BF2 Lecture1 ORP

The investment Decision Portfolio of Risky Assets Asset Allocation The Markowitz Portfolio Optimization Summary
Lecture 1
Chapter 7. Optimal Risky Portfolios
Associate Professor Dr. Phan Dinh Khoi
Faculty of Finance and Banking

School of Economics
Can Tho University
Oct 16 2023
Phan Dinh Khoi Business Finance 2 - Lecture 1 1 / 45

Outline
1 The investment Decision
2 Portfolio of Risky Assets
3 Asset Allocation
4 The Markowitz Portfolio Optimization
5 Summary

A top-down process with 3 steps:

Step 1. Capital allocation between the risky portfolio and
the risk-free asset
Step 2. Asset allocation across broad asset classes
Step 3. Security selection of individual assets within each
asset class

The Optimal Risky Portfolio is the portfolio on the efficient

frontier that offers the highest return per unit of risk
measured by the Sharpe ratio.
The Optimal Risky Portfolio can be obtained through the
diversification principle in which additional risky assets are
selectively added to the existing risky portfolio based on
Markowitz’s minimum-variance idea.
This is the third step of the investment decision.
The power of diversification shall be explained in this lecture

Diversification Principles
Suppose your portfolio currently consists of one stock VFS.
What would be the source of risk associated with this

investment?
How can you likely reduce the risk of your investment?

Diversification Principles
Consider a portfolio of n risky assets of which the portfolio risk is

expressed as a function of the number of risky assets in the
portfolio.
Figure: A: All risk is firm-specific Figure: B: Some risk is systematic

Market Risk and Firm-specific Risk
Firm-specific risk
- Risk that can be eliminated by diversification
- So-called: Non-systematic or diversifiable
- For example: EV industry, fuel cell technology, CEO leaders,
etc.
Market risk
- Market-wide risk sources
- Remains even after diversification
- So-called: Systematic or non-diversifiable
- For example: economic growth, inflation, interest rate, etc.

Portfolio risk and number of stocks
The average standard deviation of returns of portfolios

composed of only one stock was 49.2%. The average portfolio
risk fell rapidly as the number of stocks included in the
portfolio increased.
The portfolio risk could be reduced to only 19.2%
Figure: C: The power of diversification

Covariance and Correlation
Two important concepts underpin the diversification idea.

Portfolio risk depends on the correlation and covariance
between the returns of the assets in the portfolio.
Covariance and the correlation coefficients provide a
measure of the way the returns of two assets vary.

Portfolio of Risky Assets
Given a portfolio of two risky assets (P) that includes a corporate

bond (D) and a stock (E), an investor would like to know the
parameters of the portfolio as follows:
Expected return
Portfolio risk
Portfolio covariance
These parameters are the starting point of the efficient
diversification problem.
This is also called the two-security portfolio case of the portfolio
selection problem.

Two-security Portfolio: Return
Definition: Given a portfolio (P) that consists of a bond (D)

and an equity (E)
Notations:
rP : Portfolio return
wD : Bond weight
rD : Bond return
wE : Equity weight
rE : Equity return
E (rP ) = wD E (rD ) + wE E (rE ) (1)

Two-security Portfolio: Risk
Notations:
2 = Variance of Security D
σD
σE2 = Variance of Security E
σD = Standard deviation of Security D
σE = Standard deviation of Security E
Cov (rD , rE )= Covariance of returns of D and E
Cov (rD , rE ) = ρDE σD σE
σP2 = wD2 σD
2 + w 2 σ 2 + 2w w Cov (r , r )
E E D E D E (2)

Range of values for ρDE
−1.0 ≤ ρ ≤ +1.0
If ρ = +1.0 i.e., D and E are perfectly positively correlated
If ρ = 0.0 i.e., D and E are uncorrelated
If ρ = −1.0 i.e., D and E are perfectly negatively correlated
How does ρ affect the portfolio risk in Eq(2)?
σP2 = wD2 σD
2 + w 2 σ 2 + 2w w ρ
E E D E DE σD σE (3)

