Universidad Carlos III de Madrid 9/2/2010

Topic 5: Portfolio Theory

Outline
1. DIVERSIFICATION EFFECT WITH TWO ASSETS
Different cases according to the correlation coefficient
Topic 5
1.

2. The optimal portfolio

Portfolio Theory 2. THE MARKOWITZ MODEL
• The mean-
mean-variance model
Copyright of Spanish version from David Moreno
Translation into English by Francisco Romero • The feasible set

Universidad Carlos III • Efficient Portfolio and Efficient Frontier

Financial Economics • CAL: Capital Allocation Line

• Optimal or tangency portfolio

Topic 5: Portfolio Theory

- Objectives 1- THE DIVERSIFICATION EFFECT
To analyze the feasible set with two assets and different Assume there are two risky assets (1 and 2)
values for the correlation coefficient between their returns.
To analyze the mean-variance model (a classical model in The expected return and variance of a portfolio which
asset management). includes both assets is:
Learn the definition of efficient portfolio and of efficient
frontier E[ R p ] = w1 E[ R1 ] + w2 E[ R2 ] = w1 E[ R1 ] + (1 − w1 ) E[ R2 ]
Understand which efficient portfolio an investor chooses σ 2p = w12σ 12 + w22σ 22 + 2 w1w2σ 1, 2
when a risk-free assets is also available.
or
Analyze how the results change when the interest rate at σ p = w12σ 12 + w22σ 22 + 2 w1w2 ρ1,2σ 1σ 2 = ( w12σ 12 + w22σ 22 + 2w1w2 ρ1, 2σ 1σ 2 )1/ 2
which investors can raise funds exceeds the risk free rate.

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1- THE DIVERSIFICATION EFFECT 1- THE DIVERSIFICATION EFFECT

CASE 1: CORRELATION COEFFICIENT = +1 In this case there is no diversification effect.

 It indicates perfect (positive) correlation

 Using the formula

E[Rp]

Asset 1
( a + b ) = a + b + 2ab
2 2 2

 The portfolio’s volatility is: A risk-free

Asset 2
portfolio can
be obtained
σ p = ( w12σ 12 + (1 − w1 ) 2 σ 22 + 2 w1 (1 − w1 ) ρ1, 2σ 1σ 2 )1/ 2 = w1σ 1 + (1 − w1 )σ 2 when short-
selling is
allowed.
Volatility
 i.e. it is the linear combination of the volatility of the
individual assets.
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1- THE DIVERSIFICATION EFFECT 1- THE DIVERSIFICATION EFFECT

CASE 2: CORRELATION COEFFICIENT = -1 As shown in the graph below, it is possible to obtain zero
 It indicates perfect (negative) correlation
volatility without using short-selling strategies

E[Rp]

 Using: (a − b) 2 = a 2 + b 2 − 2ab Asset 1

 The volatility of the portfolio is: Asset 2

σ p = [ w σ + (1 − w1 ) σ + 2w1 (1 − w1 ) ρ1, 2σ 1σ 2 ]
2
1
2
1
2 2
2
1/ 2
= w1σ 1 − (1 − w1 )σ 2

Volatility

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1- THE DIVERSIFICATION EFFECT 1- THE DIVERSIFICATION EFFECT

CASE 3: CORRELATION COEFFICIENT Standard

deviation (%)
BETWEEN -1 and +1 This graph shows how
correlation coeff.= -1 the feasible set varies
 Depending on the correlation coefficient value, the hyperbolic Asset A depending on the
curve will change. Lower correlation between the assets value of the
returns leads to lower risk. correlation coeff.=1 correlation coefficient
between the returns
of the two assets.
E[Rp] correlation coeff.=0.5
Asset 1 Asset B
The graph showns the
cases for which short-
Asset 2 selling is not possible.
Expected return (%)

Volatility

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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

PORTFOLIO 1
INTRODUCTION TO PORTFOLIO THEORY Examples:
10%

 Portfolio Theory studies how to create portfolios that

maximize an investor’s expected utility. 20% national equity
international equity

60% bonds

 One of the most influential models in this area is the 10% tbills

Markowitz
arkowitz Model or the Mean-Variance Model, developed in
the 50s; Harry Markowitz received the Nobel Prize in PORTFOLIO 2

Economics for this theory.

