Chapter 7 Optimal Risky Portfolios

Diversification and Portfolio Risk

Each security has two sources of risk
- Systematic risk/Market risk: risk factor that is attributable to market-wide risk
sources
- Unsystematic risk/Firm-specific risk: risk factor that affects only a specific
company.

Total Risk or = Market Risk + Firm-specific Risk

When a portfolio becomes more and more diversified (more securities are added),
standard deviation falls as firm-specific risk is diversified.

A well-diversified portfolio has essentially no unsystematic risk.

Standard deviation of a well-diversified portfolio in reality cannot be reduced to zero

because market risk cannot be eliminated.
 7.2 Portfolios of Two Risky Assets
A risky portfolio (P) consists of stock E and stock D.

Expected Return Risk

( combining risky and risk-free assets )

÷÷
set
portfolio opportunity
risk free
-
•

portfolio

ˢ↳t
-

sell E

When

), there is no
diversification benefit by forming a portfolio as the portfolio standard deviation is
exactly standard deviation.
 When

),
there is diversification benefit by forming a portfolio as the portfolio standard
deviation is
deviation. The lower the correlation, the more the diversification benefit.

When

becomes

), there is
maximum diversification benefit by forming a portfolio as the minimum portfolio
standard deviation can be zero. risk free portfolio can be constructed
-

When short selling is allowed, the portfolio opportunity set can be extended to the right.

In a no risk-free asset world, an optimal risky portfolio can be constructed only based
on risk aversion level of each investor. CAL cannot be constructed

Expected
Return

set
portfolio opportunity

Standard Deviation
7.3 Asset Allocation with Stocks, Bonds, and Bills
Expected Return Risk
M car Sharpe ratio
=

ratio
T-bill ↳ Maximize Sharpe
↳ CAL tangent to portfolio opportunity
set

Given two risky assets, a portfolio opportunity set can be created.

With a risk-free asset, different Capital Allocation Lines (CALs) can be drawn from
the risk-free rate to a possible portfolio located on the portfolio opportunity set.

The CAL that is just tangent to the portfolio opportunity set yields the steepest slope
and the highest Sharpe ratio.

The tangency point is the tangency portfolio, which is also the optimal risky portfolio
(P).
In order to construct the optimal risky portfolio (P),

After the optimal risky portfolio (P) is established, each individual investor would
choose an optimal complete portfolio (C) based on specific risk aversion level, A.
7.4 The Markowitz Portfolio Selection Model
Security Selection

⇔ .

① Prepare the input list from a set of estimates for the expected returns of each
security and a set of estimates of variances and covariances.

For each expected return level, find a portfolio that minimizes the standard
④ deviation. Portfolio opportunity set created is summarized as Minimum-Variance
Frontier (MVF).

③ Portfolios that are on the Minimum-Variance Frontier (MVF) from the Global
Minimum Variance Portfolio (GMVP) and upward are efficient portfolios. The
frontier that lies above the global minimum variance portfolio is called the
Efficient Frontier (EF).

Any investor only chooses to invest in an efficient portfolio on the Efficient

Frontier (EF).
 Capital Allocation and Separation Property

④ Identify the risk-free asset and the CAL that is just tangent to the Efficient
Frontier (EF).

The tangent portfolio is the optimal risky portfolio (P). It is the portfolio that
maximizes the Sharpe ratio and on the Efficient Frontier (EF).

⑤ The determination of the composition of combined portfolio (C), depends on risk

aversion, A, of each investor.

Assuming investors can lend and borrow at risk-free rate:

 SELF-STUDY PROBLEM SET 1
When adding real estate to an asset allocation program that currently includes only stocks,
bonds, and cash, which of the properties of real estate returns affect portfolio risk? (You can
choose more than one answer in this problem set.)
0a. Standard deviation.
b. Expected return.
0c. Correlation with returns of the other asset classes.

SELF-STUDY PROBLEM SET 2

Which statement about portfolio diversification is correct?
a. Proper diversification can reduce or eliminate systematic risk. ✗
b.
total risk.

:
c. As more securities are added to a portfolio, total risk typically would be expected to fall
at a decreasing rate.
d. The risk-reducing benefits of diversification do not occur meaningfully until at least 30
individual securities are included in the portfolio.

SELF-STUDY PROBLEM SET 3

Which of the following statements about the minimum variance portfolio of all risky
securities are valid?
a. Its variance must be lower than those of all other risky securities or portfolios.
b. Its expected return can be lower than the risk-free rate.
c. It may be the optimal risky portfolio.
d. It must include all individual securities including the risk-free asset.

SELF-STUDY PROBLEM SET 4

Which one of the following portfolios cannot lie on the efficient frontier as described by
Markowitz?
Portfolio Expected Return (%) Standard Deviation (%)
a. W 15 36
b. X 12 15
c. Z 5 7
d. Y 9 21
0
SELF-STUDY PROBLEM SET 5
Stocks A, B, and C have the same expected return and standard deviation. The following
table shows the correlations between the returns on these stocks.

