The Mean Variance Portfolio

Theory
2017

1
 Introduction
• In this topic we seek to explore the risk
and return provided by portfolios.
•  
• Ultimately we want to be able to establish
portfolios that different clients with different
risk profiles would be comfortable with.

2
 Optimal Portfolio Choice
U4
U3
U2
E(Rp ) U1

rf
Minimum variance opportunity set
0  p

3
 Efficient Portfolio
• An efficient portfolio is a combination of
assets that has the best expected level of
return for a given level of risk.

• It yields the best possible combination of

risk and return.

4
 Portfolio return: Expected Value and Variance
Let the return on asset 1 be R1and that on asset 2 be
R2.

If we start with a portfolio made up of two assets then

the portfolio return is:

Rp = w1R1+w2R2, where wi’s are the portfolio weights

and w1+w2 = 1.

For a portfolio with more than two assets:

n
R p   wi Ri
i 1
5
The portfolio expected return is:

E ( R p )  w2 E ( R1 )  w2 E ( R2 )
n
More generally we get: E ( R p )   w E(R )
i 1
i i

The variance of a portfolio return is:


2
p
 w   w   2w1 w2 12
2 2
1 1
2
2
2
2
n n

More generally,  p   wi w j ij or:

2

i 1 i 1
n n n

  w    w w 
2 2 2
p i i i j ij
i 1 i 1 i 1, j i 6
 Example
Consider a portfolio composed of assets X and Y
with the following attributes:
Return on X Return on Y Probability
11 -3 0.2
9 15 0.2
25 2 0.2
7 20 0.2
-2 6 0.2
Assume the portfolio is split equally between the two
assets (i.e., wi=0.5).

Calculate portfolio return and portfolio variance.

7
 N
 x2  var( X )   pi [ X i  E( X )] 2  0.0076
i 1
N
 y2   pi [ Yi  E( Yi )] 2 0.00708
i 1

Cov( X ,Y )  E [( X  E( X ))( Y  E( Y ))]   xy  0.0024

N
E( X )   pi X i  0.1
i 1
N
E( X )   piYi  0.08
i 1

E( R p )  w1 E( R1 )  w2 E( R2 )  0.5( 0.1 )  0.5( 0.08 )  0.09  9%

 p 1 1 2 2  2w1 w2 12  0.00247

2
 w 
2 2
 w 2 2

  p  4.97% 8
 Correlation Coefficient  12 
 12
12    12  12 1 2 ,  1    1
 1 2 12

From the above example

 12  0.0024
12    0.33
 1 2 (0.0872)(0.0841)

9
 The Portfolio Opportunity Set (for a
two-asset portfolio)
• A portfolio opportunity set (POS) is a set of
all feasible portfolios with different
combinations of X and Y.

1.The case where ρ12 = +1

2.The case where ρ12 = - 1

3.The case where ρ12 = 0 10

 Case 1: The case where ρ12 = +1
E ( R p )  w1E ( R1 )  w2 E ( R2 )  w1E ( R1 )  (1  w1 ) E ( R2 )


2
p
 w  2
1w   22
1w1 w2 12
2
2
2
2
 12
12    12  12 1 2
 1 2
  w   w   2w1 w2 12 1 2
2
P
2
1
2
1
2
2
2
2

 w   w   2w1w2 1 2 , since 12  1

2
1
2
1
2
2
2
2

  w1 1  w2 2 
2

 p  w1 1  w2 2  w1 1  (1  w1 ) 2

11
Equation above is a straight line. It can be shown
that indeed this is a straight line by showing that the
slope of the equation does not change as the weight
changes:

dE ( R p )
dE ( R p ) E ( R1 )  E ( R2 )
slope   dw   cons tan t
d p d p 1   2
dw

12
Thus the portfolio opportunity set when ρ12 = +1 is linear.

There are no benefits to diversification since as you change

the weights there is a constant relationship between risk and
return, i.e., it is not possible to sacrifice risk without sacrificing
some return.

XY line below is a straight line whose points are established

by changing the weights wi.

At point X the whole portfolio is held in asset 1 (that is w1 = 1

and w2 = 0). As one changes the portfolio composition by
moving from X to Y, w1 gradually goes down as w2 gradually
goes up.

