Revision of last lecture

Portfolio Theory
 Basic Ideas

 Efficient Frontier

 Capital Market Line and the Market Portfolio

 Practical Issues in Portfolio Allocation

 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.

 Modern PORTFOLIO THEORY

 Modern portfolio theory (MPT), or mean-variance analysis,

is a mathematical framework for assembling a portfolio of assets
such that the expected return is maximized for a given level of
risk. 
 MPT assumes that investors are risk averse, meaning that given
two portfolios that offer the same expected return, investors will
prefer the less risky one. 
 Modern PORTFOLIO THEORY

 In 1952, an economist named Harry Markowitz wrote his

dissertation on “Portfolio Selection”, a paper that contained
theories which transformed the landscape of portfolio
management—a paper which would earn him the Nobel Prize in
Economics nearly four decades later.
 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’
 PORTFOLIO THEORY
 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
12 /1 2 = 
 PORTFOLIO THEORY

 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
P = w21 1+ w22 2 + 2 w1 w2(  1 2)
 PORTFOLIO THEORY

 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
P = w21 1+ w22 2 + 2 w1 w2(  1 2)
 PORTFOLIO THEORY
 Risk of a single asset is the standard deviation (SD = 1 )
of its return

 Risk of a portfolio of shares depends crucially on

covariance (correlation) between the returns.
 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
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

Can we do better than “random selection” ?
 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, 
Markowitz Efficient portfolio

 Markowitz efficient portfolio frontier that offers highest return

at given level of risk. Or assume lowest risk for given level of
returns.
 A B C D
1 100%
2 50% 50%
4 25% 25% 25% 25%
10 10% 10% 10% 10% 10%
100 1% 1% 1%
1000 0.1% 0.1% 0.1%
10000 0.01% 0.01% 0.01%
  Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
Correlation and Risk 
P = w21 1+ w22 2 + 2 w1 w2(  1 2)

 Return-A=0.1 Return- B=0.1 RISK-A =0.20 RISK-B= 0.20

 W1=0.50 W2=0.50
 RP=0.5*0.1+0.5*0.1=0.05+0.05=0.10
 Variance of Portfolio= (0.5)^2 * ( 0.2)^2 + (0.5)^2 * ( 0.2)^2
+2*0.5*0.5*0.2 *0.2 r12
 =0.01+0.01+0.02 r12= 0.02+0.02 r12
 r12=+1 var= 0.04 Std dev= 0.2
 r12=+0.5 var= 0.03 Std dev= 0.173
 r12= 0 var= 0.02 Std dev= 0.141
 r12= -0.5 var= 0.01 Std dev= 0.1
 r12= - 1 var= 0 Std dev= 0
 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.
 PORTFOLIO THEORY
 Expected Return of Portfolio
E(RP) = W1 R1 + W2 R2

 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
P = w21 1+ w22 2 + 2 w1 w2(r12 1 2)
Note 12 = 1 2 r12 - from statistics 12 /1 2 = r12

 Weights of Stocks in Portfolio

w1 + w2 = 1
 Weights of Stocks in risk minimizing Portfolio
W1 = (2 - 12 ) / (1+ 2 - 212 
Example-1

Find Risk and Return of a portfolio comprising of following stocks

R1 = 0.1
R2 = 0.2
σ1 = 0.1
σ2 = 0.2
W1 = 0.4
W2 = 0.6
r12 = - 0.5
Rp =?
σp = ?


 Example-1
 Expected Return of Portfolio
E(RP) = 0.4 (0.1) + 0.6 (0.2) = 0.04+0.12
E(RP) = 0.16
 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2(r12 1 2)
P = 0.42 *+ 0.62 *  + 2 * 0.4 * 0.6 * - 0.5 * 0.1 * 0.2
P = 0.16 *+ 0.36 * + 2 * 0.4 * 0.6 * - 0.5 * 0.1 * 0.2
P = 0.0016 + 0.0144 - 0.0048 =0.0112
P = 0.1058

w1 + w2 = 1.
Note 12 =  1 2 - from statistics
12 /1 2 = 
Example-2

 The risk and Return of Two stocks is given below.

R1 = 0.1 R2 = 0.2
σ1 = 0.1 σ2 = 0.2
r12 = - 0.5
 How much should be invested in each stock to minimize the risk?
W1 = ? W2 = ?

 What is risk and return of risk minimizing portfolio?

Rp = ?σp = ?


