L05 MBA Port Thry

11/9/2001
LECTURE :
PORTFOLIO THEORY AND RISK

Note that only a selection of these slides will be dealt with in detail, in
the lecture
All other slides are there to guide you towards the key points in
Cuthbertson/Nitzsche “Investments” and in the end of chapter questions
Revise your elementary stats before the lecture
Copyright K. Cuthbertson and D. Nitzsche 1

TOPICS
Basic Ideas
Efficient Frontier
Transformation Line, Capital Market Line

and the Market Portfolio
Practical Issues in Portfolio Allocation
Self-Study Slides

READING
Investments:Spot and Derivative Markets,

K.Cuthbertson and D.Nitzsche
CHAPTER 10:
Section 10.1: Overview
Section 10.2: Portfolio Theory
Note:
Chapter 18 also contains much useful material
for those who wish to learn more !

Basic Ideas

PORTFOLIO THEORY
Portfolio theory works out the ‘best combination’ of

stocks to hold in your portfolio of risky assets.
You like return but dislike ‘risk’
We assume the investor is trying to ‘mix’ or combine

stocks to get the best return relative to the overall
riskiness of the chosen portfolio.
As we shall see ‘Best’ has a very specific meaning.

PORTFOLIO THEORY
Question 1
What proportions of your own $100 should you put in
two different stocks
(e.g. ‘weights’ = 25%, 75% which implies $25, $75)
Different ‘weights’ give rise to different ‘risk-return’

combinations and this is the ‘efficient frontier’
Question 2
We now allow you to borrow or lend (from the bank),
How does this alter your choice of ‘weights’ and the
amount you actually choose to borrow or lend?
Latter depends on your ‘love of risk’
Statistics: Some Definitions
Expected Return of Portfolio

E(RP) = w1 ER1 + w2 ER2
Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
P = w21 1+ w22 2 + 2 w1 w2(  1 2)
Also, ‘proportions’ are: w1 + w2 = 1.

Note 12 =  1 2 - from statistics

Some Intuition: Domestic Assets
Risk of a single asset is the variance (SD = 1 )

of its return
( eg. Man.Utd share)
Risk of a portfolio of shares depends crucially

on covariance (correlation) between the
returns.
(Eg. Man Utd and Arsenal)

Random selection of shares
Increasing the size (=n) of the portfolio
(each asset has ‘weight’ wi = 1/n)
Standard
Note: 100%=risk when holding
Deviation
only one asset
100%
Diversifiable /
Idiosyncratic Risk
Market /
Non-Diversifiable Risk
1 2... 20 40 No. of shares in portfolio
Some Intuition: International Diversification
US resident invests $100 in UK Stock index (FTSE100)
Suppose whenever FTSE100 goes up by 1% the sterling
exchange rate always goes down by 1% - perfect
negative correlation between the two returns
Then the US resident has zero US dollar risk
Hence negative correlations (strictly any  < +1) reduces risk
(True, she also has zero expected USD return but seeing as
she is holding zero risk, that seems OK. ‘It’s the 1st rule
of finance, stupid!’)

Random Selection: International Portfolio
Standard
Deviation Note: 100%=risk when holding
100% only one asset
Domestic Only
International
1 2... 20 40 No. of shares in portfolio

Efficient Frontier

Can we do better than “random selection” ?
Consider ‘Return’ together with ‘Risk’
Assumptions
You like return and dislike portfolio risk (variance/ SD).
Assume everyone has the same view of future returns ERi

and correlations 12 , 12 .
2-Stage Decision Process

STAGE 1
Use only “own wealth” of $100 and work out the risk-
return combinations which are open to you by distributing
this $100 in different combinations (proportions, wi ) in
the available stocks. This gives the “efficient frontier”

