Introduction to Portfolio

Selection and Capital Market

Theory: Static Analysis
BaoheWang
baohewang0592@sina.com

Introduction

The investment decision by

households as having two parts:
(a) the consumption-saving choice
(b) the portfolio-selection choice
In general the two decisions cannot
be made independently.
However, the consumption-saving
allocation has little substantive
impact on portfolio theory.

One-period Portfolio Selection

The solution to the general problem

of choosing the best investment mix
is called portfolio-selection theory.
There are n different investment
opportunities called securities.
The random variable one-period
Zj
return per dollar on security j is
denoted

Any linear combination of these

securities which has a positive
market value is called a portfolio.
U (W ) denote the utility function.
W is the end-of-period value of the
investors wealth measure in dollars.
U is an increasing strictly concave
function and twice continuously
differentiable.
So the investors decision is relevant
to the subjective joint probability
( Z1 , Z 2 , L , Zfor
distribution
.
n)

Assumption 1: Frictionless Markets

Assumption 2: Price-Taker

Assumption 3: No-Arbitrage Opportunities

Assumption 4: No-Institutional
Restrictions

Given these assumptions, the

portfolio-selection problem can be
formally stated as
n

max E{U ( w j Z jW0 )}

{ w1 , w2 ,L wn }

S. T .

(2.1)

Where E is the expectation operator

for the subjective joint probability
distribution.

) a solution (2.1), then it will

If ( w1 , w2 ,L , wnis
satisfy the first-order conditions:

E{U ( Z W0 Z j )}
W0

Where
is the random variable
n
Z 1 w j Z j
return per dollar on the optimal portfolio.
With the concavity assumptions on U, if
the variance-covariance matrix of the
return is nonsingular and an interior
solution exists, the the solution is
unique.

Formula (2.1) rules out that any one

of the securities is a riskless security.
If a riskless security is added to the
menu of available securities then the
portfolio selection problem can be
stated as:
n
max E{U ( w j Z jW0 (1 1 w j ) RW0 )}
n

{ w1 , w2 ,L wn }

max E{U ([ w j ( Z j R) R ]W0 )}

(2.4) {w ,w ,L w }
1

The first-order conditions can be

written as:
E{U ( Z W0 )( Z j R )} 0

j 1, 2, L , n

w
can be rewritten as
1 j ( Z j R ) R
n

Where Z
If it is assumed that the variancecovariance matrix of the returns on
the risky securities is nonsingular
and an interior solution exits, then
the solution is unique.

But neither (2.1) nor (2.3) reflect that

end of period wealth cannot be negative.
To rule out bankruptcy, the additional
constraint that, with probability one,
Z 0
could be imposed on( w , w , L , w* ) .
1
2
n
This constraint is too weak, because the
probability assessments on
are
{Z j }
subjective.
An alternative treatment is to forbid
borrowing and short-selling securities
Zj 0
where, by law,
.

The optimal demand functions for

{wjW0 }
risky securities,
, and the
resulting probability distribution for
the optimal portfolio will depend on
(1) the risk preferences of the
investor;
(2) his initial wealth;
(3) the join distribution for the
securities returns.

The von Neumann-Morgenstern

utility function can only be
determined up to a positive affine
transformation.
The Pratt-Arrow absolute riskaversion function
to any
U (is
W invariant
)
positive affine transformation of
.

The preference orderings of all

choices available to the investor are
completely specified by absolute
riskaversion function
U (W )
A(W )
U (W )

The change in absolute risk aversion

with respect to a change in wealth is
dA
U (W )
A(W ) A(W )[ A(W )
]
dW
U (W )

A(W ) is

positive, and such investor are

call risk averse.
An alternative, measure of risk
aversion is the relative risk-aversion
function defined by

U (W )W
R (W )
A(W )W
U (W )

Its change with respect to a change

in wealth is given by

R(W ) A(W )W A(W )

The certainty-equivalent end-of-period

wealth WC is defined to be such that

U (WC ) E{U (W )}

WC is the amount of money such that

the investor is indifferent between
having this amount of money for certain
or the portfolio with random variable
W
outcome .
We can proof follows directly by Jensens
inequality: if U is strictly concave
U (WC ) E{U (W )} U ( E{W })
Because U is an increase function, So
WC E{W }

The certainty equivalent can be used

to compare the risk aversions of two
investor.
If A is more risk averse than B and
they hold same portfolio, the certainty
equivalent end of period wealth for A
is less than or equal to the certainty
equivalent end of period wealth for B.