Eventually point Y is reached and the whole portfolio is

13
composed of asset 2 (w1 = 0 and w2 = 1).
 The Portfolio Opportunity when 12  1

E(Rp ) X(75; 20)

Y (50;16)

0  p

14
 The straight line of the portfolio opportunity set when ρ12 = +1
can be calculated as follows:
E ( R p )  w1E ( R1 )  (1  w1 ) E ( R2 )
To make things more tractable we shall let E ( R p )  rp , E ( R1 )  r1 ,
E ( R2 )  r2
Thus the portfolio return can now be expressed as follows:
rp  w1r1  (1  w1 )r2
We know that:  p  w1 1  w2 2  w1 1  (1  w1 ) 2
Solving for w1 yields: w1   p   2
1   2
Substitute w1 into the portfolio return function:

 p   2     p   2   r1  r2  r1  r2
rp    r1  1    r2  r2   2    p
  1   2     1   2    1   2   1   2 15
Which is a straight line taking the form: rp  a  b p

 r1  r2  r1  r2
Where; a  r2   2   and b 
1  2
 1  2 

16
 Example:
Expected return Standard deviation
Asset 1 14 6
Asset 2 8 3
Calculate the portfolio opportunity set. Just substitute the
respective values into equation 11.
 r1  r2   14  8  r1  r2 14  8
a  r2   2    8   3  2, and b   2
 1   2   63  1  2 6  3

Thus the equation of the opportunity set is:

rp  2  2 p
17
 Case 2: The case where ρ12 = -1

Going back to our two main equations: p
2
 w 
2 2
1 1  w2  2  2 w1 w2 12 1 2
2 2

and rp  w1r1  (1  w1 )r2

If ρ12 = -1 the portfolio variance becomes:

  w   w   2w1 w2 1 2,
2
p
2 2
1 1
2 2
2 2 
so  p   w1  1  w2 2 
rp  w1r1  (1  w1 )r2
We have to establish two straight lines for the opportunity set:
p 
One equation when:   w   w 
1 1 2 2 

And the other when:  p   w1  1  w2 2 

18
 When:
 p 2
 p   w1  1  w2 2  and so w1 
1   2
And rp  w1r1  (1  w1 )r2

Substituting w1 into the portfolio return equation yields:

 p 2    p   2   r1  r2   r1  r2 
rp  r1  1    r2  r2   2      p
 1   2    1   2   1   2   1   2 

rp  a  b p
19
 When:

 p   w1  1  w2 2  and rp  w1r1  (1  w1 )r2

Solving for w1 and substituting w1 into the portfolio return

equation yields:

 p 2    p   2   r1  r2   r1  r2 
rp  r1  1    r2  r2   2      p
 1   2    1   2   1   2   1   2 

rp  a  b p
20
So the general result when ρ12 = -1 is:

 p 2    p   2   r1  r2   r1  r2 
rp  r1  1    r2  r2   2      p
 1   2    1   2   1   2   1   2 

OR rp  a  b p

21
 Example
Expected return Standard deviation
Asset 1 14 6
Asset 2 8 3

 r1  r2  14  8 r1  r2 14  8 6 2
a  r2   2    8  3  10, and b    
 1   2  63 1   2 6  3 9 3

2 2
Thus rp  a  b p  10   p and rp  a  b p  10   p
3 3

2
Thus rp  a  b p  10   p
3
22
 The case where ρ12 = 0

Going back to our two main equations: p
2
 w 
2 2
1 1  w2  2  2 w1 w2 12 1 2
2 2

and rp  w1r1  (1  w1 )r2

If ρ12 = 0 the portfolio variance becomes:

 w  w 
2
p
2 2
1 1
2 2
2 2

rp  w1r1  (1  w1 )r2
Solving for w1 in the portfolio variance equation and then
plugging the result into the return function yields a hyperbola
with:
rp  f ( p )
2

23
 The Portfolio Opportunity Set for different 12
values
E(Rp )
Y
12  1 (6;14)

(0;10) Z 12  0
C
B
A

12  1
X
(3;8)

0  p

24
Portfolio Opportunity Set: The Case of One Risky
Asset and One Risk-free Asset
Let asset 1 be a risky asset and the other asset be a risk free
asset. Let the return from the risk-free asset be rf .

