portfolio combinations as a
function of µ depending on σ,
e.g. µ = x ± 𝑦 + 𝑧 ∗ σ

(1) What will be the x in the

function?
A: The return of the market
portfolio
B: The return of the minimum
variance portfolio
C: The return of any portfolio
(not specified)

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Exercise 8 b – Mean-Variance Efficient Portfolios

Minimum Variance Portfolio

Suppose you express the

portfolio combinations as a
function of µ depending on σ,
e.g. µ = x ± 𝑦 + 𝑧 ∗ σ

(1) Which part of the function

(+ or -) describes the
efficient combinations?
A: The + part
B: The - part

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Exercise 8 c – Mean-Variance Efficient Portfolios

Minimum Variance Portfolio

Short Sale:
• Selling an asset you actually
don’t own at the moment. At a
later point of time, you have to
buy the asset. A short sale leads
to a negative position (or
weight) in an asset
• borrowing money = short
position in the risk free asset

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The Mechanics of a Short Sale

• Person X wants to short stocks that person Y currently owns

• X contacts his broker -> broker borrows the stocks from Y
• X sells the borrowed stocks
• At some time in the future X must „close the short sale“ by actually buying
stocks from Y
• Until the short sale is closed, X has to pay the dividends to Y
• Naked short sale: You don‘t locate the share to borrow before making the sale.
• Covered short sale: You locate the share to borrow before making the sale
Cashflows Date 0 Date 1 Date 2
Buying a stock -P0 + Div +P1
Shorting a stock +P0 - Div -P1

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Examples

https://www.ft.com/content/904a571b-b802-449f-b500-
40406ddb38e4

https://www.bbc.com/news/world-europe-39666302

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The Risks of Short-Selling

Financial Times (2018): The Day Volkswagen briefly conquered the world (https://www.ft.com/content/0a58b63a-4294-
3e07-8390-c3aabef39a26)

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Example 1: Portfolio with a long position
(150%) in stock A and a short position (-50%) in stock B

• Notice: The weights still sum up to 100%!

• µ= 1.5 ∗ 0.09 + −0.5 ∗ 0.13 = 0.07 = 7%
• σ2 𝑃 = 1.52 ∗ 0.04 + (−0.5)2 ∗ 0.09 + 2 ∗ 1.5 ∗ −0.5 ∗ 0.012 =0.0945
• σP = 0.0945 = 0.3074

• Suppose you have 100€ at your disposal for investing -> This means you sell 50€
worth of stock B short, receive those 50€ and invest them (+the initial 100€) in
stock A (in sum 150€)

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Example 2: Portfolio with a long position
(150%) in stock B and a short position (-50%) in stock A

• Notice: The weights still sum up to 100%!

• µ= −0.5 ∗ 0.09 + 1.5 ∗ 0.13 = 0.15 = 15%
• σ2 𝑃 = (−0.5)2 ∗ 0.04 + 1.5 2 ∗ 0.09 + 2 ∗ 1.5 ∗ −0.5 ∗ 0.012 =0.1945
• σP = 0.1945 =0.4410

• Suppose you have 100€ at your disposal for investing -> This means you sell 50€
worth of stock A short, receive those 50€ and invest them (+the initial 100€) in
stock B (in sum 150€)

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Exercise 8 d – Mean-Variance Efficient Portfolios

Tangency Portfolio

• MVP = Portfolio with

minimum variance
• Tangential portfolio = The
most efficient portfolio
 the tangency point of the line
drawn from the point of the risk
free asset to the feasible region
ri with maximum slope

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Exercise 8 d – Mean-Variance Efficient Portfolios

Tangency Portfolio

• Where does the line drawn from the risk-free rate coincide with the efficient
frontier?

• What is the green function?

– Tangent of risky assets curve at TP

rTP −rf
– slope = σTP

– Return μ depends on σ

– Intercept = rf
rTP −rf
• μ = rf + ∗σ
σTP

i.e., “Capital Allocation Line”

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 18
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Exercise 8 d – Mean-Variance Efficient Portfolios

Tangency Portfolio To be calculated: σ and μ of the tangency portfolio

rTP −rf
• Given: μ = rf + ∗ σ and μ = 0.1006 ± 0.0151(σ2 − 0.0326)
σTP

• Only μ = 0.1006 + 0.0151(σ2 − 0.0326) describes the efficient

combinations
• Remember: tangent slope is the slope of curve at TP -> use this to calculate the
return and sd of TP
(1)Calculate the 1st derivative of both functions

a) μ = 0.1006 + (0.0151(σ2 − 0.0326))0.5

μ′ = 0.0151 ∗ 0.5 ∗ σ ∗ 2 ∗ (0.0151 σ2 − 0.0326 )−0.5
r −r
b) μ = rf + TP f
∗σ
σTP
′
rTP − rf
μ= Sharpe ratio = ratio of
σTP reward to volatility
provided by a portfolio
FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 19
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Exercise 8 d – Mean-Variance Efficient Portfolios

