Program: M.

Sc Business Analytics
Course: Financial Analytics

Unit-5: Portfolio Analytics

Session to be Delivered by
Dr. Suman Chakraborty
suman.chakraborty@manipal.edu

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Unit-5: Portfolio Analytics

1. Portfolio Risk and return relationship,

2. Portfolio Diversification
3. Portfolio Construction,
4. Portfolio evaluation

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 CALCULATION OF RISK OF TWO RISKY ASSET PORTFOLIOS
While selecting assets in a portfolio, an important parameter that needs to be decided is the
proportion of money to be allocated for each asset.

When two assets with variances of σ2a and σ2b are combined to form a portfolio, the
variances of the portfolio can be calculated as
 

σ2p = σ2aW2a + σ2bW2b + 2 * Cova,b * Wa * Wb

 
where, Wa & Wb are the proportion of wealth in asset a & b resepectively and
Wa + Wb = 1

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3
 Calculation of Covariance with Correlation
If Cov is not given in the question, instead Correlation is given then,
Correlation (r) = COVa,b
σ a σb

Where, COVa,b = r * σa * σb

Notation used in the above formulas and explanations:

r = correlation; W = weights;
σ = Standard deviation σ2 = (Variance)
a = security A b = Security B in a portfolio
Cov = Covariance between Stock A and Stock B
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4
 Calculation of Portfolio returns & risks-Two asset case]
Mean X Std Dev σ
Assume Correlation (ρ)= 0.46.
Find out Covariance between RIL & WIPRO RIL .86 7.45
Solution: WIPRO .94 6.28
Correlation (r)= COVx,y
σx. σy
0.46 = COV ril, wipro COV ril, wipro = .46 * 7.45 * 6.28 = 21.52
7.45 * 6.28
 Assuming 50% weight-age for each stock in portfolio, we can find σp
σp (SD) = √ σ2aW2a + σ2bW2b + 2 * ra,b* σa σb Wa * Wb
So the relation
σp = √(7.45) *(0.5) + (6.28) * (0.5) + 2 * 0.46*7.45*6.28*0.5*0.5
2 2 2 2
between two stocks in
a portfolio affects the
σp = 5.87 portfolio risk risk of the portfolio

In case, r =1 then σp will be 6.86,

IfDepartment
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portfolio
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Email:( doc.office@manipal.edu
σp ) will be more
 Calculation of Expected Return of portfolio
Calculation of Expected Return of portfolio
when 75% of security A is expected to earn 12% &
25% of security B is expected to earn 16% for the portfolio.
 
Retp = Wa*Ra + Wb*Rb = (0.75*.12 + 0.25*.16) *100 = 13%
 
[B] Calculation of Portfolio risk
When 75% of security A & 25% of security B is considered for the portfolio with a correlation
coefficient of +0.5
Standard deviation for Security A is given as .10 (i.e., 10%) and of security B is .20 (i.e., 20%)
σp = √ σ2aW2a + σ2bW2b + 2 * ra,b* σa σb Wa * Wb

σp = √ (.75)2*(.1)2 +(.25)2*(.2)2 + 2*(.75) (.25) (+.50) (.10) (.20) σp = 10.90%

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Divisions of Portfolio Management Theory
a) Modern Portfolio Theory [Harry Markowitz 1952 – awarded
Nobel for “Portfolio Selection”]
Markowitz focused on the stock’s risk and returns; the
construction of a portfolio considering the stock’s correlation with
other stocks, and diversification to minimise the risk and
maximize returns. He also introduced the concept of MVP,
Efficient Frontier and efficient portfolios and finally evaluated the
portfolio’s performance and rebalance portfolio]