Now our expected portfolio return and variance are:

 
rp  w1r1  (1  w1 )rf  w1r1  rf  w1rf  rf  w1 (r1  rf )

  w   w   2w1 w f 1 f  1 f
2
p
2
1
2
1
2
f
2
f

But for the risk free asset variance is zero, so:  w
2
p
2
1
2
1
 p   w12 
1
So 2 2
1  w1 1
p
 w1 
1 25
 Substituting w1 into the portfolio return equation
.
yields: 
rp  rf  w1 (r1  rf )  rf  p
r  r 
1 f
1
The resultant POS is a straight line. It
has an intercept equal to the risk free rate (rf)
and a slope equal to:

r  r 
1 f

1

26
 The POS when there is a riskless security
E(Rp )
POS Equation

Slope of POS =
r  r 
1 f

1

rf

0  p

27
The Minimum Variance Portfolio
E(Rp )
Y

0  p

28
 Finding Minimum Variance Portfolio (two-asset
portfolio case)
If we have two assets (X and Y) then an MVP is the
combination of X and Y that provides the portfolio with
minimum variance.

Investors who are extremely risk averse will select the MVP if
no risk free investment is available.
R p  w1 Rx  1 w1  R y
 xy
  w   (1  w )   2w (1  w ) , but 
2 2 2
1 x 1
2 2
y 1 1 xy xy    xy   xy x y
p
 x y
  w   (1  w )   2w (1  w )
2
xy x y
2 2 2 2
p 1 x 1 y 1 1

29
We minimize the portfolio variance by setting the first
derivative of portfolio variance w.r.t. w1 equal to zero:

d
2
p
 2w1   2  2w1  2  xy x y  4w1  xy x y  0
2
x
2
y
2
y
dw1
Solving for w1 yields:

   xy x y
2
y
w1* 
    2  xy x y
2
x
2
y

30
 Example
Use the information in the following table to calculate the
minimum variance portfolio?
Asset X (%) Asset Y (%) Probability
11 -3 0.2
9 15 0.2
25 2 0.2
7 20 0.2
-2 6 0.2

E(X)= 10%; E(Y) = 8%; Var(X) = 0.0076; Var (Y)=0.00708

Cov(X,Y) = -0.0024
0.00708  ( 0.33)(0.0872)( 0.0841)
w1 *   0.487
0.0076  0.00708  2(0.33)( 0.0872)(0.0841)

Thus 48.7% of the investor’s wealth should be invested in

asset X and the remainder (51.3%) in Y.
31
 The portfolio return and variance for the MVP are:
E ( R p )  w1 E ( R1 )  w2 E ( R2 )  0.487(0.10)  0.513(0.08)  8.974%

p
2
 w1 
2 2
1  (1  w1 ) 2
2  2 w1 (1  w1 ) 2
 12
 (0.487) 2 (0.0076)  (0.513) 2 (0.00708)  2(0.487)(0.513)( 0.33)(0.0872)(0.0841)
 0.0018025  0.0018632  0.0012092
 0.0024565
 p  4.956%

The point [ p , E ( R p )]  (4.956,8.974%) in the

mean-variance plane is just one point of the minimum variance
opportunity set.

We can get several points of the opportunity set by looking for

combinations of risk and return offered by portfolios of risky
assets that yield minimum variance for a given rate of return.
32
 Portfolio Diversification Benefits
• We want to prove that as the assets in a portfolio increases
the risk or the portfolio variance decreases.

• To simplify our calculations we assume that the assets have

equal weights. That is, if we have N assets in the portfolio
then the weight wi = 1/N.

• We shall also start by assuming that all assets in question

are uncorrelated (that is, the correlation coefficient is zero).

• For simplicity assume that the variances for the different

assets are equal.

• The variance of the portfolio given the above assumptions

is : 33

2
p
 w   w   ..............  w n
2
1
2
1
2
2
2
2
2 2
N

But wi = 1/N, and  1   2  .......   N  

1 2 1 2 1 2
So: 
2
p
 2   2   .......... ....  2 
N N N
1
 p  N 2 N
2 2

1 2
 p N
2

1 2 1
 p  N   N
• Thus as N increases the portfolio standard
deviation or risk goes down.

• Thus as more and more uncorrelated risks

are pooled together, total risk is reduced.

• This is known as the insurance principle:

insurance companies like to take on more
and more uncorrelated risk.

35
 Relaxing some of the above
assumptions
• The above proof is based on a number of
simplifying assumptions.

• Let us relax some of the assumptions and

show that the conclusion does not change.