25%
 Remember that a portfolio is a group of assets (shares, bonds, 40% national equity
bills, derivatives, etc.) whose weights in the portofolio (wi,) international equity

depend on how much is invested in each asset relative to the 5% bonds

tbills
total value of the portfolio.
30%

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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

The Mean-Variance model takes the name from the fact

that the selection of assets to be included in a portfolio
depends on:
 First-order moment, i.e. the expected return (mean)
 Second-order moment, i.e. the variance
The model only looks at means and variances. For this to
make sense at least one of the following assumptions needs
to hold:
 Asset returns follow a normal distribution
 Investors utilities are represented by a quadratic utility function.

 This is a static model (the focus is on the “next period”) and does In this model investors are risk averse, i.e., they want to
not consider things such as skewness of distributions or how liquid
an asset is.  Maximize expected return (E(Rp))
 Minimize risk (σp)
 Even though it has limitations, it is still considered a key model in
finance and in portfolio theory

 Its main conclusion could be graphically depicted as: “do not put all
your eggs into a single basket”.
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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

Rentabilidad
return In these graphs we can Let's use the example below to analyze portfolio theory and
return represent all possible the mean-variance model.
portfolios and investors’
preferences.
A B
Example: Assume an equally-weighted portfolio of
Example:
ACCIONA and BBVA shares. Calculate the portfolio risk
 In graph 1, A is preferred
and return using the following information from one year
risk
Riesgo
 In graph 2, B is preferred ago.
Rentabilidad risk
return
esperada

E[RB ] B

Asset Ri Variance Covariance

E[Ra]
A
ACCIONA 10% 0.0076
-0.0024
BBVA 8% 0.00708
risk
Riesgo

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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

Compute the return and risk Acciona BBVA

Rp σp All possible portfolios
(w1) (w2)
(standard deviation) for the 0 1 0,08 0,08414
are included in the Red
different portfolios (by 0,1 0,9 0,082 0,07334
Line. Feasible
Formaciónset
dewith two risky
Carteras con 2 assets
activos
Po
modifying the weights: w1 0,2 0,8 0,084 0,06377 The concepts below
and w2). 0,3 0,7 0,086 0,05608
should be taken into 0,105
account: 0,1

s p e ra d a
0,4 0,6 0,088 0,05112

R e s ta b .EReturn
0,095
0,5 0,5 0,09 0,0497 0,09
 Minimum variance 0,085

Expected
0,6 0,4 0,092 0,05212
Portfolio 0,08
0,7 0,3 0,094 0,05791  Feasible set 0,075
0,07
0,8 0,2 0,096 0,06618  Dominated Portfolios
0,04 0,05 0,06 0,07 0,08 0,09
0,9 0,1 0,098 0,07612  Efficient Frontier
Desv.Típica
Standard Deviation Portfolios
Carteras
1 0 0,1 0,08718 Minimum
variance portfolio Dominated portfolios

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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

With 3 or more assets In this case, the efficient frontier includes any portfolio between the
minimum variance portfolio and the portfolio which maximizes return.
 Portfolios are located in the curve but also in the area
inside the curve.
EFFICIENT
Efficient Frontier PORTFOLIOS:
those that
maximize return
for a given level of
risk.

EFFICIENT
Feasible set FRONTIER: set
of all the efficent
portfolios.
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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

PORTFOLIOS OF RISKY ASSETS EFFICIENT PORTFOLIOS:

PORTFOLIOS: maximize return for a given level of
risk.
 How do we calculate the weights of the individual assets in a
portfolio? EFFICIENT FRONTIER:
FRONTIER: complete set of efficient portfolios.
An example with three shares:
 We observe that:
1. There is a combination of assets that leads to the
An investor always
minimum variance portfolio. chooses a portfolio
2. There are dominated portfolios.
Efficient Frontier
located on the
efficient frontier.