Tangency Portfolio

(2) Set the two equations equal:

2 −0.5
rTP − rf
0.0151 ∗ 0.5 ∗ σ ∗ 2 ∗ (0.0151 σ − 0.0326 ) =
σTP
0.0151 ∗ 0.5 ∗ σ ∗ 2rTP − rf
=
2
0.0151 σ − 0.0326 σTP

(3) Rewrite 𝐫𝐓𝐏 as 𝟎. 𝟏𝟎𝟎𝟔 + 𝟎. 𝟎𝟏𝟓𝟏 𝛔𝟐 − 𝟎. 𝟎𝟑𝟐𝟔 and set 𝐫𝐟 = 𝟎. 𝟎𝟓𝟒

0.0151 × σ 0.1006 + 0.0151(σ2 − 0.0326) − 0.054

=
2
0.0151 σ − 0.0326 𝜎

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Exercise 8 d – Mean-Variance Efficient Portfolios
Tangency Portfolio
(4) Divide by 𝝈
0.0151 0.1006+ 0.0151(𝜎2 −0.0326)−0.054
=
0.0151 𝜎2 −0.0326 𝜎2

(5) Multiply with 𝝈𝟐 and 𝟎. 𝟎𝟏𝟓𝟏 𝝈𝟐 − 𝟎. 𝟎𝟑𝟐𝟔

2
2
0.0151 ∗ σ = 0.1006 − 0.054 ∗ 0.0151(σ2 − 0.0326 + 0.0151 σ2 − 0.0326

0.0151 ∗ σ2 = 0.1006 − 0.054 ∗ 0.0151(σ2 − 0.0326 + 0.0151σ2 − 0.0151 ∗ 0.0326

(6) Subtract 𝟎. 𝟎𝟏𝟓𝟏 ∗ 𝝈𝟐 from both sides of the equation

0 = 0.0466 ∗ 0.0151(σ2 − 0.0326 + 0 − 0.0151 ∗ 0.0326

(7) Add (0.0151 * 0.0326)

0.0151 ∗ 0.0326 = 0.0466 ∗ 0.0151(σ2 − 0.0326)

(8) Divide by 0.0466 and take both sides to the power of 2

0.0001115 = 0.0151σ2 − 0.0004923
FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 21
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Exercise 8 d – Mean-Variance Efficient Portfolios

Tangency Portfolio
(9) Add 𝟎. 𝟎𝟎𝟎𝟒𝟗𝟐𝟑
0.0006038 = 0.0151σ2

(10) Divide by 0.0151

σ2 = 0.04 → σ = 0.20

(11) Plug the variance into the return formula in order to get the return of the tangency
portfolio

r = 0.1006 + 0.0151(0.04 − 0.0326) = 11.1%

(12) Use the return of the portfolio and the individual returns of the stocks to derive the
portfolio weights

0.09 ∗ xA + 0.13 1 − xA = 0.111 → xA = 0.475; xB = 0.525

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Exercise 8 e – Mean-Variance Efficient Portfolios

Tangency Portfolio

Mr. Chicken is very risk averse. In

which area will his portfolio
allocation lie?
(1) Area A
(2) Area B
(3) Area C

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Exercise 8 e – Mean-Variance Efficient Portfolios

Tangency Portfolio

Investors who want less return

(but also less risk) will lend
money to the bank (= invest in
the risk-free asset) and invest the
rest of their wealth into the
tangential portfolio.
 wrf > 0; 0 < wTP < 1

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 24

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Exercise 8 e – Mean-Variance Efficient Portfolios

Tangency Portfolio

Mrs. Risky is less risk averse. In

which area will her portfolio
allocation lie?
(1) Area A
(2) Area B
(3) Area C

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Exercise 8 e – Mean-Variance Efficient Portfolios

Tangency Portfolio

Investors who want more return

(and also more risk) will borrow
money from the bank (= short the
risk-free asset) and invest the
proceeds + the initial amount of
their wealth into the tangential
portfolio.
 wrf < 0; wTP > 1

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On the shoulders of giants…

https://www.risknet.de/themen/risknews/harry-max-
markowitz-begruender-der-modernen-portfoliotheorie/ https://de.wikipedia.org/wiki/James_Tobin

Markowitz Tobin
• Which portfolio combinations are • What are the implications if we let
efficient? investors combine efficient portfolios
• Mathematical models for calculating with an investment in the risk free
the efficient frontier rate?
• Effect of diversification
FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 27
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Exercise 8 e – Mean-Variance Efficient Portfolios

