OPTIMAL PORTFOLIOS

• Today individual has an amount of wealth (W);

he must decide what amount to use for
consumption today and what amount to invest
today (market securities). The amount
invested today would be used for consumption
tomorrow.
• The individual wants to maximise his utility of
consumption today and utility of consumption
tomorrow (equivalent to maximising utility of
investment today), under his wealth
constraint.
• In chapter 1, the return for financial
investments (market rate of return) was given.
In this chapter it is assumed that if today an
investment is being made, the return obtained
tomorrow is unknown (i.e. there is an
uncertainty over the return/payoff); e.g. today
invest Rs100 and tomorrow obtain Rs90,
Rs110 or Rs120. Therefore individual would be
maximising the expected utility from
investment.
Generalisation:
2 market securities A and B and 2 states (1 & 2)

p1qA1 + p2qA2 = pA
p1qB1 + p2qB2 = pB

pA & pB: prices of market securities A & B

Where p1 & p2 : prices of pure securities; qA1
qA2 are quantities of pure securities 1 & 2
needed to replicate payoff of asset A (likewise
for qB1 & qB2)
Financial Theory 4
• Consider an investor who possesses an initial
wealth of W, to allocate between consumption
today and a combination of securities (which
will allow consumption tomorrow). The time
frame is today and tomorrow.
• Utility of consumption today is U (C0).
• Expected Utility tomorrow is ∑ ∏s U(Qs)(from
doing investment today)
• Where ∏s is the probability of state s
happening and Qs the number of pure
securities that pay $1 in state s.
• Q1 = (1, 0, 0…): quantity of pure security 1
which pays 1 in state 1 and 0 in all other
states.
• Q2 = (0, 1, 0, 0…): quantity of pure security 2
which pays 1 in state 2 and 0 in all other
states.
• Π1 = probability that state 1 occurs and payoff
1 is obtained from pure security 1
• Π2 = probability that state 2 occurs and payoff
1 is obtained from pure security 2
Wealth: W
Maximise utility of consumption today: U (C0)
I.e. determine optimal: C0*

Maximise utility of consumption tomorrow =

maximise expected utility of investment
= U (C1) = E U (X)
I.e. determine optimal: C1* OR X* (payoff from
investment)

Consider the investment in terms of pure

securities. Financial Theory 7
S = 1, 2, 3, … n (all future states)

Pure securities:
S=1 S=2 S=3S=n

1 0 0 0
0 1 0 0
. . 1 .
. . . .
0 0 0 1
Quantities of pure securities: QS = Q1, Q2, ... Qn
bought
Financial Theory 8
Payoff pure securities:
S=1 S=2 S=3 S=n
Q1 0 0 0
0 Q2 0 0
. . Q3 .
. . . .
0 0 0 Qn
If state 1 occurs, payoff = 1*Q1; state 2, payoff
= 1*Q2, ...state n, payoff = 1*Qn
Financial Theory 9
Probabilities associated with each state:
πS = π1, π2, π3, …, πn

Expected utility from investment (pure securities)

E [U (QS)] = π1*U(Q1)+π2*U(Q2)+…+πnU(Qn)

= S 1

n
 S
U (QS
)
Maximise U (C0) + E [U (QS)]
Under budgetary constraint

Financial Theory 10
 Budgetary constraint
• Budgetary constraint implies that the level of
consumption and investment would be
restricted by the level of wealth available.
Budgetary constraint:

W C   pQ
s 1

0 n s s

Example (invest in 2 pure securities)

W  C  pQ  p Q
0 1 1 2 2

How to maximise utility under constraint?

Apply Lagrange Method

Financial Theory 12
Lagrange equation:
L = function (maximised) – λ (Budgetary
constraint)

L (C0, Qs)
= U (C0) + ∑ πsU (Qs) – λ (C0 + ∑ psQs – W)

Optimal values of consumption [C0*] and

investments [QS*]:
∂L/∂C0 = 0
∂L/∂Qs = 0
∂L/∂λ = 0
Financial Theory 13
Maximise utility of consumption and
Investment under budgetary constraint:
S 1
Max U (C0) + 
n
 S
U (QS
)

W C   pQ
s 1
under constraint: 0 n s s

With investment in 2 pure securities:

Max U (C )  [ U (Q )   U (Q )]
0 1 1 2 2

Constraint: W  C0  [ p1Q1  p2Q2 ]

14
Example (2 states and 2 pure securities)
Utility function: U (X) = log X
W = $10 000
π1 = 1/3; π2 = 2/3
p1 = $0.4; p2 = $0.6

Maximise U (C0) and E U(Q1, Q2)

Determine the optimal consumption and
investment today: C0*; Q1* and Q2*
15
Lagrange equation:
L = function (max) – λ(Budgetary constraint)

L (C0, Q1, Q2)