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Divisions of Portfolio Management Theory
b) Capital Market Theory [Extension of MPT, Sharpe
(1964)]
[CPT followed MPT by Markowitz. Risk-free asset (RFA) is
introduced. Sharpe (1964), Linter (1965) and Mossin (1966)
independently contribute to the development of the CAPM.
Distinction of systematic and unsystematic risk.
Introduction of Beta of the stock. Introduction of Single Index
Model; Concept of security market line (SML) and Capital
mrket line (CML) ]
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Divisions of Portfolio Management Theory
c) Arbitrage Pricing Theory [Multi-factor asset pricing model is
based on the idea that an asset's returns can be predicted
using the linear relationship between the asset’s expected
return and a number of macroeconomic variables that
capture systematic risk. Contributed by Ross 1976]
d) Multi-factor asset pricing model is based on the idea that an
asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of
macroeconomic variables that capture systematic risk.
Portfolio Rebalancing
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Divisions of Portfolio Management Theory
e) Efficient Market Theory: The EMH is an investment theory primarily
derived from concepts attributed to Eugene Fama’s research as
detailed in his 1970 book, “Efficient Capital Markets: A Review of
Theory and Empirical Work.”
Theory proves that it is impossible to consistently “beat the market” –
to make investment returns that outperform the overall market
average as reflected by major stock indexes such as the S&P 500 Index.
There are always a large number of both buyers and sellers in the
market, price movements always occur efficiently (i.e., in a timely, up-
to-date manner). Thus, stocks are always trading at their current fair
market value.
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Capital Market Theory - CAPM
CPT builds on Markowitz portfolio theory. Each investors is
assumed to diversify his or her portfolio according to
Markowitz model (i.e., by choosing a location on the efficient
frontier that matches his risk –return preference).

Expected Return = αi + βi (rm – rf) +ei

i = Return of stock “i” if market’s excess return is zero (it’s a constant)
i(rmt - rft) = component of return due to market movements
eit = component of return due to unexpected firm-specific events

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Assumptions of CAPM
1. Individual investors are risk averse

2. There are many investors. No single investor can affect the price of a
stock through his or her buying and selling decisions. Investors are price
takers and act al if prices are unaffected by their own trades.

3. There is no inflation or any change in interest rates, or inflation is

fully anticipated.
This is a reasonable initial assumption, and it can be modified.
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 Assumptions of CAPM
4. Individuals have homogeneous expectations – they have identical subjective
estimates of mean, variances & co-variances among returns. It means, all
investors estimate identical probability distributions for future rates of return.
– Again, this assumption can be relaxed. As long as the differences in
expectations are not vast, their effects are minor.

5. All investors have the same one-period time horizon such as one-month, six
months, or one year.
– The model will be developed for a single hypothetical period, and its results
could be affected by a different assumption. A difference in the time horizon
would require investors to derive risk measures and risk-free assets that are
consistent with their time horizons.
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Assumptions of CAPM
6. All investments are infinitely divisible, which means that it is possible to buy or
sell fractional shares of any asset or portfolio.
This assumption allows us to discuss investment alternatives as continuous curves.
Changing it would have little impact on the theory.
7. There are no taxes or transaction costs involved in buying or selling assets.
This is a reasonable assumption in many instances. Neither pension funds nor
religious groups have to pay taxes, and the transaction costs for most financial
institutions are less than 1 % on most financial instruments. Again, relaxing this
assumption modifies the results, but does not change the basic thrust.
8. Capital markets are in equilibrium.
This means that we begin with all investments properly priced in line with their risk
levels.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Assumptions of CAPM
9. Investors can borrow or lend any amount of money at the risk-free rate of
return (RFR).
– Clearly it is always possible to lend money at the nominal risk-free rate by buying
risk-free securities such as government T-bills. It is not always possible to borrow at
this risk-free rate, but we will see that assuming a higher borrowing rate does not
change the general results.

10. All investors are Markowitz efficient investors who want to target points on
the efficient frontier.
– The exact location on the efficient frontier and, therefore, the specific portfolio
selected, will depend on the individual investor’s risk-return utility function.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Justification of CAPM Assumption
Most investors recognize that all of the assumption of CMT are not unrealistic. Such
as:
a. Some institutional investors are tax exempt.

b. Brokerage costs today as a percentage of the transaction are quite small for large
volume trade.

c. One period time horizon of CAPM model is also not illogical.

d. Inflation is fully (and in most cases) anticipated and therefore not a major factor.

Most importantly, brokerage, tax, inflation are common to all investors but risk may
vary according to each investor’s risk taking capabilities.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Basics of Modern Portfolio Theory
(Markowitz)

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Modern Portfolio Theory (Markowitz)
MPT: Two Sources of Risk
– Variation (risk of the stocks in portfolio)
– Covariance (co-movement of stocks in portfolio)

Risk Management / Reduction Strategy

– Hold a diversified portfolio of assets
– The more assets, the lower the risk
– Assets in a portfolio are considered in terms of the variance and covariance