Efficient Frontier: Diversification
Expected
wi = (50%, 50%)
Return
wi = (25%,75%) . A
. Own wealth of $100 split between 2
assets in proportions wi. As you alter
the proportions you move around
ABC
Individual variances and correlation
B coefficients are held constant in this
graph
C
RISK, 
Figure 10.4 : Risk Reduction Through Diversification
25
Corr = + 1
Corr = +0.5
20
Corr = 0
Expected return
15 Corr = -1
Corr = -0.5
10
0
0 5 10 15 20 25 30 35
Std. dev. 15
Copyright K. Cuthbertson and D. Nitzsche
Transformation Line
the
Capital Market Line CML
and the
Market Porfolio

Borrowing and Lending, ‘safe rate’= r
STAGE 2
You are now allowed to borrow and lend at risk free
rate, r while still investing in any SINGLE ‘risky bundle’
on the efficient frontier .
For each SINGLE risky bundle, this gives a new set of

risk-return combinations =“transformation line, TL”
~ which is a ‘straight line’
Each risky asset bundle has its ‘own’ TL
You can move along this TL by altering your borrowing/lending

Transformation Line(s) TL
TL = Combination of ANY SINGLE ‘risky bundle’ and the safe asset
+ This is TL to
ER B . point M =‘CML’
ERm
M . Point M corresponds to fixed w (e.g.
50%, 50%)
i
A . .Z Point Z corresponds to fixed wi

(e.g. 25%, 75%)
rr
This is TL to Everyone would choose the ‘highest’ TL
point Z = point M and proportions 50-50.
m 
CML: Some Properties
NO BORROWING OR LENDING (ONLY USE OWN $100)

You are then at point M
LEND SOME OF $100 (e.g lend $90 at r and $10 in risky bundle)
You are then at point like A
BORROW (say $50 ) and put all $150 in risky assets

You are then at point like B
Surprisingly the proportions at A and B are the same as at M

(I.e. 50%,50%) - but the $ amounts are NOT the same! (Tricky !)

CML and Market Portfolio (M)
M/s-B less risk

. averse than M/s-A
ER
CML
B
ERm
M
wi - optm proportions at M
A ERm - r
r m wi maximises “reward to risk ratio”

- “Sharpe Ratio”
m 
Market Portfolio = Passive Investment Strategy
Optimal wi maximises “reward to risk ratio” - “Sharpe Ratio”.
At the time you choose your optimal proportions you expect to

obtain a ‘reward to risk ratio’ of
S = ( ERm - r ) / m
Note that both M/s-A and M/s-B have the same Sharpe ratio
Of course the ‘out-turn’ for the Sharpe ratio could be very different
to what you envisaged (because your forecasts turned out to be
poor).
Ball park estimate for Sharpe ratio for S&P500 (annual)

= 0.4 [= (12-4)/20]

Practical Issues
in
Portfolio Allocation

‘Active’ versus ‘Passive’ Strategy
Sharpe Ratio for any portfolio-k

Sk = ( ERk - r ) / k
Active portfolio managers must try and beat the Sharpe ratio of the
‘passive’ investment strategy (I.e. holding the market portfolio,
month in-month-out ).
ERk = average of ‘out-turn’ values for monthly portfolio returns (net

of transactions costs) over say 3 years, for any portfolio-k and
any ‘strategy’ (e.g. trying to pick winners)
= sample SD of these monthly returns (over 3 years)
Compare investment strategies:

The investor with the highest value of Sk is the ‘winner’

Practical Issues
1) Suppose all investors do not have the same views about
expected returns and covariances.
~ we can still use our methodology to work out optimal
proportions/weights for for each individual investor.
2) The optimal weights will change as forecasts of returns and

correlations change - the ‘passive’ portfolio needs ‘some
rebalancing’ - ‘Tracking Error’
3)The method can be easily adopted to include transactions costs

of buying and selling, and investing “new” flows of money.
4) Lots of weights might be negative, which implies short-selling,

possibly on a large scale. If this is ‘impractical’ you can re-
calculate, where all the weights are forced to be positive.

