CHAPTER 7 Optimal Risky

Portfolios

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Diversification and Portfolio Risk

• Market risk
– Systematic or nondiversifiable
• Firm-specific risk
– Diversifiable or nonsystematic

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Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio

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Figure 7.2 Portfolio Diversification

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 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 two
assets vary

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 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 (rp )  wD E (rD )  wE E (rE )

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 Two-Security Portfolio: Risk

  w   w   2wDw
2
P
2
D
2
D  EE Cov(rD , rE )
2
E
2
E

 D2 = Variance of Security D

 2
E = Variance of Security E

Cov(rD , rE )= Covariance of returns for

Security D and Security E

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Two-Security Portfolio: Risk Continued

• Another way to express variance of the

portfolio:
 P2  wD wDCov(rD , rD )  wE wE Cov(rE , rE )  2wD wE Cov (rD , rE )

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 Covariance

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

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Correlation Coefficients: Possible Values

Range of values for 1,2

+ 1.0 >  > -1.0
If = 1.0, the securities would be perfectly
positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated

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Table 7.1 Descriptive Statistics for Two
Mutual Funds

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 Three-Security Portfolio

E (rp )  w1 E (r1 )  w2 E (r2 )  w3 E (r3 )

2p = w1212 + w2212 + w3232

+ 2w1w2 Cov(r1,r2)
Cov(r1,r3)
+ 2w1w3
+ 2w2w3 Cov(r2,r3)
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 Table 7.2 Computation of Portfolio
Variance From the Covariance Matrix

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Table 7.3 Expected Return and Standard
Deviation with Various Correlation
Coefficients

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Figure 7.3 Portfolio Expected Return as
a Function of Investment Proportions

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Figure 7.4 Portfolio Standard Deviation
as a Function of Investment Proportions

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Minimum Variance Portfolio as Depicted
in Figure 7.4
• Standard deviation is smaller than that of
either of the individual component assets
• Figure 7.3 and 7.4 combined demonstrate the
relationship between portfolio risk

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Figure 7.5 Portfolio Expected Return as
a Function of Standard Deviation

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 Correlation Effects

• The relationship depends on the correlation

coefficient
• -1.0 <  < +1.0
• The smaller the correlation, the greater the
risk reduction potential
• If = +1.0, no risk reduction is possible

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Figure 7.6 The Opportunity Set of the
Debt and Equity Funds and Two
Feasible CALs

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 The Sharpe Ratio

• Maximize the slope of the CAL for any

possible portfolio, p
• The objective function is the slope:

E (rP )  rf
SP 
P

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

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Figure 7.8 Determination of the Optimal
Overall Portfolio

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Figure 7.9 The Proportions of the
Optimal Overall Portfolio

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 Markowitz Portfolio Selection Model

• Security Selection
– 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

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Figure 7.10 The Minimum-Variance
Frontier of Risky Assets

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 Markowitz Portfolio Selection Model
Continued
• We now search for the CAL with the highest
reward-to-variability ratio

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Figure 7.11 The Efficient Frontier of
Risky Assets with the Optimal CAL

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 Markowitz Portfolio Selection Model
Continued
• Now the individual chooses the appropriate
mix between the optimal risky portfolio P and
T-bills as in Figure 7.8
n n
 P2    w w Cov(r , r )
i j i j
i 1 j 1

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Figure 7.12 The Efficient Portfolio Set

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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

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Figure 7.13 Capital Allocation Lines with
Various Portfolios from the Efficient Set

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 The Power of Diversification
n n
• Remember: P  
  w w Cov(r , r )
2
i j i j
i 1 j 1

• If we define the average variance and

average covariance of the securities as:
1 n 2
   i
2

n i 1
n n
1
Cov  
n( n  1) j 1
 Cov(r , r )
i 1
i j

j i

• We can then express portfolio variance as:

1 2 n 1
P   
2
Cov
n n
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Table 7.4 Risk Reduction of Equally
Weighted Portfolios in Correlated and
Uncorrelated Universes

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Risk Pooling, Risk Sharing and Risk in
the Long Run
• Consider the following:
Loss: payout = $100,000
p = .001

No Loss: payout = 0

1 − p = .999

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Risk Pooling and the Insurance Principle

• Consider the variance of the portfolio:

1 2
  
2
P
n
• It seems that selling more policies causes
risk to fall
• Flaw is similar to the idea that long-term
stock investment is less risky

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Risk Pooling and the Insurance Principle
Continued
• When we combine n uncorrelated
insurance policies each with an expected
profit of $ , both expected total profit and
SD grow in direct proportion to n:

E (n )  nE ( )
Var (n )  n Var ( )  n 
2 2 2

SD(n )  n
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 Risk Sharing

• What does explain the insurance business?

– Risk sharing or the distribution of a fixed
amount of risk among many investors

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