Unit 4:

Portfolio Models - II
Prof. Hemendra Gupta
PORTFOLIO RETURN: TWO-
ASSET CASE
• The return of a portfolio is equal to the weighted average
of the returns of individual assets (or securities) in the
portfolio with weights being equal to the proportion of
investment value in each asset.
• We can use the following equation to calculate the
expected rate of return of individual asset:

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PORTFOLIO RISK: TWO-ASSET
CASE
• Risk of individual assets is measured by their
variance or standard deviation.

• We can use variance or standard deviation to

measure the risk of the portfolio of assets as
well.

• The risk of portfolio would be less than the risk

of individual securities, and that the risk of a
security should be judged by its contribution to
the portfolio risk.
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 Measuring Portfolio Risk for Two
Assets
• The portfolio variance or standard deviation depends on
the co-movement of returns on two assets.
• Covariance of returns on two assets measures their co-
movement.
• Three steps are involved in the calculation of covariance
between two assets:

Determining the
Determining the sum of the product
Determining the deviation of of each deviation
possible returns
expected returns from the of returns of two
on assets. expected return assets and
for each asset. respective
probability.

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Covariance & Correlation
σ(𝑋−𝑋𝑚𝑒𝑎𝑛)(𝑌−𝑌𝑚𝑒𝑎𝑛)
Cov(X,Y) =
𝑁−1

𝐶𝑜𝑣(𝑋,𝑌)
Cor(X,Y) =
𝑆𝐷𝑥.𝑆𝐷.𝑦
 Deviation from Product of
State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8

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Example
The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5)2 + 0.2(10 - 5) 2 + 0.4(8 - 5)2

+ 0.2(5 - 5)2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
sx = 33.6 = 5.80%
s 2y = 0.1(14 - 8)2 + 0.2(- 4 - 8)2 + 0.4(6 - 8)2
+ 0.2(15 - 8) 2 + 0.1(20 - 8)2
= 3.6 + 28.8 + 1.6 + 9.8 + 14.4 = 58.2
sy = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80´ 7.63 44.25

Securities X and Y are negatively correlated. The correlation coefficient of –

0.746 indicates a high negative relationship.
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Measuring Portfolio Risk for Two
Assets

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Correlation

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 Correlation
• The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
• It depends on the sign of covariance since
standard deviations are always positive
numbers.
• The correlation coefficient always ranges
between –1.0 and +1.0.
• A correlation coefficient of +1.0 implies a
perfectly positive correlation while a correlation
coefficient of –1.0 indicates a perfectly negative
correlation.
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Variance and Standard Deviation of a
Two-Asset Portfolio

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Suppose two securities Low & High have the following characteristics

Logrow Rapidex

Expected Return % 12 18

SD % 10 24
Low High Corr 1 0.5 0.25 0 -0.25 -0.5 -1

W1 W2 Ex Mean SD SD SD SD SD SD SD

1 0 12.00 10.00 10.00 10.00 10.00 10.00 10.00 10.00

0.9 0.1 12.60 11.40 10.41 9.88 9.31 8.72 8.07 6.60

0.8 0.2 13.20 12.80 11.20 10.31 9.33 8.24 6.97 3.20

0.7 0.3 13.80 14.20 12.30 11.23 10.04 8.70 7.10 0.20

0.6 0.4 14.40 15.60 13.63 12.53 11.32 9.97 8.40 3.60

0.5 0.5 15.00 17.00 15.13 14.11 13.00 11.79 10.44 7.00

0.4 0.6 15.60 18.40 16.76 15.88 14.95 13.95 12.87 10.40

0.3 0.7 16.20 19.80 18.48 17.79 17.07 16.31 15.52 13.80

0.2 0.8 16.80 21.20 20.27 19.79 19.30 18.80 18.28 17.20

0.1 0.9 17.40 22.60 22.12 21.87 21.62 21.37 21.12 20.60

0 1 18.00 24.00 24.00 24.00 24.00 24.00 24.00 24.00

20.00

18.00

16.00

14.00

1
12.00
0.5
0.25
10.00
0
-0.25
8.00 -0.5
-1
6.00

4.00

2.00

0.00
0.00 5.00 10.00 15.00 20.00 25.00 30.00
Minimum Variance Portfolio

W* is the optimum proportion of investment or weight in

security X
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 Portfolio Risk Depends on
Correlation between Assets
• Investing wealth in more than one security reduces
portfolio risk.
• This is attributed to diversification effect.
• However, the extent of the benefits of portfolio
diversification depends on the correlation between
returns on securities.
• When correlation coefficient of the returns on individual
securities is perfectly positive then there is no
advantage of diversification. The weighted standard
deviation of returns on individual securities is equal to
the standard deviation of the portfolio.
• Diversification always reduces risk provided the
correlation coefficient is less than 1.