Rothschild and Stiglitz define the

meaning of increasing risk for a
security so we can compare the
riskiness of two securities or
portfolios.
E (W1 ) E (W2 ) , E{U (W1 )} E{U (W2 )}
If
for
U
all concave
with
U strict inequality
holding for some concave
, we said
the first portfolio is less risky than
the second portfolio.

Its equivalence to the two following

definitions:
(1) W2 is equal in distributionWto
plus
1
some noise.
(2) W2 has more weight in its tails W1
than
.

If there exists an increasing strictly

V
concave function
such that
E{V ( Z )( Z j R)} 0, j 1, 2, L , n. , we call this
portfolio is an efficient portfolio.
All portfolios that are not efficient are
called inefficient portfolios.

It follows immediately that every

efficient portfolio is a possible
optimal portfolio, for each efficient
U
portfolio there exists
an increasing
concave such that the efficient
portfolio is a solution to (2.1) or (2.3).
Because all risk-averse investors
have different utility function, so they
will be indifferent between selecting
their optimal portfolios.

Theorem 2.1: If Z denotes the random

variable return per dollar on any feasible
portfolio and if Z e Z e is riskier than Z Z
in the Rothschild and Stiglitz sense, then
( Z is an efficient portfolio)
Ze Z
e

Proof: By hypothesis

E{U [( Z Z )W0 ]} E{[( Z e Z e )W0 ]}

Z Ze

E
{
U
(
ZW
)}

E
{
U
(
Z
W
)}
0
e
0
then trivially
.

If
But Z is a feasible portfolio andZ e is
Ze Z
an efficient portfolio. By contradiction,

Corollary 2.1: If there exists a riskless

Ze R
security with return R, then
,
with equality holdingZonly
if
is a
e
riskless security.
Proof: If Z e is riskless , then by
Assumption 3,Z e R . IfZ e
is not
Z e R 2.1,
riskless, by Theorem
.

Theorem 2.2: The optimal portfolio for

a nonsatiated risk-averse investor will
Z j only
R
be the riskless security if and
if
for j=1,2,..,n.
Proof: If Z Ris an optimal solution,
then we haveU ( RW0 ) E{Z j R} 0 By the
nonsatiation assumption,
so
Zj R
U ( RW0 ) 0
If Z R j 1, 2L , nthen Z R will
j

satisfy U ( Z W ) E{Z R} 0 because the

0
j
property of U, so this solution is
unique.

From Corollary 2.1 and Theorem 2.2,

if a risk-averse investor chooses a
risky portfolio, then the expected
return on the portfolio exceeds the
riskless rate.

Theorem 2.3: Let Z pdenote the return on

any portfolio p that does not contain
security s. If there exists a portfolio p such
that, for security s, Z Z , where
s
p
s
E{ s | Z j , j 1, 2, L , n, j s} 0then the fraction of
every efficient portfolio allocated to
security s is the same and equal to zero.
Proof: Suppose is the return on an efficient
Ze
portfolio with fraction
allocated to
security s,
be the return on a portfolio
s 0
with the same fractionalZ holding as
except that instead of security s with
portfolio P Z

Hence Z e Z s ( Z s Z p ) Z s s
So Z Z
e
Therefore ,for s 0, Z is riskier than Z
e
in the Rothschild-Stiglitz. This contradicts
that
is an efficient
portfolio.
Ze
Corollary 2.3: Let denote the set of n

securities and
denote
the same set of
that is replace with .
securities except
Z s , then all risk Z s
If
and
Z s Zinvestor
E{ s | Z }prefer
0
averse
would
to choose
s s

Theorem 2.3 and its corollary

demonstrate that all risk averse
investors would prefer any
unnecessary and noise to be
eliminated.
The Rothschild-Stiglitz definition of
increasing risk is quite useful for
studying the properties of optimal
portfolios.
But this rule is not apply to individual
securities or inefficient portfolios.

2.3 Risk Measures for Securities and

Portfolios in The One-Period model

In this section, a second definition of

increasing risk is introduced.
Z ek is the random variable return per
dollar on an efficient portfolio K.
VK ( Z eK ) denote an increasing strictly
dVK

K
concave function such that Vfor
dZ eK
E{VK ( Z j R )} 0

j 1, 2, L , n

W0 1

VK E{V }
YK
Random variable
cov(VK , Z eK )

bpK
Definition: The measure of risk
portfolio P relative to efficient
Z eK
portfolio K with random variable
return
is defined by

of

b cov(YK , Z P )
K
p

and portfolio P is said to be riskier

than portfolio
relative to efficient
P
bpK bpK K if
portfolio
.