When ρDE = +1.0, there is no diversification
σP = wD σD + wE σE (4)
When ρDE = −1.0, a perfect hedge is possible
σP = wD σD − wE σE (5)
Hence, we have a special case to obtain weights that drive the

standard deviation σP of the portfolio to zero.
σD
wE =
σD + σE
wD = 1 − wE

Three-security Portfolio: Return & Risk
Definition: A portfolio (P) of three equities (E1 , E2 , E3 )

Notations:
rP : Portfolio return
w1 : Bond weight, and r1 : Bond return
w2 : Equity weight, and r2 : Equity return
w3 : Equity weight, and r3 : Equity return
Portfolio return
E (rP ) = w1 E (r1 ) + w2 E (r2 ) + w3 E (r3 ) (6)
Portfolio variance
σP2 =w12 σ12 + w22 σ22 + w32 σ32

(7)
+ 2w1 w2 σ1 ,2 +2w1 w3 σ1 ,3 +2w2 w3 σ2 ,3

N-security Portfolio: Return & Risk
Portfolio return
n
X
E (rP ) = w1 E (r1 ) + w2 E (r2 ) + ... + wn E (rn ) = wi E (ri ) (8)
i=1
Portfolio variance
n X
X n
σP2 = wi wj Cov (ri , rj ) (9)
i=1 j=1

Portfolio weights, returns, and standard deviations
How do weights of risky assets affect the portfolio

expected returns?
Figure: 7.3 Expected return and standard deviation with various

correlation coefficients

How do weights of risky assets affect the portfolio

expected returns?
Figure: 7.3 Portfolio expected return as a function of investment

proportion

How do weights and correlation coefficients of risky

assets affect the portfolio standard deviations?
Figure: 7.4 Portfolio standard deviation as a function of investment

proportion

How do weights and correlation coefficients of risky

assets affect the portfolio standard deviations?
Figure: 7.5 Portfolio expected returns as a function of standard deviation

Asset Allocation with Stocks, Bonds, and Bills
Generally, investors want to invest in risky portfolios that offer the

highest reward-to-volatility. That means they seek the risky
portfolio that results in the greatest expected return corresponding
to any level of volatility. This is known as Sharpe ratio.
The Sharpe ratio is defined as the portfolio’s risk premium in
excess of the risk-free rate, divided by the standard deviation.
When choosing their capital allocation between risky and risk-free
assets, the steepest Sharpe ratio, which is the slope of the capital
allocation line (CAL).
E (rp )−rf
Sp = σp (10)
How do we find the highest possible Sharpe ratio or the

steepest CAL?
To illustrate, we use the optimal risky portfolio given in Table 7.3

for the case of ρ = 0.3 and the risk-free rate T-bills yielding 5%.
Two possible capital allocation lines (CALs) are drawn starting
from the risk-free rate rf to two feasible portfolios.
Portfolio A: 82% in Bond and 18% in Equity, its expected
return is 8.9% and standard deviation is 11.45%.
Sharpe ratio at A:
SA = E (rσA A)−rf = 8.9−5
11.45 = 0.34
Portfolio B: 70% in Bond and 30% in Equity, its expected
return is 9.5% and standard deviation is 11.7%.
Sharpe ratio at B:
SB = E (rσB B)−rf = 9.5−5
11.7 = 0.38

How do we find the highest possible Sharpe ratio or the

steepest CAL?
Figure: 7.6 The opportunity set of the debt and equity funds and two
feasible CALs

Can we find a steeper CAL? The tangency portfolio, labeled P in

Figure 7.7, is the optimal risky portfolio to combine with T-bills.
Figure: 7.7 The opportunity set of the debt and equity funds and the
optimal CAL

We want to maximize the slope SP that is subject to the

constraint WD + WE by solving the optimization problem:
E (rP ) − rf X
MaxSP = subject to wi = 1
σP
The solution for weights of the optimal portfolio P
E (RD )σE2 − E (RE )Cov (RD , RE )

wD =
E (RD )σE2 + E (RE )σD2 − [E (R ) + E (R )]Cov (R , R )
D E D E
and
wE = 1 − wD
Note that R is defined as excess returns, e.g. RE = rE − rf .