36
 Portfolio Variance
n n

 
2
p
 wi w j  ij
i 1 i  j

37
• Note that variance is a special type of
covariance. Variance is the covariance of
  
2
an asset with itself. That is, . ii i

• Separating the above expression into

variance and covariance terms yields:
n n n

   w w 
2
p
 w  2
i i
2
i j ij
i 1 i 1 i  j , j i

38
• Note that a 2-asset portfolio has 2 variance and 2
covariance terms. A 3-asset portfolio has 3 variance and 6
covariance terms. An N-asset portfolio has N variance
terms and N2-N covariance terms. We shall assume that
the portfolio is equally weighted: wi = wj = 1/N and that
 12   32  .......   jn  Cov.
2
 1  n
1 n n

 p    i  2   ij
2
• Then, 2

i 1  N  N i 1 i  j , j i

1 n
( N 2
 N )Cov
 
2
 2 i 
2
p
N i 1 N2

1 n 2  1 1 n 2 Cov
  2   i  1  Cov  2   i  Cov 
2
p
N i 1  N N i 1 N
39
• Thus as N increases portfolio variance goes down.

• More importantly, as N increases portfolio variance

approaches covariance. That is, as we increase the
number of assets in a portfolio the covariance terms
become more important.

• The risk associated with each asset comes from

unique/diversifiable risk and market/systematic risk.

• As N increases diversifiable risk is eliminated and the

risk of the portfolio is only explained by market risk,
which in this case comes from the covariance term.

40
Total Risk Diversification Benefits

Number of Securities in Portfolio

41
 Mean-Variance Frontier for N-Risky Assets

Derivation
•  Up to now we have learnt how to compute the mean-
variance frontier in the following cases:
–  Two risky assets
– Two assets (one risky, one risk-free)

• How do we compute the mean variance frontier for an

N-assets portfolio?
• There are two important cases to be looked at:
– Many risky assets (no risky free asset)
– Many risky assets (with a risk-free asset)

42
 Case 1: MVF - Many risky assets (no
risk free asset)
• The formal optimization problem that should be solved to
get the MVF is: for a given value of expected portfolio
return, choose portfolio proportions, wi’s to minimize risk.

• That is: n

• Min var (Rp) s.t. E (Rp) = μ and w

i 1
i 1

• Carry out a separate minimization for each given

value of E(Rp), so that as E(Rp) changes the
frontier is traced out. 43
 Minimization in Matrix Notation
1
 w1   R1 
1
 .   R2 
w=     
R= .  1= . 
 . 
.  . 
 .  R 
w   N 1
 N  

W    w1 w2 ........... wN 
R   R1 R2 ........... RN 

1  1 1 1...........1 1
44
 The return for an N-assets portfolio is:
N
R p   wi Ri  w1 R1  w2 R2  ....................  wn RN
i 1

In vector form the return is:

 R1 
R 
N  2
R p   wi Ri  [ w1 w2 .. .... w n ].   W R
i 1  
. 
 RN 
 
The condition that the weights add up to 1 is:
 w1 
w 
n  2

i 1
wi  w1  w2  w3  ...............  wN  1  1  [1 1 ....1].   1W
 
. 
 wn 
  45
We can now get the mean of the N-asset portfolio
as follows:  E ( R1 ) 
E(R ) 
n  2 

E ( R p )   wi E ( Ri )  [ w1 w2 ....wn ].   W E ( R)  W E
i 1  
. 
 E ( RN ) 
 
The last equality just simplifies notation. The vector of mean
returns shows up so much that I’ll call it E instead of carrying
E(R) around.
The variance of the portfolio return is:

p
2
 E (R p  E ( R p ))2 2

 E W R  W E   E (W ( R  E ))
2
  EW (R  E)(R  E)W 
 WE  ( R  E )( R  E )W  W W
where   E  ( R  E )( R  E ) and is the variance - covariance
46
matrix of returns
 Now, let’s restate our problem with this notation. Minimizing
the variance is the same as minimizing 1/2 the variance, so
we want to choose weights to:
1
min W W s.t WE   ; W1  1
W 2

This is a constrained optimization problem. The Lagrangian can

be formed as follows:
1
L  W W   (W E   )   (W 1  1)
2
L
The FOCs:  W  E   1  0 .........FOC1
W
L
 W E    0 ....................FOC2