Theorem 2.4: IfZ p is the return on a

K
Z
feasiblePportfolio
and
is the return
e
on efficient portfolio
Z p RK b, pKthen
( Z eK R )
.
Proof: From
E{VKthe
( Z j definition
R )} 0
j 1, 2, L , n
j
be the fraction of portfolio P allocated
n
to security j, then
Z P j (Z j R) R

and

E{V (Z
j

R )} E{VK ( Z P R )} 0

By a similar argument,
E{VK ( Z e R )} 0
Hence,
K
K
K

cov(VK , Z e ) E[VK ( Z e Z e )]

E[VK ( Z eK R R Z eK )]
K
K

E[VK ( Z e R )] E[VK ( R Z e )]

( R Z ) E[VK ]
K
e

and

cov(VK , Z P ) ( R Z P ) E{VK }

K
Z
By Corollary 2.1 e, R

. Therefore

Z p R b (Z R)
K
p

K
e

Hence, the expected excess return on

portfolio P, Z P R is in direct
proportion to its risk and the larger is
its risk , the larger is its expected
return.
Consider an investor
with utility
W0
function U and initial wealth
who
solves the portfolio-selection problem:
max E{U ([ wZ (1 w) Z ]W )}
w

The first order condition:

E{U ([ w* Z j (1 w* ) Z ]W0 )( Z j Z )}

If Z Z * then the solution is

.
W* 0
However , an optimal portfolio is an
efficient portfolio. By Theorem 2.4

Z j R b (Z R)
*
j

So w*W is similar to an excess demand

*
b
function . j Measures the
contribution of security j to the
Rothsechild-Stiglitz risk of the
optimal portfolio.

By the implicit function theorem, we

have: *
*
w W0 E{U ( Z Z j )} E{U }
w

Z j
W0 E{U ( Z Z j ) }

Zj
Therefore (,Zif
, b ) lies above the riskreturn line in the
plane, then
the investor would prefer to increase
his holding in security j.

bpK is a natural measure of risk for

individual securities.
The ordering of securities by their
systematic risk relative to a given
efficient portfolio will be identical
with their ordering relative to any
other efficient portfolio.

Lemma 2.1:
K

(i) E{Z P | VK } E{Z P | Z e } for efficient

portfolio K.
K
cov( Z p , VK ) 0
E
{
Z
|
Z
(ii) If
P
e } Z p then
(iii) cov( Z p ,VK ) 0 for efficient portfolio
K if and only
for every
cov(ifZ PVL ) 0
efficient portfolio L.
Proof: (i) VK is a continuous monotonic
function ofZ eK and henceVK
and
Z eK
are in one to one correspondence.

(ii) cov( Z p ,VK ) E{VK ( Z p Z P )} E{VK E{Z p Z P | Z eK }} 0

(iii)BecausebpK 0 cov( Z p ,VK ) 0
K
b
if p 0 , thenZ p R .
Property I: If L and K are efficient
K
K L
b

b
portfolios, then for any p portfolio
p,
L bp
.
Proof : From Theorem 2.4
L
Ze R
b K
Ze R
K
L

b
K
p

Zp R

Z R
K
e

b
L
p

Zp R

Z eL R

Property 2: If L and K are efficient

K
bK 1 and
bKL 0
portfolios, then
.
Hence, all efficient portfolios have
positive systematic risk, relative to
any efficient portfolio.
K
Z

R
b
Property 3: p
if and only if
p 0
for every efficient portfolio K.
Property 4: Let p and q denote any
two feasible portfolios and let K and L
K K
denote any two efficient portfolios.
bp bq

L L
if andbponly
bq if

Proof: From Property 1, we have

b b b
K
p

K
L

L
p

b b b
K
q

K L
L q

Thus the bpK measure provides the

same orderings of risk for any
reference efficient portfolio.
Property 5: For each efficient portfolio
K and any feasible portfolio
Zp p
,R bpK ( Z eK R ) p
where E{ p } 0 and E{ pVL ( Z eL )} 0 for
every efficient portfolio L.

Proof: From Theorem 2.4 E{ p } 0 . If

portfolio q is constructed by holding
one dollar
dollars riskless
bpK p,
K short selling
security,
dollarsZ q R p
bp
portfolio
K, then
bqL 0
so b L 0 for every
efficient
portfolio
L.

cov(
Z
,
V
)

E
{

,
V
}
q
q
L
p
L
But
implies
for every efficient portfolio L.

n
Property 6: If a feasible
portfolio
K p has
bp 1 j b Kj
(1 ,L , n )
portfolio weight
,then

Hence , the systematic risk of a portfolio

is the weighted sum of the systematic
risks of its component securities.
The Rothschild Stiglitz measure provides
only for a partial ordering.
K measure provides a complete
bp
ordering.
They can give different rankings.
The Rothschild Stiglitz definition
measure the total risk of a security. It
is appropriate definition for identifying
optimal portfolios and determining the
efficient portfolio set.