Given the data in Table 7.1, we can calculate
The Optimal Portfolio’s weights
(8−5)400−(13−5)72
wD = (8−5)400+(13−5)144−(8−5)(1−5)72 = 0.4
wE = 1 − 0.4 = 0.6

Portfolio P’s expected return

E (rp ) = (0.4 ∗ 8) + (0.6 ∗ 13) = 11%
Portfolio P’s standard deviation

σp = [(0.42 ∗ 144) + (0.62 ∗ 400) + (2 ∗ 0.4 ∗ 0.6 ∗ 72)]1/2
σp = 14.2%
Sharpe ratio at P:
E (rp )−rf 11−5
Sp = σp = 14.2 = 0.42

Given a level of risk aversion e.g. A = 4, how do investors

allocate funds between the risky portfolio and risk-free asset?
E (rp ) − rf 0.11 − 0.05

y= 2
= = 0.7439
Aσp 4 ∗ 0.1422
Figure: 7.8 Determination of the optimal complete portfolio


1-0.7439 - rf
The total fraction of wealth in T-Bills: 25.61%
The total fraction of wealth in Bonds:
y ∗ wD = 0.7439 ∗ 0.4 = 29.76%
The total fraction of wealth in Equities:
y ∗ wD = 0.7439 ∗ 0.6 = 44.63%
weight of risk asset and rf
Figure: 7.8 The proportion of the optimal complete portfolio

The Markowitz Portfolio Optimization
In general, the portfolio construction problem for the case of many

risky assets and a risk-free asset can be established by the
following steps:
First, identify the risky-return combinations available from the
set of risky assets.
Next, identify the optimal portfolio of risky assets by obtaining
the portfolio weights that result in the steepest CAL.
Finally, determine an appropriate complete portfolio by mixing
the risk-free asset with the optimal risky portfolio.
In 1952, Harry Markowitz published a formal model of portfolio
selection that embodies principles of diversification to the
identification of an efficient set of portfolios, so-called the efficient
frontier of risky assets. Hence, the portfolio construction problem
is so-called the Markowitz portfolio optimization.
Security selection
The first step is to determine the risk-return opportunities

available.
Given the historical data for expected returns, variances, and
co-variances, the minimum-variance frontier is obtained for
any target expected return. This frontier is a line of the lowest
possible variance that can be attained for a given portfolio
expected return.
When short selling is not allowed, all the portfolios that lie on
the minimum-variance portfolio and upward provide the best
risk-return combination, and hence are candidates for the
optimal portfolio.
The part of the frontier that lies above the global
minimum-variance portfolio is called the efficient frontier of
risky assets.

Security selection
The concepts of:

Minimum-variance frontier
Global minimum-variance portfolio
Efficient portfolio
Figure: 7.10 The minimum-variance frontier of risky assets

Security selection
The second step is to identify the optimal portfolio of risky assets

with the highest Sharpe ratio (i.e, the steepest CAL)
Given a risk-free asset, the capital allocation line (CAL)
connects the risk-free asset to any optimal minimum-variance
portfolio on the efficient frontier.
Given P is the tangent point of the efficient frontier to the
CAL, this CAL(P) dominates all alternative feasible lines.
Therefore, portfolio P is the optimal risky portfolio.
Figure: 7.11 The efficient frontier of risky assets with the optimal CAL

Security selection
The final step is to choose an appropriate mix between the optimal

risky portfolio and T-Bills). Given a level of risk aversion, the
investor chooses the appropriate mix between the optimal
risky portfolio P and the risk-free asset T-bills.
E (rp )−rf
y= Aσp2
Figure: 7.12 Determination of the optimal complete portfolio