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Perfect Positive Correlation

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There is no advantage of diversification when the returns of securities have
perfect positive correlation.

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Perfect Negative Correlation
• In this the portfolio return increases and the
portfolio risk declines.
• It results in risk-less portfolio.
• The correlation is -1.0.

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21
Zero-variance portfolio

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Zero Correlation

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Positive Correlation
• In reality, returns of most assets have positive
but less than 1.0 correlation.

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 Limits to diversification

Since any probable correlation of securities Logrow and Rapidex will range between – 1.0
and + 1.0, the triangle in the above figure specifies the limits to diversification. The risk-
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return curves for any correlations within the limits of – 1.0 and + 1.0, will fall within the
triangle ABC.
Minimum variance portfolio
• When correlation is positive or negative, the
minimum variance portfolio is given by the
following formula:

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 Mean-variance Criterion

• Inefficient portfolios- have lower return and

higher risk

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 Efficient Portfolios of risky
securities Markowitz Efficient Portfolio
An efficient portfolio is
one that has the highest
expected returns for a
given level of risk. The
efficient frontier is the
frontier formed by the
set of efficient
portfolios. All other
portfolios, which lie
outside the efficient
frontier, are inefficient
portfolios.
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 COMBINING A RISK-FREE ASSET AND
A RISKY ASSET

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Variance Covariance Matrix 2 Asset
Case
Asset X Y

Asset Weights Wx Wy

WxWyCov(x,y)
X Wx 𝑾𝒙𝟐 σ𝟐

Y Wy WxWyCov(x,y) 𝑾𝒚𝟐 σ𝟐
 Variance Covariance - Matrix

Asset
X Y Z

Wz
Asset Weights Wx Wy

WxWyCov(x,y)
WxWyCov(x,z)
X Wx 𝑾𝒙𝟐 σ𝟐

WxWyCov(y,z)
Y Wy WxWyCov(x,y) 𝑾𝒚𝟐 σ𝟐

Wz WxWyCov(x,z) WxWyCov(y,z) 𝑾𝒛𝟐 σ𝟐

Z
 MULTIPLE RISKY ASSETS AND
A RISK-FREE ASSET
• In a market situation, a large number of investors
holding portfolios consisting of a risk-free
security and multiple risky securities participate.

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 Investment Opportunity Set:
The n-Asset Case
• An efficient portfolio is one that has the highest
expected returns for a given level of risk.
• The efficient frontier is the frontier formed by the
set of efficient portfolios.
• All other portfolios, which lie outside the efficient
frontier, are inefficient portfolios.

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 PORTFOLIO RISK: THE n-ASSET
CASE
• The calculation of risk becomes quite involved
when a large number of assets or securities are
combined to form a portfolio.

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 N-Asset Portfolio Risk Matrix

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37
 RISK DIVERSIFICATION:
SYSTEMATIC AND
UNSYSTEMATIC RISK
• When more and more securities are included in
a portfolio, the risk of individual securities in the
portfolio is reduced.
• This risk totally vanishes when the number of
securities is very large.
• But the risk represented by covariance remains.
• Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

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 Risk-return relationship for portfolio of risky
and risk-free securities

We draw three lines from the risk-free rate (5%) to the three
portfolios. Each line shows the manner in which capital is allocated.
This line is called the capital allocation line.

Portfolio M is the optimum risky portfolio, which can be

39 combined with the risk-free asset.
 Slope of CML

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Suppose the expected Return on Market is 12% and Risk free rate is
4% and Standard Deviation of Market is 2%. Find the expected Return
of the portfolio is SD of portfolio has to be 1%

(𝐸 𝑅𝑚 −𝑅𝑓)
𝐸 𝑅𝑝 = 𝑅𝑚 + 𝜎𝑝 ( )
𝜎𝑚

(12%−4%)
𝐸 𝑅𝑝 = 4% + 1% ( )
2%

8%

How will the expected Return change if SD of Portfolio has to be

3%?
Sharpe𝑅Ratio
𝑝 −𝑅𝑓
•
𝑆𝐷𝑝
The Sharpe ratio is the average return earned in excess of the risk-
free rate per unit of volatility or total risk
 CAPITAL ASSET PRICING
MODEL (CAPM)
• The capital asset pricing model (CAPM) is a model that
provides a framework to determine the required rate of return
on an asset and indicates the relationship between return
and risk of the asset.
• The required rate of return specified by CAPM helps in
valuing an asset.
• One can also compare the expected (estimated) rate of
return on an asset with its required rate of return and
determine whether the asset is fairly valued.
• Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of
return.

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 Investment opportunity sets
given different
correlations

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 Systematic Risk
• Systematic risk arises on account of the
economy-wide uncertainties and the tendency of
individual securities to move together with
changes in the market.
• This part of risk cannot be reduced through
diversification.
• It is also known as market risk.
• Investors are exposed to market risk even when
they hold well-diversified portfolios of securities.

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