K
j

Theb measure the systematic

risk of a security.
K
To determine theb j
, the efficient
portfolio set must be determined.
The manifest behavioral
characteristic shared by all risk
averse utility maximization is to
diversify.

The greatest benefits in risk

reduction come from adding a
security to the portfolio whose
realized return tends to be higher
when the return on the rest of the
portfolio is lower.
Next to such countercyclical
investments in terms of benefit are
the noncyclic securities whose
returns are orthogonal to the return
on the portfolio.

Theorem 2.5 : If Z p andZ q denote the

returns on portfolio p and q
respectively and if, for each possible
Ze
dG p ( Z e )of dG
value
,
q (Ze )

dZ e
dZ e
with strict
inequality holding
over some finite
Ze
probability measureZ of Z ,then
p
q
portfolio p is riskier than portfolio q
Ze
G p ( Z e ) E{Z p | Z e }
and
.
Where
,
is the
realized return on an efficient portfolio.

Proof:
bp bq cov[Y ( Z e ), Z p Z q ] E[Y ( Z e )( Z p Z q )]
E[Y ( Z e )( E{Z p | Z e } E{Z q | Z e })]
E[Y ( Z e )(Ge ( Z p ) Ge ( Z q ))
cov[Y ( Z e ), Ge ( Z p ) Ge ( Z q )]

Y (Ze )

Ge ( Z p ) Ge ( Z q )
is a strictly increasing function,
is a nondecreasing function, so
bp bq cov[Y ( Z e ), Ge ( Z p ) Ge ( Z q )] 0

From Theorem 2.4 Z p Z q

Zq
Theorem 2.6: IfZ p and
denote the
returns on portfolio p and q
Ze
respectively and if, for each possible
dG
p (Ze )
value
of dGq ( Z e,) a pq
dZ e
dZ e
then
bp bq a pq
Z p Z q ,a
a pqconstant,
(Z e R)
and
.
Gehypothesis
( Z p ) Ge ( Z q ) a pq h
Proof: By

bp bq cov[Y ( Z e ), Ge ( Z p ) Ge ( Z q )]
cov[Y ( Z e ), a pq Z e h] a pq
Z p R bp ( Z e R ) R bq ( Z e R ) a pq ( Z e R ) Z q a pq ( Z e R )

Theorem 2.7: If, for all possible

dG ( Z )
values
of
Z p Ze
1
dZ
(i)
, then

dG p ( Z e )

(II)
dG p ( Z e )

(III)
dG p ( Z e )

(IV)

dZ e

dZ e

dZ e

R Z p Ze

, then
R Zp

, then
ap

, a constant, then

Z p R a p ( Z e R)

Ze

Theorems 2.5, 2.6 and 2.7

demonstrate, the conditional
expected return function provides
considerable information about a
securitys risk and equilibrium
expected return.

2.4 Spanning, Separation, and

Mutual-Fund Theorems

Definition: A set of M feasible

portfolios with random variable
( X 1 ,L X M )
returns
is said to span the
space of portfolioscontained in the
if for any portfolio Z p
set
if and only
M
(1 ,L M ) by1 there
i 1
in
with return denoted
M
exist numbers
,
such
Z p 1 j X j
that

A mutual fund is a financial

intermediary that holds as its assets a
portfolio of securities and issues as
liabilities shares against this collection
of assets.
Theorem 2.8 If there exist M mutual
funds whose portfolio span the portfolio
set
, then all investors will be
indifferent between selecting their

optimal portfolios from

and selecting
from portfolio combination of just the M
mutual funds.

Therefore the smallest number of

M
such funds
is a particularly
important spanning set.
When such spanning obtain, the
investors portfolio-selection problem
can be separated into two steps.
However, if the smallest funds can be
constructed only if the fund
managers know the preferences,
endowments, and probability beliefs
of each investor.

Theorem 2.9: Necessary conditions

( X 1 ,L , X M )
for the M feasible portfolios with
f
return
to spanthe portfolio
M
set
are
(a)
that the rank of
M
(1 ,L ,there
M ), 1exist
j 1 numbers
and (b) that
M
j X j the random
suchthat
1
n
variable
has
zero
Z p 1 a j Z jvariance.
b
Proposition 2.1: If
is the
return on some security or portfolio
and if there are no arbitrage
n
n
opportunities
then
(a ) b (1 a j ) R and (b) Z p R a j ( Z j R )

Proof: LetZ be the return on a

j 1,L
portfolio with
j fraction allocated to
security
j,
p
Zp
n
1 p 1 j to the security with
allocated

j allocated to
return ; and

a
Z with
R preturn
[b R (1
a )]
the riskless
R,
j
p security
j
1 j if
Z ,then
R
is chosen such that
is riskless security
and therefore
but
can be
chosen arbitrarily. So we get the
result.