Capital allocation and the Separation property
Given the efficient frontier, if the risk-free asset is not included in

the investment decision then all investors will arrive at the same
optimal risky portfolio, regardless of their degree of risk aversion.
The investor’s risk aversion involves only capital allocation, and the
selection of the desired point along the CAL. As a result, the
difference between investors’ choices is that the higher risk-averse
client invests more in the risk-free asset and less in the optimal
risky portfolio than does a less risk-averse investor.
This result is called a separation property; it tells us that the
portfolio choice problem may be separated into two tasks:
The first task is to determine the optimal risky portfolio. It is
merely technical. Given the availability of all risky assets, the
best risky portfolio may be the same for all investors,
regardless of risk aversion.
The second task, capital allocation, depends on each
investor’s risk preference.
The power of diversification
The general formula for the variance of a portfolio of n risky assets

is written as:
n X
X n
σP2 = wi wj Cov (ri , rj ) (11)
i=1 j=1
Given an equally weighted portfolio, we have wi = 1/n and

Cov (ri , ri ) = σi2 , then Eq.(12) is rewriten as:
n n n
1X 2 X X 1
σP2 = σi + Cov (ri , rj ) (12)
n n2
i=1 j=1,j̸=i i=1
Note that there are n variance terms and n(n-1) covariance terms
in Eq.(13).

Define the average variance and average covariance as:

n
1X 2
σ 2P = σi (13)
n
i=1
n n
1 X X
Cov = Cov (ri , rj ) (14)
n(n − 1)
j=1,j̸=i i=1
Then the portfolio variance is written as:

1 2 n−1
σP2 = σ + Cov (15)
n n
Now we examine the effect of diversification
If Cov is zero, σP2 can be driven to zero.
However, if market risk factors impart a positive correlation
among risky asset returns then all firm-specific risk can be
diversified, and the Cov remains positive.
The same intuition is applied when we replace the average

covariance Cov by a common correlation coefficient ρ. The
portfolio variance is written as:
1 2 n−1 2
σP2 = σ + ρσ (16)
n n
The effect of correlation becomes clear.
ρ = 0, diversifiable against firm-specific risk.
ρ > 0, portfolio variance remain positive.
ρ = 1, non-diversifiable any firm-specific risk.

Table 7.13 presents portfolio standard deviation as we include more

numbers of securities in the portfolios for two cases, ρ = 0 and
ρ = 0.4.
We can see that the correlation among securities defines the power
of diversification.
Figure: 7.13 Risk reduction of equally weighted portfolios in correlated

and uncorrelated assets

Risk pooling and Risk sharing
Diversification entails spreading the investment budget across

a variety of assets in order to limit overall risk.
The idea is also associated with risk pooling and risk sharing
terminologies.
Risk pooling means spreading your exposure risks across
multiple uncorrelated risky ventures, known as the insurance
principle.
Risk sharing allows other investors to share the risk of a
portfolio of assets, known as the risk sharing strategy.

Risk pooling and Risk sharing
By adding an uncorrelated to the initial portfolio, there are

changes:
the expected risk premium is doubled
the variance is doubled
√
the standard deviation is increased by 2
√
the Sharpe ratio is increased by 2

Take home remarks
The expected return of a portfolio is the weighted average of

the component security expected returns with the investment
proportion as weights
The variance of a portfolio is the weighted sum of the
elements of the covariance matrix with the product of the
investment proportion as weights.
Even if the covariances are positive, the portfolio standard
deviation is less than the weighted average of the component
standard deviations, as long as the assets are not perfectly
positively correlated. Hence, portfolio diversification is of
value as long as assets are less likely perfectly correlated.
An asset that is perfectly negatively correlated with a portfolio
can serve as a perfect hedge. That perfect hedge asset can
reduce the portfolio variance to zero through diversification.

Take home remarks
The efficient frontier is the graphical representation of a set of

portfolios that maximize expected return for each level of
portfolio risk. Rational investors tend to select a portfolio on
the efficient frontier.
If a risk-free asset is and a universal list of assets is available,
all investors will arrive at the same portfolio on the efficient
frontier of risky assets: the portfolio tangent to the CAL.
Differences among investors’ decisions lie in how much fund
each allocates to the optimal portfolio and to the risk-free
asset.
Diversification is based on the allocation of a portfolio of fixed
size across several assets, limiting the exposure to any one
source of risk.