L
 W 1  1  0 .................FOC3
 47
 From FOC1 we get: W   1 (E  1 )
Plugging W into the two constraints yields:
W E  E W    E  1 ( E  1 )  
  
W 1  1 W  1  1  ( E  1 )  1
1

We want to solve the following two equations for two

unknowns,  and . So we can write them as:
 
E  E  E  1  
1 1

1 1E  1 11  1

Which can be written in matrix form as follows:

 E  1 E E  11     
 1 1   
 
 1 E 1 1     1 
Solving the above for  and  yields:
1
   E E E 1  
1 1

     1 1   
   1  E 1 1   1 
Which implies that:
1
    E 1   
     1    E 1   1 
      
Now that we know what the λ and δ multipliers are, we can go
back and find the weights,
 
W   (E  1 )    E 1  
1 1

 
 1
    E 1   
     1    E 1   1 
      
 
So we can plug   into the weights equation to get:
 
1
  E  1   
W    E 1     E 1   
1

  1   1

Now use these weights to find the portfolio variance:

  W W
2
P
If you plug in W and its transpose you should be able to get:
1

  E  1   
 p    1  1   E 1   1 

2

 A B    E 1 
Let  B C     1    E 1 

    
This implies that variance of the portfolio is:
 A B
1
    C  B    1  C  B  
 p    1  B C   1   AC  B 2   1  B A   1   AC  B 2   1  B A   1 
2 1

1    C 2  2 B  A
  C  B  B  A   
AC  B 2
1
  AC  B 2

• Thus the variance is a quadratic function of the mean. This is

the reason why we draw bow-shaped frontiers all the time!!
• Note that we used the notation μ = E(Rp).
Markowitz Optimization Problem: A More Practical
Approach (The Case of N-risky Assets)
• The Markowitz optimization problem can be stated as
follows:

k k
Min w w C
n m mn s.t.  wn  1 and  wn rn  r
n 1 n 1

• Where wm is the weight of the mth asset in the portfolio,

wn is the weight of the nth asset in the portfolio and Cmn is
the covariance between the returns of assets m and n.
• Minimizing  
wn wmCmn and 1 2 wn wmCmn yield the
same results, we therefore multiply the objective function
by 0.5 to make the calculations simpler.

• The Markowitz optimization problem can therefore be

restated as:

k k k
Min
w
w w C
n,m 1
n m nm s.t.  wn  1 and  wn rn  r
n 1 n 1
 Differentiating in the Presence of a
Covariance Term
• We need clarity on how to differentiate the
following term of the objective function:
1 k

2 n,m1
wn wmCmn

k n n
• Note that:  wn wmCmn   p   wi w j ij
2

n , m 1 i 1 i  j

• It is just different notation being used in

the two expressions.
• Let us start with the case of a portfolio with three assets
and then generalize from there.
3 3

   w w 
2
p i j ij
i 1 i  j
3
   wi w1 i1  wi w2 i 2  wi w3 i 3 
i 1
3 3 3
  wi w1 i1   wi w2 i 2   wi w3 i 3
i 1 i 1 i 1

 w1w1 11  w2 w1 21  w3w1 31  w1w2 12  w2 w2 22  w2 w3 32  w1w3 13  w2 w3 23  w3 w3 33

 w12 11  2w2 w1 21  2w3 w1 31  w22 22  2w2 w3 23  w32 33
 w12 11  w22 22  w32 33  2w2 w1 21  2w3 w1 31  2w2 w3 23
• So in a 3-asset portfolio the variance-covariance or total
risk is given by:
n n

   wi w j ij
2
p
i 1 i  j

 w12 11  w22 22  w32 33  2 w2 w1 21  2w3 w1 31  2w2 w3 23

Differenti ating the above function yields :

 p2
 2w1 11  2 w2 21  2w3 31
w1

More generally we have :

 p2 n
  2 w j 1 j
w1 j 1
Now, going back to our optimization problem. First, we
formulate the Lagrange function and then calculate the first
order conditions as follows:
1 k  k   k 
L   wn wmCmn    wn  1    wn rn  r 
2 n , m 1  n 1   n 1 
L k
  wn C1n    r1  0
w1 n 1
L k
  wn C2 n    r2  0
w2 n 1
.
L k
  wn Ckn    rk  0
wk n 1
L  k 
   wn  1  0
  n 1 
L  k 
   wn rn  r   0
  n 1 
To help see how the above system can be transformed into
matrix notation we rewrite the above first order conditions as
follows:
w1C11  w2C12  w3C13  .......  wk C1k    r1  0
w1C21  w2C22  w3C23  .......  wk C2 k    r2  0
.
.
w1Ck1  w2Ck 2  w3Ck 3  .......  wk Ckk    rk  0
w1  w2  w3  ......................  wk 1
w1r1  w2 r2  .........................  wk rk r
The above system can then be restated in matrix notation
as follows:

 C11 C12 C13 C1k 1  r1   w1  0 

C   w2  0 
 21 C22 C23... C2 k  1  r2     
.  .
 . . .... . . .   
 . . .... . . .  .  . 
     
 . . .... . . .  .  . 
Ck 1 Ck 2 Ck 3 ... Ckk  1  rk   wk  0 
    
1 1 1... 1 0 0    1 
 r1 r2 r3 ... rk 0 0     r 
 

Call this Matrix A

• If A is invertible then the unique solution to our
optimization problem would be:

 w1  0
 w2  0 
  . 
.   
.  . 
   A 1  
.  . 
w  0 
 k  
  1 
  r 

   
Case 2: MVF - Many risky assets (with a risk free)
•  In the presence of a risk-free asset and any number of risky
assets the set of efficient portfolios is a straight line. The
objective function is similar to the case of risk assets only.
• The constraint that portfolio expected return must be equal
to a certain return can now be expressed as follows:

E ( R p )  w1 E ( R1 )  w2 E ( R2 )  .....  wn E ( Rn )  rf w0
n
 rf w0   wi E ( Ri )
i 1

The constraint that the sum of the weights must equal 1

n
is now given by: w  w 1 0 i 1
i

61
So the minimization problem is now given as follows:

n n
min var (Rp) s.t. rf w0   wi E ( Ri )   & w0 
i 1
w 1
i 1
i

That is, for a given expected return μ you carry out a separate
minimization problem so that as μ changes the efficient set is
traced out.

62
• That is, for a given expected return μ you carry
out a separate minimization problem so that as μ
changes the efficient set is traced out.

• You can do it as follows:

– First construct the frontier GG for risky assets alone.

– Next draw a ray to any point on the GG frontier.

•  

63
 Efficient Portfolios with a Risk-Free Asset
E(Rp ) E
G
Z
rZ

rf

G
0 Z  p
• Points along this ray show the expected return and risk for
portfolios comprising the risk free asset and the portfolio of
risk assets given by the chosen point on the GG frontier.

• For a given level of risk, high levels of expected return can

be attained by pivoting the ray through rf to higher points
along the GG frontier. This can be done until the ray is
tangent to GG (at point Z).
•  
• Beyond Z no further increases in E(Rp) is possible.
•  
• The set of efficient portfolios for all assets including the
risk free asset is then the ray formed from rf to E, that is
rfZE.
65
• So introducing a risk-free asset in the optimization problem
implies that we have a portfolio made up of K risky assets
plus one risk free asset. So we seek to minimize:
k k k

 w Cov(r , r )w
n ,m0
n n n m s.t w
n 0
n  1 and  wn rn  r
n 0

• But since variance of the risk-free asset is zero and the

covariance of the returns between the risk-free asset and
other asset returns is also zero the objective function
becomes:
k

 w Cov(r , r )w
n , m 1
n n n m
• So we seek to solve the following optimization problem:

k k k

 w Cov(r , r )w
n , m 1
n n n m s.t w
n 0
n  1 and  wn rn  r
n 0
 1 k k  k 
L   wn wmCmn    wn  1    wn rn  r 
2 n,m 1  n 0   n 0 
L
   r0  0
w0
L k
  wnC1n    r1  0
w1 n 1
L k
  wn C2 n    r2  0
w2 n 1
.
L k
  wn Ckn    rk  0
wk n 1
L k 
   wn  1  0
  n 1 
L k 
   wn rn  r   0
  n 1 
    r0  0
w1C11  w2C12  w3C13  .......  wk C1k    r1  0
w1C21  w2C22  w3C23  .......  wk C2 k    r2  0
.
.
w1Ck1  w2Ck 2  w3Ck 3  .......  wk Ckk    rk  0
w1  w2  w3  ...........................  wk 1
w1r1  w2 r2  w3r3  .............  wk rk r
 0 0 0 0... 0  1  r0   w0  0
0   w1  0 
 C11 C12 C13 ... C1k  1  r1     
. . .... . . . .  .
   