, n;

Hence, as long as there are no

arbitrage opportunities, it can be
assumed without loss of generality
that one of the portfolios in any
candidate spanning set is the riskless
security.
f

( X 1 ,L A, Xnecessary
Theorem 2.10:
and
m , R)
{aij }for
sufficient condition
to
m
span
there exist number
Z j R is1 athat
ij ( X i R ) j 1, 2, L , n.
such that

Proof:
, then
M
M
1 ij 1 such thatZ j 1 ij X i .
m
Because
Mj 1 1 ij
XM R
m
Zand
substituting
1 aij ( X i R) j 1, 2,L , n. , we
j R
have
ij aij

m
i we
1,L pick
, m the Mjportfolio
1 1 ijweights
M
for
and Z j 1 ij X i , from
f

which it follows
that
.But
Z n ) be written as
every portfolio( Zin
1 ,L , can
a portfolio combination of
and R.
If ( X 1 ,L , X m , R) span

Corollary 2.10: A necessary and

sufficient condition
to be
( X 1 ,L , X m ,for
R)
the smallest number of feasible
portfolio that span
is that the rank of X m
equals the rank of
X m

Proof:
If the rank of
, then X
are linearly independent. Moreover
m
m
hence, if the
rank
of
then
there
{aij }
Z j Z j 1 aij ( X i X i )
exist number
such that
m
j 1,L , n
Z j b j 1 aij X i
for
. Therefore
m
b j Z j 1 aij X i
where f
by Theorem 2.10

span

It follows from Corollary 2.10 that a

necessary and sufficient condition for
nontrivial spanning of f is that some of
the risky securities are redundant
securities.
By Theorem 2.10, if investors agree on a
set of portfolios
such that
( X 1 ,L , X m , R )

Z j R 1 aij ( X i R ) j 1, 2,L , nand

.
if they
{aij }
agree on the number
,then( X 1 ,L , X m , R)
f

span
even if investors do not agree
1 ,L , X m , R )
on the joint distribution( Xof
m

Proposition 2.2: If Z e is the return on a

portfolio contained in e , then any
portfolio that combines positive amount Z e
of with the riskless security is also
contained
in e, where
is the set of
e
all efficient portfolios contained
in
.
f
Proof: Let
, because Z is
Z Z e (1 ) R
e
an efficient portfolio, so
E{V ( Z e )( Z j R )} 0
Define
where
and
1
a
U (W ) V (aW b)

, Hence
,
( 1)R

E
{
U
( Z )( Z j R)} 0
b

thus Z is an efficient portfolio.

It follows from Proposition 2.2 that, for

every numberZ such thatZ R , there
exists at least one efficient portfolio
with expected return equal
.
Z to
Theorem 2.11: Let( X 1 ,L , X m ) denote the
return on m feasible portfolios. If, for
security j, there exist number
{aij } such
that
m
E{ jVK ( Z eK )} 0
Z j Z j 1 aij ( X i X i ) j
where
for some efficient portfolio K, then
Z j R 1 aij ( X i R )
m

Proof: Let Z p Z j 1 i X i (1 1 i )R
m

because Z j Z j aij ( X i X i ) j, thus

1
m

Z p R [ Z j R 1 aij ( X i R )] by
j
m

construction ,
and hence cov(Z ,V ) 0
E{ j } 0
p
K
Therefore the systematic risk of
portfolio
p,
is zero. From Theorem 2.4
K
bp
Zp R
therefore
m
Z j R 1 aij ( X i R )

Hence, if the return on a security can be

written in this linear form relative to the
portfolios ( X 1 ,L , X m ) , then its expected
excess return is completely determined
by the expected excess returns on these
portfolios and the weights{a } .
ij
Theorem 1.12: If, for every security j,
there exist numbers{a } such that
ij

Z j R 1 aij ( X i R ) j
m

where
, then
E{ j | X 1 ,L , X m } 0
( X 1 ,L , X m , R )
span the set of efficient portfolios e .