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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

How to find the assets Since this is a dual problem, it So far we have analyzed how to form a portfolio of risky
can also be seen as:
combinations located on the assets, i.e. without any risk-free asset.
efficient frontier?
N
Maximize E[ R p ] =  wi E[ Ri ]
 Mathematically, it consists of i =1
However, investors can include both risk-free and risky
solving a quadratic optimization subject to assets in their portfolios.
problem:
N N N σ 2p = λ
Minimize σ p2 =  wi2σ i2 +  wi w jσ i , j
N
The Markowitz Model analizes how to create an optimal
w
i =1 i =1 j =1,
j ≠i =1
subject to i =1
i
portfolio if:
E[R p ] = φ wi ≥ 0 i = 1,.., N  There are risk-free (rf) and risky assets.
N
 Investors are risk averse.
w i =1
i =1
 It is possible to borrow and lend at the same interest
wi ≥ 0 i = 1,.., N
rate.
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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

Investors allocate a proportion of their wealth to risky assets (w) We can plot the risk-return The CAL (Capital Allocation
and the rest to risk free assets (1-w) outcomes of various Line) represents the all
combinations in a straight line portfolios that originate from
The portfolio’s expected return and variance is: (or two…). different combinations of the
E ( R p ) = (1 − w)r f + wE ( Rc ) = r f + wE ( Rc − r f ) portfolio of risky asstes C and
σ p2 = w2σ c2
E[R]
the risk-free asset.
w is given by: CAL 1
The slope of the line is:
σp Portfolio C
Cartera P

w=
σc
We obtain the expected portfolio’s return as a function of its ∂ E [ R p ] E [ Rc ]− r f
standard deviation =
∂σp σc
This gives a a relationship
σ between risk and return. Rf
E ( R p ) = rf + p E ( Rc − r f )
σc It is graphically represented by a
line called CAL (Capital
Risk
Riesgo
Allocation Line)
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2- THE MARKOWITZ MODEL 2- THE MARKOWITZ MODEL

Which risky portfolio will the investor select?

We can have different CALs, An investor chooses a
depending on the location of the portfolio located on the
portfolio of risky assets.. efficient frontier.

The one that provides the

highest return adjusted to
risk is CAL 3.

This always happens where

Which CAL would an An investor chooses the
the CAL is tangent to the
CAL with the highest
investor choose? Which slope. Efficient Frontier.
risky portfolio will be The slope of the CAL is
Portfolio T:
selected? the: E(Rt), σt
- Ratio Sharpe
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2- THE MARKOWITZ MODEL READINGS

Which portfolio will an investor choose? Brealey, R.A. and Myers, S.C. (2003). Principles of Corporate
Finance. McGraw Hill
 Portfolio weight for the risk free asset (1-w) and for the portfolio of
risky assets (w).  Chapters 7 and 8

Suárez Suárez, Andrés S. (2005). Decisiones óptimas de inversión y

TWO FUND financiación en la empresa. Ediciones Piramide.
 Chapter 30.
SEPARATION
THEOREM Brigham E.F. and Daves, P. R. (2002). International Financial
Investors maximize their Management. South-Western.
expected utility,  Chapter 2.
irrespectively of their
Grinblatt, M. and Titman, S. (2002). Financial Markets and
level of risk aversion, Corporate Strategy. McGraw Hill
2-steps solution approach:
when investing their 1. Determine the composition of portfolio T.  Chapters 4 and 5.
wealth in Rf and in the 2. Decide the proportion of wealth to invest in T and
tangency portfolio. the proportion to borrow or lend at the risk free rate
Rf, according to investors’ preferences for risk-taking.29 30

Useful Websites

BANCO DE ESPAÑA:
 http://www.bde.es

DIRECICIÓN GENERAL DEL TESORO:

 http://www.tesoro.es

MERCADO AIAF:
 http://www.aiaf.es

BOLSA DE MADRID
 http://www.bolsamadrid.es

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