No-Short Sales Allowed
(ie. All ‘weights’ > 0 )
ERP
‘Unconstrained’ Efficient Frontier - allows short sales
Efficient Frontier - no short sales

1) Always lies ‘within’ or ‘on’ frontier which allows short sales
2) Deviates more at ‘high’ levels of expected return and P
P (=SD)
Practical Issues
5) The optimal weights depend on estimate/forecasts of

expected returns and covariances.
If these forecasts are incorrect, the actual risk-return

outcome may be very different from that envisaged when
you started out
Put another way a small change in expected returns can

radically alter the optimal weights - ie. Extreme
sensitivity to the” inputs”.
The optimal weights are relatively insensitive to errors in

forecasts of correlations and variances - hence some
investors choose weights to min. SD only.
Forecast Errors, (ER, P) Error in ‘proportions’
MIN VARIANCE
PORTFOLIO,Z
Confidence band
around Z may be M = mathematical optimum = (50%, 50%) say
ERP relatively small -
90% S&P500 +
because it does
x x x A
not use ‘poor’
forecasts of ERi x x x 10% Europe.
Optimal for US
X
x x investor ?
x x xx
It is possible that (90%,10%)
xx
.
lies within a 95%
Each ‘cross’
z x represents a
CONFIDENCE BAND
xx different set of
‘weights’ wi
C
P (=SD)
Practical Issues
6) To overcome this “sensitivity problem” try:
a) Choose the weights to minimise portfolio variance - the weights are

then independent of the “badly measured” expected returns.
(Note:does not imply a zero expected return - see fig).
b) Choose “new proportions” which do not deviate from existing

proportions by more than 2%.
c) Choose “new proportions” which do not deviate from “index tracking

proportions” (eg. S&P500) by more than 2%.
d) Do not allow any short sales of risky assets ( All wi >0).
e) Limit the analysis to investment in say 5 sectors, so sensitivity

analysis can be easily conducted (A sophisticated version of which
is Monte Carlo Simulation).

International Diversification
Tries to take advantage of “lower” (own) return correlations
compared to solely domestic investments.
-this can arise because of different timing of business cycles. (eg.

US is booming, Japan is in recession)
Diversification benefits can also arise because of exchange rate

correlations.
e.g.Suppose whenever FTSE100 goes up by 1% the sterling
exchange rate goes down by 1% (perfect negative correlation).
Then a US based investor faces no risk in dollar terms from his
UK investments.
Above extreme case is unlikely in practice so the issue of currency

hedging arises (via forwards, futures and options).

‘HOME BIAS’ PROBLEM

It appears that investors, invest too much in the home
country relative to the results given by “optimal” portfolio
weights
BUT
- actual weights may not be statistically different from
the optimal weights, given that the latter are subject to
(large ? ) estimation error.
- actual weights might reflect “ a long view” of returns,

including the fact that purchases of goods (when
investments are cashed in) are largely made the “home
currency”.

INVESTMENT COMMITTEES usually make STRATEGIC ASSET
ALLOCATION decisions based on a long term view of risk and
return (including political risk). This gives them their ‘baseline’
asset allocation between countries.
(e.g. no more than 10% portfolio in S.America over next 3 years)
- conventional portfolio theory largely ignores

political/default risk but could in principle incorporate
this in forecast of expected returns, variances etc -
but usually done on an ad-hoc basis.
The ‘international portfolio’ may then be ‘fine tuned’

using portfolio theory, but the weights will be heavily
constrained (to not move far from those set by the
Investment committee).
Within a particular country, either portfolio theory will be used to

guide proportions in each industrial sector, or they will try just
‘track’ the respective domestic indices (e.g. the S&P500,
FTSE 100).
There is some evidence that INVESTMENT COMMITTEES are

moving towards choosing industrial sector weights, subject to
limits on the resulting country proportions. This is to ‘gain’
from the disparate business cycles between industries (e.g.
world car industry has different cycle to world chemicals)
This is because ‘country indices’ are beginning to have ‘high

correlations’ (e.g. US and UK aggregate business cycles are
now more highly correlated.

