SPD4420 19-20 S2 Bodie (2013) Chapter 7 Modified

CHAPTER 7 (Modified)
Optimal Risky Portfolios
INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

JAIN
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
Learning Objectives
• The investment decision
• Diversification and portfolio risk
• Portfolios of two risky assets
• Asset allocation with stocks, bonds
and bills (risk-free asset)
• The Markowitz portfolio selection
model

JAIN
7-3
The Investment Decision

Top-down process with 3 steps:
1. Capital allocation between the risky portfolio
and risk-free assets
2. Asset allocation across broad asset classes
3. Security selection of individual assets within
each asset class

JAIN
7-4
Diversification and Portfolio Risk
• Diversification
“don’t put all your eggs in one basket”
• Harry Markowitz (1952) published a

formal model of portfolio selection
embodying diversification principles,
thereby paving the way for his 1990
Nobel Prize in Economics. Markowitz’s
work became the foundation of ‘Modern
Portfolio Theory’
JAIN
7-5
Diversification and Portfolio Risk

• Market risk
– Systematic or nondiversifiable
– Macroeconomic factors such as business cycle,
inflation, interest rates, and exchange rates…etc.
• Firm-specific risk
– Diversifiable or nonsystematic
– For example, selling ice-cream vs selling
raincoats
– Diversify into two businesses can eliminate risk

JAIN
7-6
Figure 7.1 Portfolio Risk as a Function of the

Number of Stocks in the Portfolio

JAIN
7-7
Figure 7.2 Portfolio Diversification

JAIN
7-8
Covariance and Correlation

• Portfolio risk depends on the
correlation between the returns of the
assets in the portfolio
• Covariance and the correlation

coefficient provide a measure of the
way returns of two assets vary

JAIN
7-9
Two-Security Portfolio: Return
rp  wr
D D
 wE r E
rP  Portfolio Return
wD  Bond Weight
rD  Bond Return
wE  Equity Weight
rE  Equity Return
E ( r p )  w D E ( rD )  w E E ( rE )

JAIN
7-10
Two-Security Portfolio: Risk
  w   w   2wD wE Cov rD , rE 
2
p
2
D
2
D
2
E
2
E
 = Variance of Security D
2
D
 = Variance of Security E
2
E
Cov rD , rE= Covariance of returns for

Security D and Security E

JAIN
7-11
Two-Security Portfolio: Risk
• Another way to express variance of the

portfolio:
  w D w D C ov ( rD , rD )  w E w E C ov ( rE , rE )  2 w D w E C ov ( rD , rE )
2
P
• Covariance of a security with itself is just

the variance of the security

JAIN
7-12
Covariance & Correlation Coefficient

Cov(rD,rE) = DEDE
D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D
E = Standard deviation of
returns for Security E
JAIN
7-13
Correlation Coefficients: Possible Values

Range of values for D, E
+ 1.0 > r > -1.0
If r = +1.0, the securities D & E are perfectly

positively correlated
If r = 0, the securities D & E are uncorrelated
If r = -1.0, the securities D & E are perfectly
negatively correlated
JAIN
7-14
Correlation Coefficients
• When ρDE = 1, there is no diversification
 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
D  E

JAIN
7-15
Table 7.2 Computation of Portfolio

Variance From the Covariance Matrix

JAIN
7-16
Three-Asset Portfolio
E ( r p )  w1 E ( r1 )  w 2 E ( r2 )  w 3 E ( r3 )
 p2  w12 12  w22 22  w32 32

 2 w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3

JAIN
7-17
Mathematics of Modern Portfolio

Theory
Please refer to the

supplementary handout
for the general
mathematics of MPT

JAIN
7-18
Descriptive Statistics for Two Mutual

Funds
Debt Fund Equity Fund

Expected Return, E(r) 8% 13%
Standard Deviation,  12% 20%
Covariance, COV(rD, rE) 0.0072
Correlation coefficient, ρDE 0.30
The data are used for the examples in the

figures in the following slides.

JAIN
7-19
Figure 7.3 Portfolio Expected Return as a

Function of Investment Proportions

JAIN
7-20
Figure 7.4 Portfolio Standard Deviation as a

Function of Investment Proportions

JAIN
7-21
The Minimum Variance Portfolio

• The minimum variance • When correlation is
portfolio is the portfolio less than +1, the
composed of the risky portfolio standard
assets that has the deviation may be
smaller than that of
smallest standard either of the individual
deviation, the portfolio component assets.
with least risk.
• When correlation is
-1, the standard
deviation of the
minimum variance
portfolio is zero.