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Variance as a Measure of Risk
The variance of a random variable is a measure of the dispersion of the possible outcomes
around the expected value. In the case of an asset’s return, the variance is a measure of the
dispersion of the possible outcomes for the rate of return around the expected return.
The equation for the variance of the return for asset i, denoted var(Ri), is
var(Ri) = p1[r1 − E(Ri)]2 + p2[r2 − E(Ri)]2 + ... + pN[rN − E(Ri)]2
Using the probability distribution of the return for a stock, we can illustrate the calculation of
the variance:
var(RXYZ) = 0.50 [15% − 11%]2 + 0.30 [10% − 11%]2 + 0.13 [5% − 11%]2 + 0.05 [0% − 11%]2 +
0.02[−5% − 11%]2 = 24% period Returns Expected returns
1 15% 11%
2 10% 11%
3 5% 11%
4 0% 11%
5 -5% 11%
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
•
Modern Portfolio Theory
Riskiness of a Two-Asset Portfolio
(Markowitz)
– σP2 = w12 s12 + w22 s22 + 2 w1 w2 cov1,2
– Subject to: w1 + w2 = 1

• Covariance (Correlation [r]) Excel Calculations

– Two assets may co-vary
• Positively (move in same direction) r > 0
• Not at all (zero – no correlation) r = 0
• Negatively (move in opposite directions) r < 0
– Least risk 2-asset portfolio? When cov1,2 < 0
– Most risky 2-asset portfolio? When cov1,2 > 0
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Modern Portfolio Theory (Markowitz) Fig - 1

• Correlation (2 assets)
– Positive
– Negative

– Zero (random)
– Non-Linear

– Linear

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Selecting a Portfolio
Risk Preferences or Indifference
– Investors are generally assumed to be risk averse.
• Prefer less risk to more for a given rate of return
• Prefer a higher return for a given level of risk

– Indifference curves tell us something about our utility functions

relative to wealth.
• How much do we value an additional unit of wealth?
• How much are we willing to risk to obtain it?

Suggested Readings: https://saylordotorg.github.io/text_risk-management-for-enterprises-and-individuals/s07-risk-attitudes-expected-utilit.html

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Markowitz Portfolio Theory

Diversification with
varied risk and Efficient Frontier
correlated financial [Efficient Portfolios]
assets

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 SHOWING THE EFFECT OF
DIVERSIFICATION

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 Effect of Diversification
Probability distributions of the returns of stocks A and B are assumed to be equal
for five state of economy. The last column shows the return on a portfolio
consisting of stocks A and B in equal proportions.
Return on stock A Return on Stock B Portfolio Return
State of the Economy Probability (%) (%) (%) [Given]
Excellent Boom period 0.20 15 -5 5

Very good prospects 0.20 -5 15 5

Good state of 0.20 5 25 15
economy
Fair state of economy 0.20 35 5 20
Poor state of economy 0.20 25 35 30

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Effect of Diversification
Expected Return
Stock A 0.2 (15%) + 0.2 (-5%) + 0.2 (5%) + 0.2 (35%) + 0.2 (25%) = 15 %

Stock B 0.2 (-5%) + 0.2 (15%) + 0.2 (25%) + 0.2 (5%) + 0.2 (35%) = 15 %

Portfolio 0.2 (5%) + 0.2 (5%) + 0.2 (15%) + 0.2 (20%) + 0.2 (30%) = 15 %
of A & B

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 Effect of Diversification on Portfolio Risk
Calculation of Expected Return & Standard Deviation of Stock A
Er Deviation R-
Sate PROB R (Deviation)2 (Deviation)2 x P
(P*R) (ƩEr)
1 0.2 15 3 0 0 0
2 0.2 -5 -1 -20 400 80
3 0.2 5 1 -10 100 20
4 0.2 35 7 20 400 80
5 0.2 25 5 10 100 20
  1   15 Ʃ(Deviation)2 x P = 200

Standard Deviation of Stock A = 14.14%

Calculation of Expected Return & Standard Deviation of Stock B
Deviation
Sate PROB R Er (Deviation)2 (Deviation)2 x P
R-(ƩEr)
1 0.2 -5 -1 -20 400 0
2 0.2 15 3 -0 000 80
3 0.2 25 5 -10 100 20
4 0.2 5 1 20 400 80
5 0.2 35 7 10 100 20
  1   ƩEr = 15 Ʃ(Deviation)2 x P = 200
Standard
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342 Deviation of Stock B = 14.14%
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 Effect of Diversification
If we invest only in stock A, the expected return is 15 % and the standard deviation is 14.14 %.
Likewise, if we invest only in stock B, the expected return is 15 % and the standard deviation is
14.14 %.
What happens if we invest in a portfolio consisting of stock A and B in equal proportions?
 While the expected return remains at 15 %, the same as that of either stock individually, the
standard deviation of the portfolio return, 9.49 % of lower than that of each stock individually.

