Topic: Optimal Risky Portfolios

October 2022
Master in International Finance and Entrepreneurship
Universidad Nacional del Litoral – Hochschule Kaiserslautern

Dr. Martín Dutto

 The Investment Decision
• Top-down process with 3 steps:
1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class
Diversification and Portfolio Risk

• Market risk
– Systematic or nondiversifiable

• Firm-specific risk
– Diversifiable or nonsystematic
 Figure 7.1 Portfolio Risk as a Function
of the Number of Stocks in the Portfolio
Figure 7.2 Portfolio Diversification
 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 of
two assets vary
Example: Two mutual funds
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 )

 Two-Security Portfolio: Risk

  w   w   2wD wE CovrD , rE 
2
p
2
D
2
D
2
E
2
E

2
 = Variance of Security D
D

2
 E = Variance of Security E

CovrD , rE  = Covariance of returns for

Security D and Security E
 Two-Security Portfolio: Risk

• Another way to express variance of the

portfolio:

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

 Table 7.2 Computation of Portfolio
Variance From the Covariance Matrix
 Three-Asset Portfolio

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

 p2  w12 12  w22 22  w32 32

 2 w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3
 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
 Correlation Coefficients:
Possible Values

Range of values for 1,2

+ 1.0 > r > -1.0
If r = 1.0, the securities are perfectly
positively correlated
If r = - 1.0, the securities are perfectly
negatively correlated
 Correlation Coefficients
• When ρDE = 1, there is no benefit from diversification

 P  wE E  wD D

• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
D  E
 Figure 7.3 Portfolio Expected Return
as a Function of Investment Proportions
 Expected Return and Standard
Deviations with various correlation coefficients
Figure 7.4 Portfolio Standard Deviation
as a Function of Investment Proportions
The Minimum Variance Portfolio
• The minimum variance • When correlation is less
portfolio is the portfolio than +1, the portfolio
composed of the risky standard deviation may
assets that has the be smaller than that of
smallest standard either of the individual
deviation, the portfolio component assets.
with least risk.
• When correlation is -1,
the standard deviation
of the minimum
variance portfolio is
zero.
The Minimum Variance Portfolio

This solution uses the minimization techniques of

calculus. Write out the expression for portfolio
variance from Equation 7.3, substitute 1 − wD for wE,
differentiate the result with respect to wD, set the
derivative equal to zero, and solve for wD to obtain
Figure 7.5 Portfolio Opportunity Set
 Correlation Effects
• The amount of possible risk reduction through
diversification depends on the correlation.
• The risk reduction potential increases as the
correlation approaches -1.
– If r = +1.0, no risk reduction is possible.

– If r = 0, σP may be less than the standard deviation

of either component asset.
– If r = -1.0, a riskless hedge is possible.
Figure 7.6 The Opportunity Set of the Debt
and Equity Funds and Two Feasible CALs
 The Sharpe Ratio
• Maximize the slope of the CAL for any possible
portfolio, P.
• The objective function is the slope (also Sharpe
ratio)
E (rP )  rf
SP 
P

Warning: R is risk premium

 Figure 7.7 The Opportunity Set of
the Debt and Equity Funds with the
Optimal CAL and the Optimal Risky Portfolio
 Figure 7.8 Determination
of the Optimal Overall Portfolio
 Figure 7.9 The Proportions
of the Optimal Overall Portfolio
Markowitz Portfolio Selection Model

• Security Selection
– The 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
Figure 7.10 The Minimum-Variance
Frontier of Risky Assets
Markowitz Portfolio Selection Model

• We now search for the CAL with the

highest reward-to-variability ratio
 Figure 7.11 The Efficient Frontier
of Risky Assets with the Optimal CAL
Markowitz Portfolio Selection Model
• Everyone invests in P, regardless of their
degree of risk aversion.

– More risk averse investors put more in the risk-

free asset.

– Less risk averse investors put more in P.

 Two ways to get
the Efficient frontier set
 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.
Figure 7.13 Capital Allocation Lines with
Various Portfolios from the Efficient Set