Tobin’s Separation Theorem

• Investors only want to invest in the most efficient portfolio (which is the
tangency portfolio)
• However, some investors are more and some are less risk-averse than others
• By lending or borrowing money, investors can leverage or deleverage their
position in the tangential portfolio and still achieve an efficient combination at
the return (and risk) they demand
 The composition of the market portfolio is independent of the investors‘
demand for risk! (Remember that we derived it before answering where Mr.
Chicken and Mrs. Risky’s portfolios will lie)
 Two different processes:
 Determination of Tangential Portfolio. (Same for all investors, purely technical)
 Choice of Leverage (different for investors, depends on degree on risk aversion)
 Each investor will hold the same portfolio combination of risky assets (market
portfolio), only at different levels of leverage.

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 28

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Exercise 8 f – Mean-Variance Efficient Portfolios

Portfolio Weight Calculation

Capital Allocation Line:

rTP − rf
μ = rf + ∗σ
σTP
rTP = 11.1% rf = 5.4% σTP = 20%
Portfolio Weights
0.111 − 0.054
μ = 0.054 + ∗σ
0.2
0.111 − 0.054
0.08 = 0.054 + ∗σ
0.2
σ = 9.1%

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Exercise 8 f – Mean-Variance Efficient Portfolios

Portfolio Weight Calculation

Capital Allocation Line:

rTP − rf
μ = rf + ∗σ rTP = 11.1% rf = 5.4% σTP = 20%
σTP

0.111 − 0.054 Portfolio Weights

μ = 0.054 + ∗σ
0.2
0.111 − 0.054 μ = wrf ∗ rf + 1 − wrf ∗ rTP
0.08 = 0.054 + ∗σ
0.2 0.08 = 0.054wrf + 1 − wrf ∗ 0.111
σ = 9.1% 0.08 = 0.054wrf + 1 − wrf ∗ 0.111
wrf = 0.54 = 54%
wTP = 1 − wrf = 0.46 = 46%

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 30

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Exercise 8 f – Mean-Variance Efficient Portfolios

Portfolio Weight Calculation

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 31

April 26, 2023
Exercise 8 f – Mean-Variance Efficient Portfolios

Diversification in Practice

• Diversify with asset classes (stocks, bonds, cash, …)

• Diversify among countries
• Large/small cap stocks
• Diversify with index funds

• Problem: Investors may not be rational (don’t only care about return and risk) ->
behavioural biases (favoured industries, home/employee buyers)  this
discussion will be postponed until the end of the class
• However, we are still under the assumption of rational investors (= μ-σ
preferences): Thus, investors won’t be compensated for being exposed to
diversifiable risk.

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 32

April 26, 2023
Why is the risk premium for
diversifiable risk zero?

„ If the diversifiable risk of stocks were compensated with an additional risk

premium, then investors could buy the stocks, earn an additional premium, and
simultaneously diversify and eliminate the risk. By doing so, investors could earn an
additional premium without taking additional risk. This opportunity to earn
something for nothing would quickly be exploited and eliminated.“
(Berk/DeMarzo(2011): Corporate Finance – The Core, p. 313)

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 33

April 26, 2023
Implications

• But: remember from last class that diversification has its limits -> market risk
cannot be eliminated.
• Therefore, the risk premium will not depend on the total risk but only on the
stock’s exposure to market risk (=systematic risk).

Individual investors can diversify firm-specific risks better than the firms
themselves. Thus, the return associated with owning a given companies‘ stock
only has to compensate the investors for the degree of market risk the
company is exposed to.

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 34

April 26, 2023
Outlook

• This week, we have seen how optimal investing looks like through the lens of an
individual investor
– Markowitz: efficient portfolios
– Tobin: combination of efficient portfolios and risk free rate -> combination
of tangency portfolio and risk free rate are most efficient portfolios
• Next week, we will see what happens if we take a look at the aggregate actions
of all investors in the market
– Sharpe: Given Markowitz‘ and Tobin‘s findings, which return will investors
require from a given company‘s stock such that they add it to their
diversified portfolio? (Capital Asset Pricing Model)

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 35

April 26, 2023
Exercise 8 – Main Takeaways

• A portfolio is efficient if it is not possible to find another portfolio that yields a

higher return at lower risk.
• The tangential portfolio is the portfolio that generates the steepest possible line
when combined with the risk free asset. It has the highest sharpe ratio of all
portfolios in the economy and consequently provides the best risk-return trade-
off.
• Every rational investor should invest in the tangential portfolio regardless his
demand for risk. By borrowing/lending, the investor can adjust his portfolio in
order to account for his risk preferences.
• The composition of the market portfolio is independent of the investors‘
demand for risk.

FIN 301 – Exercise 8 – Mean-Variance Efficient Portfolios 36

April 26, 2023