TACTICAL ASSET ALLOCATION
Use part of funds for market timing’ the business

cycle’
(e.g. switch 10% of speculative funds out of US and
into SE Asia )
-might use a macro-economic model for forecasts
-does not easily ‘fit’ into portfolio theory because

usually little or no formal estimate of risk is made

LECTURE ENDS HERE

SELF STUDY SLIDES
The following slides provide a simple

numerical example to construct
the efficient frontier,the capital market
line and the market portfolio
These slides will NOT be covered in the

lectures

STATISTICS REVISION: Some Definitions
Expected Return of Portfolio

E(RP) = w1 ER1 + w2 ER2
Variance of Portfolio
 P = w21 1+ w22 2 + 2 w1 w2 12

 P = w21 1+ w22 2 + 2 w1 w2(  1 2)
Also, ‘proportions’ are: w1 + w2 = 1.

Note 12 =  1 2 - from statistics
The above are used to derive the EFFICIENT
FRONTIER by (arbitrarily) altering the w’s

STAGE 1: 2 Risky Assets:
Real world data (statistician)
Risky Assets
Equity-1 Equity-2
Mean, ERi 8.75 21.25
S D) . 10.83 19.80
Correlation (Equity-1, Equity-2): - 0.9549

Cov(Equity-1, Equity-2) : -204.688

STAGE 1: Construct Efficient Frontier
Choose different w’s and calculate ERp and p
combinations)
State Shares of Portfolio
Equity-1 Equity-2 ERp

p
w1 w2
1 1 0 8.75 10.83
2 0.75 0.25 11.88 3.70
3 0.5 0.5 15 5
4 0 1 21.25 19.80
Now plot values of ERp and p and construct

the Efficient Frontier
Efficient Frontier
30
25
0, 1
Expected Return
20
0.5, 0.5
15
10
0.75, 0.25 (1, ,00 )
1
5
0
0 5 10 15 20 25
Standard deviation

Efficient Frontier with ‘n’ - Risky Assets
You require EXCEL ‘SOLVER’ to ‘draw’ the
EFFICIENT FRONTIER (=A-B)
End of Excel Each ‘cross’
minimisation
ERP represents a
wz = 25%,75%, say x xA different set of
x ‘weights’ wi
x
ERz Z ‘Start’ Excel (50%,50%, say)
ERZ X X
x Excel solver changes the
weights to minimise risk
B x (SD) for any arbitrarily
chosen level expected return,
ERz
z ‘Finish Excel’ x x So, Z moves to the left

xC P (=SD)
STAGE 2: Transformation Line
We have ‘constructed’ the efficient frontier
Now introduce a “safe asset”
What does the risk-return “trade-off” look like when we

allow borrowing or lending at the safe rate
and
we combine this with any ‘single bundle’ of risky assets?
‘New Portfolio’=1-safe asset + 1 “bundle of risky assets”
Answer = Straight Line relationship between ER and 

STAGE 2: Transformation Line
What is a ‘Risky Asset bundle’ ?:
Keep (arbitrary) fixed weights in risky assets

eg. 20% in asset-1, 80% in asset-2
So, if you have W0 = $100 you will hold $20 in
asset-1 and $80 in asset-2
Assume this gives rise to a fixed “bundle” of risky

assets” called “q” with ERq=22.5% and sq= 24.8%
Now combine ‘fixed risky bundle’ with the safe asset

by borrowing/lending different $ amounts of safe asset

Construct ‘One’ Transformation Line
Data Re turn
T-bil l (s a fe ) Equity (Ris ky)
Me an r =10 Rq = 2 2 .5
S td. De v. 0
q 2 4 . 8 7
FORMULAE FOR EXPECTED RETURN AND SD OF ‘NEW’
PORTFOLIO
N= “new” portfolio of: ‘safe + risky ‘bundle’

q 2 = variance of the risky ‘bundle’
x = proportion held in ‘risky asset’
(1-x) = proportion held in safe asset(with  = 0 )
Expected Return: E(RN) = (1- x) . r + x ERq
THEN: Variance (SD) of NEW PORTFOLIO of “ 1-safe + 1 risky asset”