 Example -2
 W1 = (2 - 12 ) / (1+ 2 - 212 

 12 /1 2 = r12

 12 = 1 2 r12 = 0.1*0.2*-0.5= -0.01

 W1 = (0.04 +0.01) / (0.01+ 0.04 + 0.02 

 W2 = 1- W1

 W2 = 1- 0.71 = 0.29
 Example -2
 Expected Return of Portfolio
E(RP) = 0.71*0.1 + 0.29* 0.2 = 0.071+0.058
E(RP) = 0.129
 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2(r12 1 2)
P = 0.712 *+ 0.292 *  + 2 * 0.71 * 0.29* - 0.5 * 0.1 * 0.2
P = 0.005041 + 0.003364 - 0.004118 =0.004287
P = 0.0655
 Example-3

period PPL FFC R1 R2 R1-E(R1) R2-E(R2)

30/6/2019 100 50 -
30/9/2019 105 49 0.05 -0.02 0.01 -0.04
31/12/2019 111 47 0.06 -0.04 0.02 -0.06
31/3/2020 108 52 -0.03 0.10 -0.07 0.08
30/6/2020 116 54 0.08 0.04 0.04 0.02
Total 0.16 0.08
E(R) 0.04 0.02
R1 R2
Example -3
(R1-E(R1))^2 (R2-E(R2))^2 (R1-E(R1)) *(R2-E(R2))

30/9/2019 0.0001 0.0016 -0.0004

31/12/2019 0.0004 0.0036 -0.0012
31/3/2020 0.0049 0.0064 -0.0056
30/6/2020 0.0016 0.0004 0.0008
Total 0.0070 0.0110 -0.0064
Variance 0.00175 0.00275
Std Dev(σ) 0.0418=1 0.0524=2
Covariance -0.0016=12

Correlation = - 0.0016/(0.0418*0.0524) = -0.73

(r12)
Example -3

 W1 = (2 - 12 ) / (1+ 2 - 212 

 W2 = 1- W1

 W1 = (0.00275 +0.0016 ) / (0.00175+ 0.00275 + 0.0032 

 W2 = 1- 0.56 = 0.44
 Example -3
 Expected Return of Portfolio
E(RP) = 0.56 (0.04) + 0.44 (0.02) = 0.0224+0.0088
E(RP) = 0.0312
 Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2(r12 1 2)
P = 0.562 *+ 0.442 *  + 2 * 0.56 * 0.44 * - 0.73 * 0.0418 * 0.0524
P = 0.000548 + 0.000532 - 0.00079 =0.000292
P = 0.0171
 CONTRIBUTION OF MARKOWITZ

 Markowitz proposed Mean Variance Efficiency theory that deals with allocation of
resources.
 Do not put all eggs in one basket and go for diversification
 When you go for diversification , unsystematic risk is diversified and you are left
with only systematic risk.
 The benefit of diversification is not due to number of stocks . it is due to covariance
among securities.
 They proposed the formula for estimation of portfolio risk and return.
Expected Return of Portfolio
E(RP) = w1 ER1 + w2 ER2
Variance of Portfolio
P = w21 1+ w22 2 + 2 w1 w2 12
Practice Question

You are considering two assets with the following characteristics:

Correlation coefficient(r1,2 ) between the two stocks is - 0.5 . How
much should be invested in each security to minimize the risk of
portfolio. Find risk and return of risk minimizing portfolio. Also
draw the diagram and identify Markowitz Efficient Portfolio
Frontier.

STOCK E(R) STD DEVIATION

S 0.10 0.08

T 0.20 0.16

     
 Assignment
Global plc currently operates only in the UK, but is considering diversifying its
activities internationally into either Europe or East Asia, the latter including
several developing economies. Estimates have been obtained of the likely risk
and return of investments in these parts of the world, which are expected to vary
during different economic states of the UK. After either diversification
approximately 30% of the market value of the company would be represented by
overseas investments
Economic state Probability Return on Return on Return on
Investment in Investment in Investment in
Europe % East Asia % UK %

Low growth 0.3 7 2 6

Average growth 0.5 12 30 13
Rapid growth 0.2 21 15 17
 Assignment
Other information
Standard deviation of expected returns
Europe 4.86
East Asia 12.26
UK 4.03
Covariances of expected returns:
UK/Europe 17·89
UK/East Asia 31·98
Members of Global’s board of directors have different views about such
diversification.
Director A believes that the company should focus exclusively upon the UK
market as it always has, because ‘overseas investments are too risky’.
Director B believes that overseas diversification will offer the company the
opportunity to achieve a much better combination of risk and return than purely
domestic investments, and ‘will open up new opportunities’.
 Assignment
Director C considers that overseas investments are expensive, and overseas
diversification will not be valued by shareholders who could easily achieve
such diversification themselves.
Director D is in favour of the diversification, but considers East Asia to be a
much better alternative than Europe.
Director E is also in favour of East Asia, but suggests that a much higher
proportion of the company’s activities should be located there, possibly
between 50% and 70%.
Required:
Discuss the views of each of the five directors. Include in your discussion
relevant calculations regarding portfolio risks and returns. Clearly report the
risk and return of individual investment and portfolios.
What other factors might influence the investment decision? State clearly
any assumptions that you make.
Estimate and explain the implications of the correlation coefficients
between: UK/Europe; and UK/East Asia