 . . .... . . .  .  . 
     
 . . .... . . .  .  . 
0 Ck1 Ck 2 Ck 3 ... Ckk  1  rk   wk  0 
    
1 1 1 1... 1 0 0    1 
r0 r1 r2 r3 ... rk 0 0     r 
 

Call this Matrix A

  w0  0 
 w1  0 
   
.   
1 .
 A  
 wk  0 
   0 
   
  
 1
 

This provides the unique solution to the optimization problem.

 Getting the Minimum Variance
Portfolio

k
1
Min  wn wmCmn s.t.  wn  1
2 n 1
 1 k k 
L   wn wmCmn    wn  1
2 n ,m1  n 1 
L k
  wnC1n    0
w1 n 1
L k
  wnC2 n    0
w2 n 1
.
.
.
L k
  wnCkn    0
wk n 1
L k 
   wn  1  0
  n 1 
w1C11  w2C12  w3C13  .......  wk C1k    0
w1C21  w2C22  w3C23  .......  wk C2 k    0
.
.
w1Ck 1  w2Ck 2  w3Ck 3  .......  wk Ckk    0
w1  w2  w3  ...........................  wk 0
 C11 C12 ....... C1K  1  w1  0
C   
 C ........ C2 K  1  w2  0
21 22
   
. . . .  .  .
 
. . . .    . 
  w 
CK 1 CK 2 ...... CKK  1  k  0
 1 1 1 0    1
 
Call this Matrix A
 w1   0 
 w2   0 
   
.  .
   A 1   
   . 
 wk   
  0

   
1
Example: Calculating expected return and variance for a
minimum variance portfolio

Consider a portfolio with 3 assets (A, B and C) with

expected returns rA=0.5, rB=1, rC=1.5, respectively. Their
covariance matrix is given by:

C AA C AB C AC   1 1 4 1 2 
C  C BA CBB C BC   1 4 2 3 4
CCA CCB CCC  1 2 1 4 3 

Calculate the expected return and variance for the

minimum variance portfolio.
 k
1
Min  wn wmCmn s.t.  wn  1
2 n 1

1 3  3 
L   wn wmCmn    wn  1
2 n ,m 1  n 1 
L k
  wnC1n    0...................( FOC1)
w1 n 1
L k
  wnC2 n    0...................( FOC 2)
w2 n 1
L k
  wnC 33n    0..................( FOC3)
w3 n 1
L k 
   wn  1  0..................( FOC 4)
  n 1 
w1C11  w2C12  w3C13    0
w1C21  w2C22  w3C23    0
w1C31  w2C32  w3C33    0
w1  w2  w3  1
C11 C12 C13  1  w1   0 
C   w   
C C  1    
2 0
 21 22 23
w3   0
C31 C32 C33 
 1    
   1
 1 1 1 0    
   
 C AA C AB C AC   1 1 4 1 2 

C  CBA CBB  
CBC   1 4 2 3 4 
CCA CCB CCC  1 2 1 4 3 
 1 1 4 1 2  1  w1   0 
1 4 2 3 4  1  w2  0
   w3   0
1 2 3 4 3  1    
      1 
1 1 1 0    
   
Call this Matrix A
 w1  0 
w  0 
 2 1  
 w3   A 0
  1 
   
   
• Thus, w1 = 0.6538, w2 = 0.2692, w3 = 0.0769, ʎ = 0.7596. 
• Now we need to calculate the expected return and the
variance for the MVP:  E (rA ) 
E (rp )  wA E (rA )  wB E (rB )  wC E (rC )   wA wB wC   E (rB ) 
 E (rC )
1 2 
  0.6538 0.2692 0.0769  1 
3 2
 0.7115
 1 1 4 1 2  0.6538
 p2  W T CW   0.6538 0.2692 0.0769 1 4 2 3 4 0.2692  0.7595
1 2 3 4 3  0.0769
 P2  0.875
Required Reading
• Markowitz, H. (1952). Portfolio selection, Journal of
Finance 7, 77-91.
•  
• Tobin, J. (1958). Liquidity preference as behaviour
towards risk. Review of Economic Studies, February
1958, 65–86.
•  
• Markowitz, H. (1991). Foundations of portfolio theory,
The Journal of Finance 46 (2), 469-477.

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