Given these correlations, the portfolio constructed from these stocks having the lowest risk
is a portfolio:
a. Equally invested in stocks A and B.
b. Equally invested in stocks A and C.

:
c. Equally invested in stocks B and C.
d. Totally invested in stock C.

SELF-STUDY PROBLEM SET 6

The correlation coefficients between pairs of stocks are as follows: = 0.85; = 0.60;
= 0.45. Each stock has an expected return of 8% and a standard deviation of 20%.
i. If your entire portfolio is now composed of stock A and you can add some of only one
stock to your portfolio, you would choose:
a. B.
b. C.
c. D.
d. Need more data.

ii. Suppose that in addition to investing in one more stock you can invest in T-bills as well.
Would you change your answers to Part i if the T-bill rate is 8%?
hold T bills as risk
=
8% 8h 0 =

premium
-

Only
- .

SELF-STUDY PROBLEM SET 7

The standard deviation of the portfolio is always equal to the weighted average of the
standard deviations of the assets in the portfolio. True or False?
F-
SELF-STUDY PROBLEM SET 8
A pension fund manager is considering three mutual funds. The first is a stock fund, the
second is a long-term government and corporate bond fund, and the third is a T-bill money
market fund that yields a rate of 8%. The information of the risky funds is as follows:
Expected Return Standard Deviation
Stock fund (S) 20% 30%
Bond fund (B) 12% 15%
The correlation between the fund returns is 0.1.

a. Tabulate and draw the investment opportunity set of the two risky funds. Use
investment proportions for the stock fund of zero to 100% in increments of 20%.

b. Solve numerically for the proportions of each asset and for the expected return and
standard deviation of the optimal risky portfolio.
15.61% -8%
c. What is the reward-to-volatility ratio of the best feasible CAL? =
0.456J
16.66%
d. You require that your portfolio yield an expected return of 14%, and that it be efficient,
on the best feasible CAL.
i. What is the proportion invested in the T-bill fund and each of the two risky
funds? Ws -0.7884
-

14% -_

8%+8115.61%-8%7=0.7884 ( 0.4561 )
ii. What is the standard deviation of your portfolio? WB 0.7Mt =

%-07884116.66%7=13.132
-

( 0.5439 )
e. If you were to use only the two risky funds, and still require an expected return of 14%, W -1=0.2116
what would be the investment proportions of your portfolio? Compare its standard
deviation to that of the optimized portfolio in d) ii, what do you conclude?
( 20%+4 Ws ) ( 12% ) Ws -0.25 14.13%
-

14% Ws Op
-
-- =

WB -0.75
-

SELF-STUDY PROBLEM SET 9

Suppose that there are many stocks in the security market and that the characteristics of
Stock A and B are given as follows:
Stock Expected Return Standard Deviation
A 10% 5%
B 15 10
Correlation = 1
What must be the value of the risk-free rate? (Hint: Think about constructing a risk-free
portfolio from stock A and B.)

wA=¥÷q ,![÷% 0.6667

-
=

WB =
0,3333
11.67%
Rf
0.6667110%7+0.3333115%7 =

E( Rp ) = =
Ws WB ECRP ) Op
0 I 12% 15%

0.2 0.8 13.6% 13.94%

0.4 0.6 15.2% 15.70%

0.6 0.4 16.8% 19.53%

0.8 0.2 18.4% 24.48%

I 0 20% 30%

wg=@% -8%745%5 (12%-8%110.1) ( 0.15 )( 0.3 )

-

(2%-8%145%74 @% -8%7130%1=[20%+12%-248%1]
(01110.15/10.3)
=
0.4561

WB 1- Ws 0.5484
"
=

E(Rp7= 0.4561120%7+0.548442%7=15.6 /
%

Op =

$456143006124454844152142144561110.54811T
30%7115%1
G. 1) (

-
16.66%
SELF-STUDY PROBLEM SET 10
Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC
Company common stock worth $100,000. Her financial adviser provided her with the
following forecast information:

The correlation coefficient of ABC stock returns with the original portfolio returns is 0.40.
a.
ABC stock. Assuming Grace keeps the ABC stock, calculate the:
i. Expected return of her new portfolio which includes the ABC stock.
E( Rnp ) 0.910.67%7+0 / ( 1.25%7--0.728 %
=
.

ii. Covariance of ABC stock returns with the original portfolio returns.
Cov
=
POABC Oop =
0.412.37%712.95%7--0.0002797
iii. Standard deviation of her new portfolio which includes the ABC stock.
0Np=t 0.942.37%72-10.142.957+210.9710 1) ( 0.4 )( 2.37%112.95%1=2.2618
.

b. If Grace sells the ABC stock, she will invest the proceeds in risk-free government
securities yielding 0.42% monthly. Assuming Grace sells the ABC stock and replaces it
with the government securities, calculate the
i. Expected return of her new portfolio, which includes the government securities.
Elrnp )= 0.910.67%1+0.110.42%7=0 -645%
ii. Covariance of the government security returns with the original portfolio
returns.
Cor = 0
iii. Standard deviation of her new portfolio, which includes the government
securities.
0.9 ( 2.37%1
Qnp
=

= 2.133%