= U (C )  [ U (Q )   U–(Qλ[C)]0+p1Q1+p2Q2 – W]
0 1 1 2 2

Optimal values of consumption today [C0*] and

investments [Q1*, Q2*]:
∂L/∂C0 = 0
∂L/∂Q1 = 0; ∂L/∂Q2 = 0
∂L/∂λ = 0
16
L (C0, Q1, Q2)
= U (C0 )  [ 1U (Q1 )   2U–(λ[C
Q2 )]0+p1Q1+p2Q2–W]

U (X) = log X; therefore U(C0) = log C0; U(Q1) =

log Q1…

L (C0, Q1, Q2) = log (C0) + π1 log (Q1) +

π2 log (Q2) – λ (C0 + p1Q1 + p2Q2 – W)

17
π1 = 1/3; π2 = 2/3; W = 10000
p1 = $0.4; p2 = $0.6

L (C0, Q1, Q2) = log (C0) + 1/3 log (Q1) +

2/3 log (Q2) – λ (C0 + 0.4Q1 + 0.6Q2 – 10000)

If ∂ log (C0)/∂ C0 = 1/ C0; then

∂L/∂C0 = 1/C0 – λ [i]

∂L/∂C0 = 0
1/C0 – λ = 0
18
∂L/∂Q1 = 1/3*1/Q1 – 0.4λ [ii]
∂L/∂Q1 = 0
1/3*1/Q1 – 0.4λ = 0

∂L/∂Q2 = 2/3*1/Q2 – 0.6λ [iii]

∂L/∂Q2 = 0
2/3*1/Q2 – 0.6λ = 0

∂L/∂λ = - C0 - 0.4Q1 - 0.6Q2 + 10000 [iv]

∂L/∂λ = 0
- C0 - 0.4Q1 - 0.6Q2 + 10000 = 0
19
Simplifying:
From [i] C0* = 1/λ
From [ii] Q1* = 1/(1.2 λ)
From [iii] Q2* = 1/(0.9 λ)

Replacing [i] to [iii] in [iv]:

- C0 - 0.4Q1 - 0.6Q2 + 10000 = 0

-1/λ - 0.4*1/(1.2 λ) - 0.6*1/(0.9 λ) + 10000 = 0

1/λ [1 + 0.4/1.2 + 0.6/0.9] = 10000
λ = 1/5000
20
C0* = 1/λ = 1/ (1/5000) = 5000
Q1* = 1/(1.2 λ) = 1/ (1.2*1/5000) = 4166.67
Q2* = 1/(0.9 λ) = 1/ (0.9*1/5000) = 5555.56

Verify:
p1Q1* + p2Q2* = 4166.67*0.4 + 5555.56*0.6
= 5000
Wealth = C0* + p1Q1* + p2Q2*
= 5000 + 5000 = 10000
21
Lagrange equation
L (C0, Q1, Q2) = U (C0) + ∑ πSU(QS) – λ (C0
+ ∑ pSQS – W)

L (C0, Q1, Q2) = log (C0) + π1 log (Q1) +

π2 log (Q2) – λ (C0 + p1Q1 + p2Q2 – W)

L (C0, Q1, Q2) = log (C0) + 1/3 log (Q1) +

2/3 log (Q2) – λ (C0 + 0.4Q1 + 0.6Q2 – 10000)

Financial Theory 22
∂L/∂C0 = 0
∂L/∂C0 = 1/C0 – λ = 0 [i]

∂L/∂Q1 = 0
∂L/∂Q1 = 1/3*1/Q1 – 0.4λ = 0 [ii]

∂L/∂Q2 = 0
∂L/∂Q2 = 2/3*1/Q2 – 0.6λ = 0 [ii]

∂L/∂λ = - C0 - 0.4Q1 - 0.6Q2 + 10000 = 0 [iv]

Financial Theory 23
Simplifying:
From [i] C0* = 1/λ
From [ii] Q1* = 1/(1.2 λ)
From [iii] Q2* = 1/(0.9 λ)

Replacing [i] to [iii] in [iv]:

- C0 - 0.4Q1 - 0.6Q2 + 10000 = 0

-1/λ - 0.4*1/(1.2 λ) - 0.6*1/(0.9 λ) + 10000 = 0

1/λ [1 + 0.4/1.2 + 0.6/0.9] = 10000
λ = 1/5000
Financial Theory 24
C0* = 1/λ = 1/ (1/5000) = 5000
Q1* = 1/(1.2 λ) = 1/ (1.2*1/5000) = 4166.67
Q2* = 1/(0.9 λ) = 1/ (0.9*1/5000) = 5555.56

Verify:
p1Q1* + p2Q2* = 4166.67*0.4 + 5555.56*0.6
= 5000
Wealth = C0* + p1Q1* + p2Q2*
= 5000 + 5000 = 10000
Financial Theory 25