Standard Deviation of the portfolio of stocks A & B – EQUAL PROPORTION

Portfolio: σ2 (A+B) = 0.2 (5 -15)2 + 0.2 (5-15)2 + 0.2 (15-15)2 + 0.2 (20-15)2 + 0.2 (30-15)2 = 90
σ (A+B) = (90)1/2 = 9.49%

Thus, in this case diversification reduces the overall Portfolio risk.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Computation of Portfolio risk with different
levels of correlation

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 Computation of Portfolio risk with different levels of correlation
Let us compute the portfolio standard deviation (risk) in three different
conditions:
When correlation (r) between two assets (Stock A & Stock B) is + 1
When r is 0 When r is – 1
Where expected return from security A (ERa)is 12% & security B (ERb) is 16%.
Standard deviation for Security A is given as .10 (i.e., 10%) and of security B
is .20 (i.e., 20%)

The main purpose of above analysis is to find out the effect on portfolio risk
when correlation between different assets in the portfolio is positive;
negative or when there is no correlation

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Statement Showing Portfolio Risk With Varied Correlation
Level And Proportion Of Assets In The Portfolio
Proportion Proportion Expected Portfolio Risk SD (%)
invested invested Return on
in security-A in security-B Portfolio
Wa (%) Wb (%) Ex R (%) r=+1 r=0 r=-1

0% 100% 16% 20 20 20
25% 75% 15% 17.5 15 12.5
33% 67% 14.67% 16.67 13.74 10
50% 50% 14% 15 11.2 5
67% 33% 13.33% 13.33 9.43 0
75% 25% 13% 12.5 9.01 2.5
100%
When 0%
67% of A and 33% of 12%
B is considered for 10 are fully inversely
the portfolio, which 10 10
correlated,
Portfolio risk is zero
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Interpretation
If we see the above table, we can easily find that when r is -1, and if 67% of the
amount is invested in security A & 33% of the amount is invested in security B, risk
(σ2 (A+B) is zero.
But at this level of security mix in the portfolio, returns from the portfolio are not
maximum.
 
For every individual, depending on his/her own risk return profile, proportion of
each categories of assets are included, with an objective of maximizing portfolio
return with minimum risk.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Markowitz Portfolio Theory
Harry Markowitz (“Markowitz”) is highly regarded as a pioneer for his
theoretical contributions to financial economics and corporate finance. In
1990, Markowitz shared a Nobel Prize for his contributions to these fields,
espoused in his “Portfolio Selection” (1952) essay first published in The
Journal of Finance, and more extensively in his book, “Portfolio Selection:
Efficient Diversification (1959).

His groundbreaking work formed the foundation of what is now popularly

known as ‘Modern Portfolio Theory’ (MPT).
The foundation for this theory was substantially later expanded upon by
Markowitz’ fellow Nobel Prize co-winner, William Sharpe, who is widely
known for his 1964 Capital Asset Pricing Model work on the theory of
financial asset price formation.
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Assumptions of MPT
1.) Investors are rational (they seek to maximize returns while minimizing
risk),
2.) Investors are only willing to accept higher amounts of risk if they are
compensated by higher expected returns,
3.) Investors timely receive all pertinent information related to their
investment decision,
4.) Investors can borrow or lend an unlimited amount of capital at a risk
free rate of interest,
5.) Markets are perfectly efficient,
6.) Markets do not include transaction costs or taxes,
7.) It is possible to select securities whose individual performance is
independent of other portfolio investments.
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 Markowitz’s Efficient Frontier
The efficient frontier represents that set of portfolios with the maximum rate of
return for every given level of risk, or the minimum risk for every level of return.

Frontier will be portfolios of investments rather than individual securities.

Every portfolio lies on the efficient frontier has either a higher rate of return for
equal risk or lower risk for an equal rate of return than some portfolio beneath the
frontier.

Fig - 2

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Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Markowitz’s Theory on Efficient frontier
As a rule, a portfolio is not an efficient if there is another portfolio with:
1. A higher expected value of a return and a lower standard deviation (risk)
2. A higher expected value of return and the same standard deviation (risk)
3. The same expected value of return but a lower standard deviation (risk)

Markowitz has defined the diversification as the process of combining assets that
are less that perfectly positively correlated in order to reduce the portfolio risk
without sacrificing any portfolio returns.