Proof:
Z 1 w j Z j 1 w j [ R 1 aij ( X i R ) j ]
n

K
e

1 w j R 1 1 w j aij ( X i R ) 1 w Kj j
n

R 1 iK ( X i R) K
m

m
Where K n wK a
K

1 j ij
1 w K j
i
Construct portfolio
m K
m K
Z 1 i X i (1 1 i ) R
Thus K
K where
K
Ze Z
E{ | Z } 0
Hence, for K
, K is riskier than Z,
Ze

0
which contradicts that K is and
efficient portfolio. So Z e
. We get
K

0
the result.
j

Theorem 2.13: Let w Kj denote the fraction

of efficient portfolio K allocation to
security j, j 1,L , n. ( X ,L , X , R)span ife
1
m
and only if there exist number
for every
{aij }
security j such that
m
Z j R 1 aij ( X i R ) j
where
m K
n K for every
K
E{ j | 1 i X i } 0, i 1 w j aij
efficient portfolio K.
Corollary 2.13: (X,R) span
if and only if
e
there exist a number for each security j,
such that a j
Z j R a j ( X R) j
j 1,L , n,
where
E{ j | X } 0

Proof: By hypothesis, Z eK K ( X R) R for

every efficient portfolio K. IfX R , then
from Corollary 2.1 K 0 for every
efficient portfolio K and R span e .
Otherwise, from Theorem 2.2, K
for

0
every efficient portfolio. By Theorem
2.13, K
E{ j | X } 0
E{ j | X } 0
so
f
e

Since
is contained in
, any
e

properties proved for portfolios that

f
span
must be properties of
portfolio
that span
.

From Theorem 2.10, 2.12, 2.13, the

essential difference is that to span
the efficient portfolio set it is not
necessary that linear combinations of
the spanning portfolios exactly
replicate the return on each available
security.
All the models that do not restrict the
class of admissible utility function,
the distribution of individual security
m
returns Zmust
be
such
that

a
(
X

ij i R) j
j
1

Proposition 2.3: If, for every security j,

E{ j | X 1 ,L , X m } 0with ( X 1 ,L , X m )linearly
independent with finite variances and if
the return on security j, Z has a finite
j
variance, then the {a } i 1,L , m, in
ij
Theorems 2.12 and 2.13 are given by
where is the ikth
m
v
aij 1 vik cov( X K , Z j )
ik
element of 1 .
X
Hence given some knowledge of the joint
distribution of a set of portfolio that span e

with
, we can determining the
and Z j Z j
aij Z j

( Z1 ,L , Z n ) contain no
Proposition 2.4: If
j
redundant securities,
denotes the
fraction of portfolio X allocated to

w j j, and
security
denotes the fraction
of any risk-averse investors optimal
1,L , n, j,
portfolio allocated toj security
then for every such risk-averse
investor w
j
*
k

j , k 1, 2,L , n

Because every optimal portfolio is an

efficient portfolio and the holding of risky
securities in every efficient portfolio are
proportional to the holding in X.
If there exist numbers where , j, k 1,L , n
*

1 j
n

*
j

*
k

and
,then
* the
* portfolio with
( ,L n )
proportions 1
is called the Optimal
Combination of Risky Assets.
e
e
(
X
,
R
)

Proposition 2.5: If
span
, then
is a convex set.

Z e1 1 ( X R ) R

Z e2 2 ( X R ) R

Proof: Let
and 1 2 , Z Z e1 (1 ) Z e2. By
substitution, the expression for Z can be
rewritten as Z ( Z e1 R) R , where
.Therefore by Proposition
( 2 )(1 )
1
2.2, Z isan
efficient portfolio. It follow
by induction that for any integer k and
number
such that
and
0 i 1, i 1,L , k
i
is the return on an
k
k
k
i
i 1, Z 1 i Z e

1
efficient portfolio. Hence , e is a convex

set.

Definition: A market portfolio is defined

as a portfolio that holds all available
securities in proportion to their market
values.
The equilibrium market value of a
security for this purpose is defined to be
the equilibrium value of the aggregate
demand by individuals for the security.
The market value of a security equals
the equilibrium value of the aggregate
amount of that security issued by
business firms.

We use V j denote the market value

VR
of security j and
denote the value
M

of the riskless security,

then is the
j
fraction of security j held in a market
Vj
portfolio.
M
j

V
n

VR

Theorem 2.14: If
is a convex set,
and if the securities market is in
equilibrium, then a market portfolio
is an efficient portfolio.

Proof: Let there be K risk averse

n k
K
Z R 1 w j ( Z j R )
investor in the economy.Define
to be the return on investor ks
K
k
k
w
W
optimal portfolio. In equilibrium,

j 0 Vj
1
k
W
, where
is
the
initial
wealth
0
K
n
K
of investor
1 W0 K, W0 1 V j VR
W
. Define
and

k 1,L K
W
K
k
M
w

j 1,L , n. of a
1 j. kBy j definition
Z j R portfolio
market
Multiplying
and summing
K byn k
K
K

w
(
Z

R
)

(
Z
R)

k 1
j
j
K
1
1
over j, it follows that
k

k
0

1 iM ( Z j R ) Z M R
n

ZM
because1 k 1, Z M 1 K Z k . Hence,
is a convex combination of the
e

returns on K efficient portfolios.

