Investment Analysis and

Portfolio Management
Lecture 4
Gareth Myles
Efficiency
 An efficient investor will choose the portfolio
with the maximum return for a given level of
risk
 Or the minimum risk for a given return
 Any other choice is inefficient
 To explore this idea it is necessary to
determine the frontier of efficient portfolios
 The set of portfolios with maximum return for given
risk
Two-Asset Portfolios
 Consider a portfolio composed of two assets A
and B
 The expected return on the portfolio is
rp  X ArA  X B rB
 The standard deviation of return is


 p  X   X   2 X A X B  AB A B
2
A
2
A
2
B
2
B 
12

 The relationship between return and standard

deviation is now derived
No Short Sales
 Assume initially that there are no short sales
 The holdings of both assets must be non-
negative
 This implies the asset proportions satisfy
X A  0, X B  0, X A  X B  1
 Now consider the standard deviation for
various values of the correlation coefficient
 1   AB  1
Perfect Positive Correlation
 Case 1: Perfect positive correlation
 AB  1
 The standard deviation becomes


 p  X   X   2 X A X B A B
2
A
2
A
2
B
2
B 12

 The term in the bracket is a perfect square

No Short Sales

 Taking the square root

 p  X A A  X B B
 The return is
rp  X A rA  X B rB
 This pair of equations determine a linear
relation between expected return and standard
deviation
 The trade-off between risk and return is
described by a straight line
Perfect Positive Correlation
 An example
Expected return % Standard
deviation %
Allied Motors 14 6
Brown Engineers 8 3
 This gives the linear relations
 p  X A 6  X B 3  X A 6  1  X A 3  3  3 X A
rp  X A14  X B 8  X A14  1  X A 8  8  6 X A
Perfect Positive Correlation
rP
A (XA = 1, XB = 0)
14

8
B (XA = 0, XB = 1)

3 6 P
Perfect Negative Correlation
 Case 2: Perfect negative correlation  AB  1

 p  X   X   2 X A X B A B
2
A
2
A
2
B
2
B 
12

 This equation has two solutions

1.  p  X A A  X B B
2.  p   X A A  X B B
 For the example
rp  8  6 X A
 p  6 X A  31  X A , p  6 X A  31  X A 
Perfect Negative Correlation
1
 Notice that at X A  ,  p  0
3
 The existence of a portfolio with zero risk is a
general property when
 AB  1
 Notice also that
 p  0  X A A  1  X A  B  0
 So B
XA 
A B
Perfect Negative Correlation
Efficient
rP
A (XA = 1, XB = 0)
14

8
B (XA = 0, XB = 1)

Inefficient

3 6 P
Intermediate Values
 Case 3: 1   AB  1

 In the intermediate case the frontier must lie

between that for the two extremes
 It must be curved with no straight segments
Intermediate Values
Efficient
rP
A (XA = 1, XB = 0)
14

Minimum
rMVP variance
portfolio
8
B (XA = 0, XB = 1)

Inefficient

 MVP 3 6 P
Minimum Variance Portfolio
 Note that for every value of  AB there is a
portfolio with minimum variance
 This is the one furthest to the left.
 It is found be choosing X A to minimize

 p  X   1  X A    2 X A 1  X A   AB A B
2 2
A A
2 2
B 
12

 Taking the first-order condition and solving

gives
 B   A B  AB
2
XA  2
 A   B2  2 A B  AB
An Example
Tesco Sainsbury
Price Return Price Return
410.8 0.005655 328.9 -0.00303
408.49 0.022247 329.9 0.015077
399.6 0.063049 325 0.023622
375.9 0.023275 317.5 0.014377
367.35 0.038886 313 0.008864
353.6 -0.03097 310.25 -0.06127
364.9 0.082147 330.5 0.055911
337.2 0.011398 313 -0.00714
333.4 0.0006 315.25 -0.0533
333.2 -0.06979 333 0.013699
358.2 -0.005 328.5 0.144599
360 0.219099 287 0.015929
295.3 -0.12994 282.5 -0.18822
339.4 -0.12436 348 0.000719
387.6 0.01599 347.75 0.102219
381.5 0.058546 315.5 -0.00864
360.4 -0.0241 318.25 -0.0868
369.3 -0.10819 348.5 -0.09126
414.1 -0.03473 383.5 0.118076
429 343

rbt 0.000727 rbs 0.000707

sigmat 0.080556 sigmas 0.077441
corr 0.392065
An Example
_
rp

p
The Efficient Frontier
 The efficient frontier is the set of portfolios that
have a higher return than the minimum
variance portfolio
 With additional assets the frontier is traced out
be considering all possible portfolios
 Any portfolio below the frontier is dominated
by one on the frontier
 There are no portfolios that allow risk/return
combinations above the efficient frontier
 The frontier is always concave
The Efficient Frontier
rP Efficient

A
14

rMVP
C

8
B

Inefficient

 MVP 3 6 P
Allowing Short Sales
 With short sales, no restrictions are placed on
the proportions X A and X B except that
XA  XB 1
 Allowing short selling introduces negative
proportions
 This extends the frontier at both ends
 It extends indefinitely
Allowing Short Sales

XA > 1, XB < 0
rP
XA = 1, XB = 0
14

rMVP

8 XA = 0, XB = 1

XA < 0, XB > 1

 MVP 3 6 P
Riskfree Borrowing and Lending
 Consider combining a portfolio, A, and the
riskfree asset in proportions X and 1 - X
 This gives expected return
rp  1  X  rf  XrA
 And standard deviation

 p  1  X    X   2 X 1  X  A f  Af
2 2
f
2 2
A 
12

 But  2f  0 and  f  0 so
 p  X A
Riskfree Borrowing and Lending

 Hence
 p p
rp  1   rf  rA
 A A
 Giving
 rA  rf 
rp  rf    p
 A 
 The attainable risk and return combinations lie
on a straight line
Risk-free Borrowing and Lending
rP

c
d

b
a

P
 Hence the efficient frontier is a straight line
 It is tangential to the frontier without the risk-
free asset
Risk-free Borrowing and Lending
Efficient frontier

rP
Xf < 0, XT > 1
14

Xf = 0, XT = 1 Portfolio T:
a mix of A and B
8
rf
Xf = 1, XT = 0

3 6 P
Borrowing and Lending Rates
 The above has assumed the interest rate for
borrowing = interest rate for saving
 In practice the borrowing rate is higher
 Explained by asymmetric information
 Borrowers other than governments cannot be
treated as risk-free
 Risky borrowers must pay a higher rate of interest
 Borrowing rate rb > lending rate rf
Borrowing and Lending Rates
 Efficient frontier now in three sections
Efficient frontier
rP
XA > 1, XB < 0
14
XA = 1, XB = 0

rb

8 XA = 0, XB = 1

rf
XA < 0, XB > 1

3 6 P