JAIN
7-22
Figure 7.5 Portfolio Expected Return as a

Function of Standard Deviation

JAIN
7-23
Correlation Effects
• The amount of possible risk reduction
through diversification depends on the
correlation.
• The risk reduction potential increases as
the correlation approaches -1.
– If r = +1.0, no risk reduction is possible.
– If r = 0, σP may be less than the standard

deviation of either component asset.
– If r = -1.0, a riskless hedge is possible.

JAIN
7-24
Figure 7.6 The Opportunity Set of the Debt and Equity Funds
and Two Feasible CALs

JAIN
7-25
The Sharpe Ratio

• Maximize the slope of the CAL for any
possible portfolio, P.
• The objective function is the slope:
E ( rP )  r f
SP 
P
• The slope is also the Sharpe ratio.

JAIN
7-26
Figure 7.7 The Opportunity Set of the Debt and Equity Funds
with the Optimal CAL and the Optimal Risky Portfolio

JAIN
7-27
Figure 7.8 Determination of the Optimal

Overall Portfolio

JAIN
7-28
Figure 7.9 The Proportions of the Optimal

Overall Portfolio

JAIN
7-29
Markowitz Portfolio Selection Model

• Security Selection
– The first step is to determine the risk-
return opportunities available.
– All portfolios that lie on the minimum-
variance frontier from the global
minimum-variance portfolio and upward
provide the best risk-return
combinations

JAIN
7-30
Figure 7.10 The Minimum-Variance

Frontier of Risky Assets

JAIN
7-31
• We now search for the CAL with the

highest reward-to-variability ratio (given
the risk-free rate of return, rf )

JAIN
7-32
Figure 7.11 The Efficient Frontier of Risky

Assets with the Optimal CAL

JAIN
7-33

• Everyone invests in P, regardless of their
degree of risk aversion.
– More risk averse investors put more in the

risk-free asset.
– Less risk averse investors put more in P.

JAIN
7-34
Capital Allocation and the

Separation Property
• The separation property tells us that the
portfolio choice problem may be
separated into two independent tasks
– Determination of the optimal risky
portfolio is purely technical.
– Allocation of the complete portfolio to T-
bills versus the risky portfolio depends
on personal preference.

JAIN
7-35
Figure 7.13 Capital Allocation Lines with

Various Portfolios from the Efficient Set

JAIN
7-36
Optimal Portfolios and Nonnormal

Returns
• Fat-tailed distributions can result in extreme
values of VaR and ES and encourage smaller
allocations to the risky portfolio.
• If other portfolios provide sufficiently better VaR

and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions.

JAIN
7-37
Risk Pooling and the Insurance Principle
Skip Section 7.5 in the textbook on the

discussion of Risk Pooling and the
Insurance Principle.
They will NOT be asked in

examination.

JAIN

SPD4420 19-20 S2 Bodie (2013) Chapter 7 Modified

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SPD4420 19-20 S2 Bodie (2013) Chapter 7 Modified

Uploaded by

Copyright:

Available Formats

CHAPTER 7 (Modified)

Optimal Risky Portfolios

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

The Investment Decision

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Diversification and Portfolio Risk

• Harry Markowitz (1952) published a

Diversification and Portfolio Risk

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.1 Portfolio Risk as a Function of the

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.2 Portfolio Diversification

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Covariance and Correlation

• Covariance and the correlation

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Two-Security Portfolio: Return

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Two-Security Portfolio: Risk

Cov rD , rE= Covariance of returns for

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Two-Security Portfolio: Risk

• Another way to express variance of the

• Covariance of a security with itself is just

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Covariance & Correlation Coefficient

D,E = Correlation coefficient of

Correlation Coefficients: Possible Values

If r = +1.0, the securities D & E are perfectly

• When ρDE = -1, a perfect hedge is possible

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Table 7.2 Computation of Portfolio

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

 p2  w12 12  w22 22  w32 32

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Mathematics of Modern Portfolio

Please refer to the

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Descriptive Statistics for Two Mutual

Debt Fund Equity Fund

The data are used for the examples in the

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.3 Portfolio Expected Return as a

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.4 Portfolio Standard Deviation as a

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

The Minimum Variance Portfolio

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.5 Portfolio Expected Return as a

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

– If r = 0, σP may be less than the standard

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

The Sharpe Ratio

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.8 Determination of the Optimal

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Figure 7.9 The Proportions of the Optimal

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,

Markowitz Portfolio Selection Model

INVESTMENTS (ASIA GLOBAL EDITION) | BODIE, KANE, MARCUS,