Therefore , if is convex, then the
e

market portfolio
is contained in
.
The efficiency of the market portfolio
provides a rigorous microeconomic
justification for the use of a
representative man to derive
equilibrium prices in aggregated
economic models.
K

Proposition 2.6: In all portfolio models

with homogeneous beliefs and riskaverse investors the equilibrium
expected return on the market portfolio
exceeds the return on the riskless
security.
Proof: From the proof of Theorem
2.14
K
k
Z M R 1 k ( Z R)
and Corollary
2.1.
,
k
k 0
ZM R
Z

R
because
,
. Hence
The market portfolio is the only risky
portfolio where the sign of its
equilibrium expected excess return can
always be predicted.

e
Returning to the special case where
is spanned by a single risky portfolio
and the riskless security, the market
portfolio is efficient. So the risky
spanning portfolio can always be
chosen to be the market portfolio.
e
(
Z
,
R
)

Theorem 2.15: If M
span , then
the equilibrium expected return on
security j can be Zwritten
as
j R
j (Z M R)
where
cov( Z j , Z M )
j

var( Z M )

This relation, called the Security Market

Line, was first derived by Sharpe.
In the special case of Theorem 2.15, j
measure the systematic risk of security
j relative to the efficient portfolio
.
ZM
j can be computed from a simple
covariance betweenZ
andZ
. But the
M
j
sign of k can not be determined by the
bj
sign of the correlation coefficient
between k
Zj
Ze
and

Theorem 2.16: If ( Z1 ,L , Z n ) contain no

redundant securities, then (a) for each
value , j , j 1,L , n, are unique, (b)
there exists a portfolio contained in
with return X such that( X , R) span min ,
and (c)
where,
Z R a ( X R)
j

cov( Z j , X )
a

, j 1,L , n.
j
Where
var(
X
)
denote the set

of portfolios
min
contained in f such that there exists

no other portfolio
in
with the same
f
a smaller variance.
expected return and

Proof: Let ij denote the ijth element

1
v

of and
denote the ijth element of
ij
min
. So all portfolios
in
with
expect return u, we need solutions
the problemmin n n

S .T Z ( )
Z ( R) R

ij

jR 0, j 1, 2L , n

If
then
and
R
Consider the case when
. The n
n conditions
first-order
0 1 j ij u ( Z i Rare
) i 1, 2,L , n

Multiplying by

and summing, we get

1 1
i i (Zi R) 0
ij
n

u var[ Z ( )] ( R)

By definition of , must be the same

min

for all Z ( ) . Because

is nonsingular,
unique solution
the linear equation has

v (Zi R
) j 1,L , n
1 ijFrom
(a).
this solution we

j
u
prove

This
have

j k are the same for every value .

Hence all portfolios in min are perfectly

correlated. Hence we can pick any

 min with
R and call its
portfolio in
return X. Then we have
Z ( ) ( X R) R

min which proves

Hence ( X , R) span
(b).
and from Corollary 2.13 and
Proposition 2.3 (c) follows directly.

From Theorem 2.16,ak will be

equivalent
to
as a measure of a
bkK
securitys systematic risk provided that
the
chosen for X is such
.
that
R
Theorem 2.17: If( X , R ) span e and if X
has a finite variance, then
e is
contained
in
.
min
Proof: Let
. Let Z be
Z e R ae ( X R )
p
the return on any portfolio in f
such

that Z Z . By Corollary 2.13 Z R a ( X R)

p
p
p
e
p
where
E{ p } E{ p | X } 0

Therefore a p ae
Thus
var( Z p ) a 2p var( X ) var( p ) a p var( X ) var( Z e )

Hence, Z e is contained
inmin
.
Theorem 2.18: If( Z1 ,L , Z n ) have a
joint normal probability distribution,
then there exists a portfolio with
e
return
( X , R)X suchthat
span
.

Proof: construct a risky portfolio

min
contained
in
, and call its return X.
Define
k Z k R ak ( X R ), k 1,L , n
by
E{ k } 0
Theorem 2.16
part
and by
cov(
k , (c)
X) 0
Z1 L Z n
construction
. Because
are normally distributed, X will be
k
normally distributed. Hence
is normal
distributed , and becausecov( X , k ) 0 , so
they are independent. Therefore
E{ k } E{ k | X } 0 , From Corollary 2.13
e

it follows that ( X , R ) span

Theorem 2.19: If p(Z1 ,L , Z n ) is a symmetric

function with respect to all its
arguments, then there exists a portfolio
e
with return( X
X ,such
that
span
.