N 2 = x2 q 2 or N = x q
“New Portfolio (N) :
“Arbitrarily alter ‘x’ to give different Expected
Return ERN and risk combinations N
This gives a straight line = Transformation Line

State Shares of “New” portfolio
Wealth in
T-bill Equity ERN N (SD)

1-x -x)
1 1 0 10 0
2 0.5 0.5 16.25 12.4373
3 0 1 22.5 24.8747
4 -0.5 1.5 28.75 37.312

Variance of ( 1-safe + 1 risky asset BUNDLE)
Note: Borrowing:
When proportion (1-x)= - 0.5 is in the safe asset, this implies
x = 1.5 held in risky asset
Suppose ‘own’ initial wealth W0 =$100
Hence above implies borrowing 50% of “own wealth” (=$50) to

add to your initial $100 and putting all $150 into the bundle of
risky assets (in the fixed proportions 20%, 80%, I.e $30 and
$120 in each risky asset)
- this is referred to as ‘leverage’ and involves a higher expected

return but also higher risk (SD). ‘Its the first law of finance
again!
Now plot the combinations ER and  in the previous slide

Transformation Line
30 1 safe asset + 1 risky "bundle"
25 Borrow -0.5,
22.5 put all 1.5 in
Exp. Return
20 risky bundle
15 No Borrowing/ No lending
10
5 0.5 lending +
All lending 0.5 in risky bundle
0
0 10 20 24.87 30 40
Standard deviation
Note: At “no borrow/lend” position, ER and  of “new” portfolio equals that
for the risky asset alone (not surprisingly)

Transformation Lines
Safe asset plus ANY ONE ‘arbitrary’ risky bundle,

gives a specific transformation line (which is straight
line) between r and the s.d of the risky bundle
Every single, risky bundle has its own transformation

line
Which transformation line is “best”?
“THE HIGHEST ACHIEVABLE” = Capital Market Line

Transformation Lines
1 safe + risky "bundles"
30 L’
25 q =24.87
L
Exp. Return
20
15
r =10 k = 10
5
0
0 10 20 30 40
Standard deviation
q and k are both ‘points’ on the efficient frontier. So q might represent(20%,80%) in risky assets
and k might represent (70%,30%). Each “fixed weight” risky bundle has its own transformation
line
“B” is highest attainable transformation line, while still remaining on the
efficient frontier. ‘B’ represents the optimal weights (50%,50%) for the risky
bundle.
Efficient Frontier
CML
and CML
L’
30
25 A L
Expected Return
20
B
15
C
10
D
0
0 5 10 15 20 25
Standard deviation

Market Portfolio
Point-B is therefore a rather special portfolio and

hence is known as the “Market Portfolio” (as
indicated by the subsript ‘m’ in the next slide)
IF everyone has the same expectations about

returns, standard deviation and correlations then:
Everyone chooses point-B (which here gives 50%,

50% held in each risky asset)

CML and Market Portfolio (M)
+
M/s-B less risk CML
B
ER
averse than M/s-A
ERm
M
wi - optm proportions at M
A ERm - r
r m
wi maximises “reward to
risk ratio” - “Sharpe Ratio”
m 
How Much Should an Individual Borrow or Lend?
~while still maintaining the 50:50 proportions in the 2-RISKY assets ?
This depends on the individual’s “preferences” for risk versus return
M/s-A is VERY “risk averse” (=dislike risk)

implies uses e.g. $90 of her $100 “own wealth” to invest in the
safe asset and puts only V= $10 in the risky “bundle” thus holding
$5 in each risky asset (5/10 = 50%)
M/s-B is LESS “risk averse” (=not too worried about risk)