Final Remarks on Optimal portfolios and Non-normal returns
Non-normal returns indicate that distributions are no longer

solely described by the first two moments’ mean and variance.
Investors are more concerned with ”flat tails”, i.e. the
probability of very large losses.
Modern risk measures such as Value at Risk (VaR) or
Conditional Value at Risk (CVaR) and Expected Shortfall
(ES) should account for flat tails.
If other portfolios provide sufficiently better VaR, CVaR and
ES values than the mean-variance efficient portfolio, one may
prefer these when faced with flat-tailed distributions of assets.

QUESTIONS AND ANSWERS

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The investment Decision Portfolio of Risky Assets Asset Allocation The Markowitz Portfolio Optimization Summary

Associate Professor Dr. Phan Dinh Khoi

Faculty of Finance and Banking

Phan Dinh Khoi Business Finance 2 - Lecture 1 1 / 45

1 The investment Decision

2 Portfolio of Risky Assets

4 The Markowitz Portfolio Optimization

Phan Dinh Khoi Business Finance 2 - Lecture 1 2 / 45

A top-down process with 3 steps:

Phan Dinh Khoi Business Finance 2 - Lecture 1 3 / 45

The Optimal Risky Portfolio is the portfolio on the efficient

Phan Dinh Khoi Business Finance 2 - Lecture 1 4 / 45

Suppose your portfolio currently consists of one stock VFS.

What would be the source of risk associated with this

Phan Dinh Khoi Business Finance 2 - Lecture 1 5 / 45

Consider a portfolio of n risky assets of which the portfolio risk is

Figure: A: All risk is firm-specific Figure: B: Some risk is systematic

Phan Dinh Khoi Business Finance 2 - Lecture 1 6 / 45

Market Risk and Firm-specific Risk

Phan Dinh Khoi Business Finance 2 - Lecture 1 7 / 45

Portfolio risk and number of stocks

The average standard deviation of returns of portfolios

Figure: C: The power of diversification

Phan Dinh Khoi Business Finance 2 - Lecture 1 8 / 45

Covariance and Correlation

Two important concepts underpin the diversification idea.

Phan Dinh Khoi Business Finance 2 - Lecture 1 9 / 45

Portfolio of Risky Assets

Given a portfolio of two risky assets (P) that includes a corporate

Phan Dinh Khoi Business Finance 2 - Lecture 1 10 / 45

Two-security Portfolio: Return

Definition: Given a portfolio (P) that consists of a bond (D)

E (rP ) = wD E (rD ) + wE E (rE ) (1)

Phan Dinh Khoi Business Finance 2 - Lecture 1 11 / 45

Two-security Portfolio: Risk

Phan Dinh Khoi Business Finance 2 - Lecture 1 12 / 45

Two-security Portfolio: Risk

Range of values for ρDE

How does ρ affect the portfolio risk in Eq(2)?

Phan Dinh Khoi Business Finance 2 - Lecture 1 13 / 45

Two-security Portfolio: Risk

When ρDE = +1.0, there is no diversification

When ρDE = −1.0, a perfect hedge is possible

Hence, we have a special case to obtain weights that drive the

Phan Dinh Khoi Business Finance 2 - Lecture 1 14 / 45

Three-security Portfolio: Return & Risk

Definition: A portfolio (P) of three equities (E1 , E2 , E3 )

σP2 =w12 σ12 + w22 σ22 + w32 σ32

Phan Dinh Khoi Business Finance 2 - Lecture 1 15 / 45

N-security Portfolio: Return & Risk

Phan Dinh Khoi Business Finance 2 - Lecture 1 16 / 45

Portfolio weights, returns, and standard deviations

How do weights of risky assets affect the portfolio

Figure: 7.3 Expected return and standard deviation with various

Phan Dinh Khoi Business Finance 2 - Lecture 1 17 / 45

Portfolio weights, returns, and standard deviations

How do weights of risky assets affect the portfolio

Figure: 7.3 Portfolio expected return as a function of investment

Phan Dinh Khoi Business Finance 2 - Lecture 1 18 / 45

Portfolio weights, returns, and standard deviations

How do weights and correlation coefficients of risky

Figure: 7.4 Portfolio standard deviation as a function of investment