R)
Proof: By hypothesis
p ( Z1 ,L Z i ,L Z n ) p( Z i ,L Z1 ,L Z n )for each set
of given values. Therefore every risk
averse investor will choose
.
But

1 i
this is true for all i. Hence , all investor
will hold all risky securities in the same
relative proportions. Then
span e

( X , R)

The APT model developed by Ross

provides an important class of linearfactor models that generate
spanning without assuming joint
normal probability distributions.
If we can construct a set of m
Yi
X i such
( X 1 ,returns
L , XM )
portfolios with
i 1,L , m,
that
and
are perfectly
(correlated,
X 1 ,L , X M , R )
then
e
will span

The APT model is attractive because

the equilibrium structure of expected
returns and risks of securities can be
derived without explicit knowledge of
investors preferences or
endowments.

For the study of equilibrium pricing, the

Vj0
usual format is to derive equilibrium
given the distribution ofV j
.
Theorem 2.20: If ( X 1 ,L , X m ) denote a set
of linearly independent portfolios that
satisfy the hypothesis of Theorem 2.12 ,
and all securities have finite variances,
then a necessary condition for
equilibrium in the securities market is
that
m
m
Vj0

V j 1

vik cov( X k ,V j )( X j R )
R

where vik is the ikth element of X

V j Z jV j 0
Proof: By linear independence
m
by Theorem 2.12
V j V j 0 [ R 1 aij ( X i R ) j ]
E{ j | X 1 ,L , X m } 0
where
. Take
expectations, we have

V j V j 0 [ R 1 aij ( X i R)]
m

Noting that cov( X k , V j ) V j 0 cov( X k , Z j )

m
From Proposition 2.3aij 1 vik cov( X K , Z j )
m
Thus V j 0 aij 1 vik cov( X K ,V j )
We can get
V j 1

Vj0

m
1

vik cov( X k ,V j )( X j R )
R

Hence, from Theorem 2.20, a sufficient

set of information to determine the
equilibrium value of security j is the
first and second moments for the join
distribution of ( X 1 ,L , X m ,V j ) .
Corollary 2.20a: If the hypothesized
conditions of Theorem 2.20 hold and if
the end-of-period value a security is
givenn by
V 1 jV j
then in nequilibrium
V0 1 jV j 0

This property of formula is called

value additivity.

Corollary 2.20b: If the hypothesized

conditions of Theorem 2.20 hold and
if the end-of-period value of a
V qVis
u
security
by E{u} E{u | X 1,,L , X m } u
j given
E{q} E{q | X 1 ,L , X m } and
q
where
V0 in
qV jequilibrium
then
0 u R
Hence, to value two securities whose
end of period values differ only by
multiplicative or additive noise, we
can simply substitute the expected
values of the noise terms.

Theorem 2.20 and its corollaries are

central to the theory of optimal
investment decisions by business
firms.
Although the optimal investment and
financing decisions by a form
generally require simultaneous
determination, under certain
conditions the optimal investment
decision can be made independently
of the method of financing.

Theorem 2.21: If firm j is financed by q

different claims defined by the function
f k (V j ) k 1,L , q, and if there exists an
equilibrium such that the return
distribution of the efficient portfolio set
remains unchanged from the
equilibrium in which firm j was all
equity financed, then

q
1

fk 0 V j 0 (I j )

where f is the equilibrium initial value

k0
of financial claim k.

Hence, for a given investment policy,

the way in which the firm finances its
investments changes the return
distribution of the efficient portfolio
set.
Clearly, a sufficient condition for
Theorem 2.21 to obtain is that each
of the financial claims issued by the
firm are redundant securities.

An alternative approach to the

development of nontrivial spanning
theorems is to derive a class of utility
functions for investors .
Such that even with arbitrary joint
probability distributions for the
available securities,investors within
the class can generate their optimal
portfolios from the spanning
portfolios.

Let u denote the set of optimal

portfolios selected
from
by investors
f
with strictly concave von NeumannMorgenstern utility functions.
Theorem 2.22 There exists a portfolio
u
with return X such( Xthat
span
if
, R)

and only
, where
is
Ai
Ai (Wif) 1 (ai bW ) 0
the absolute risk-aversion function for
investor
i u
in .

Because the b in the statement of

Theorem 2.22 does not have a subscript
i
u
, therefore all investorsin
must have
virtually the same utility function.
Cass and Stiglitz (1970) conclude: it is
requirement that there be any mutual
funds, and not the limitation on the
number of mutual funds.
This is a negative report on the
approach to developing spanning
theorems.

The End
thanks