She borrows say $60 and invests the whole V= $160 in the risky
bundle thus holding $80 in each risky asset (80/160 =50%)
Hence both A and B invest the same PROPORTIONS in the risky

assets but DIFFERENT $-amounts. The latter implies A and B hold
different DOLLAR risk (For the ‘experts’: $-RISK = V x m )

END OF SLIDES

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11/9/2001

PORTFOLIO THEORY AND RISK

Revise your elementary stats before the lecture

Copyright K. Cuthbertson and D. Nitzsche 1

Transformation Line, Capital Market Line

Practical Issues in Portfolio Allocation

Copyright K. Cuthbertson and D. Nitzsche 2

Investments:Spot and Derivative Markets,

Copyright K. Cuthbertson and D. Nitzsche 3

Copyright K. Cuthbertson and D. Nitzsche 4

Portfolio theory works out the ‘best combination’ of

You like return but dislike ‘risk’

We assume the investor is trying to ‘mix’ or combine

As we shall see ‘Best’ has a very specific meaning.

Copyright K. Cuthbertson and D. Nitzsche 5

Different ‘weights’ give rise to different ‘risk-return’

Expected Return of Portfolio

Also, ‘proportions’ are: w1 + w2 = 1.

Copyright K. Cuthbertson and D. Nitzsche 7

Risk of a single asset is the variance (SD = 1 )

Risk of a portfolio of shares depends crucially

(Eg. Man Utd and Arsenal)

Then the US resident has zero US dollar risk

Hence negative correlations (strictly any  < +1) reduces risk

Copyright K. Cuthbertson and D. Nitzsche 10

1 2... 20 40 No. of shares in portfolio

Copyright K. Cuthbertson and D. Nitzsche 12

Consider ‘Return’ together with ‘Risk’

Assume everyone has the same view of future returns ERi

2-Stage Decision Process

Copyright K. Cuthbertson and D. Nitzsche 13

Copyright K. Cuthbertson and D. Nitzsche 16

For each SINGLE risky bundle, this gives a new set of

Each risky asset bundle has its ‘own’ TL

You can move along this TL by altering your borrowing/lending

Copyright K. Cuthbertson and D. Nitzsche 17

A . .Z Point Z corresponds to fixed wi

NO BORROWING OR LENDING (ONLY USE OWN $100)

BORROW (say $50 ) and put all $150 in risky assets

Surprisingly the proportions at A and B are the same as at M

Copyright K. Cuthbertson and D. Nitzsche 19

M/s-B less risk

r m wi maximises “reward to risk ratio”

At the time you choose your optimal proportions you expect to

Ball park estimate for Sharpe ratio for S&P500 (annual)

Copyright K. Cuthbertson and D. Nitzsche 21

Copyright K. Cuthbertson and D. Nitzsche 22

Sharpe Ratio for any portfolio-k

ERk = average of ‘out-turn’ values for monthly portfolio returns (net

Compare investment strategies:

Copyright K. Cuthbertson and D. Nitzsche 23

2) The optimal weights will change as forecasts of returns and

3)The method can be easily adopted to include transactions costs

4) Lots of weights might be negative, which implies short-selling,

Copyright K. Cuthbertson and D. Nitzsche 24

Efficient Frontier - no short sales

5) The optimal weights depend on estimate/forecasts of

If these forecasts are incorrect, the actual risk-return

Put another way a small change in expected returns can

The optimal weights are relatively insensitive to errors in

a) Choose the weights to minimise portfolio variance - the weights are

b) Choose “new proportions” which do not deviate from existing

c) Choose “new proportions” which do not deviate from “index tracking