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Efficient frontier for two security case - [Mean-variance theory]

Assume Stock A and Stock B has following characteristics.

Particular Security A Security B
Expected return 12% 20%
Standard Deviation of return 20% 40%
Coefficient of correlation -0.20
Consider the correlation between Stock A and Stock B is (-0.20).
You are required to compute the Markowitz Minimum Variance Portfolio considering following
six proportion level of each stocks in a portfolio.
Portfolio-1 Portfolio-2 Portfolio-3 Portfolio-4 Portfolio-5 Portfolio-6
Stock A 100% 90% 75.9% 50% 25% 0%
Stock B 0% 10% 24.10% 50% 75% 100%
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 Efficient frontier for two security case - [Mean-variance theory]

Suppose an investor is evaluating two securities A & B

Particular Security A Security B
Expected return 12% 20%
Standard Deviation of return 20% 40%

io
ce ol
oi rtf
Coefficient of correlation -0.20

ch l po
a
tim
op
Expected Expected Portfolio Portfolio
A B return of A return of B Risk of A Risk of B Return Risk Diagram for feasible frontier
1 0 0.12 0.2 0.2 0.4 12.00% 4.00% 20%
6 (B)
0.9 0.1 0.12 0.2 0.2 0.4 12.80% 3.11%
0.759 0.241 0.12 0.2 0.2 0.4 13.93% 2.65% 12%
3
0.5 0.5 0.12 0.2 0.2 0.4 16.00% 4.20% 2
1 (A)
0.25 0.75 0.12 0.2 0.2 0.4 18.00% 8.65%
20% 40%
0 1 0.12 0.2 0.2 0.4 20.00% 16.00%
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 Interpretation of Efficient Frontier - [Mean-variance theory]
•The benefit of diversification arises when the correlation between the two
securities is less than 1. Since the correlation between securities A & B is -0.20
(which is less than 1), the effect of diversification can be seen by comparing the
curved line between the points A & B with the straight line between A & B.
•The straight line represents the risk return possibilities by combining A & B if the
correlation coefficient between the two stocks had been 1.
•Portfolio 3 represents the minimum variance portfolio (MPV). It is
also termed as minimum standard deviation portfolio. The term MPV is very
much commonly used in the literature and by the financial analysts.
•The curved line bends backward between point A & 3 (the minimum variance
portfolio). This means that for a portion of the feasible set, standard deviation
decreases although expected return increases.
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 Same Illustration with different Proportion of
Stock A and Stock B

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 Efficient Frontier For Two Security Case
[Mean-Variance Theory]
Assume Stock A and Stock B has following characteristics.
Particular Security A Security B
Expected return 12% 20%
Standard Deviation of return 20% 40%
Coefficient of correlation -0.20
Consider the correlation between Stock A and Stock B is (-0.20).
You are required to compute the Markowitz Minimum Variance Portfolio considering following
six proportion level of each stocks in a portfolio.

σ2p = σ2a * W2a + σ2b * W2b + 2 * Cova,b * Wa * Wb Cov a,b = ra,b * σa * σb

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 W of W of
Expected Expected Risk of Portfolio Portfolio Sharpe
Portfolios Stock Stock return of A return of B RFR Risk of A B Risk Return Index
A B
A 1 0 0.12 0.2 6% 0.2 0.4 20.00% 12.00% 0.30

1 0.9 0.1 0.12 0.2 6% 0.2 0.4 17.87% 12.80% 0.38

2 0.8 0.2 0.12 0.2 6% 0.2 0.4 16.13% 13.60% 0.47

3 0.75 0.25 0.12 0.2 6% 0.2 0.4 15.40% 14.00% 0.52

4 0.6 0.4 0.12 0.2 6% 0.2 0.4 13.79% 15.20% 0.67

5 0.5 0.5 0.12 0.2 6% 0.2 0.4 13.20% 16.00% 0.76

6 0.3 0.7 0.12 0.2 6% 0.2 0.4 13.17% 17.60% 0.88

7 0.25 0.75 0.12 0.2 6% 0.2 0.4 13.40% 18.00% 0.90

B 0 1 0.12 0.2 6% 0.2 0.4 16.00% 20.00% 0.88

Prepared by Dr. Suman Chakraborty
RFR = Risk Free Rate Asset (91 days T-Bills), Sharpe Index=(Portfolio Return – RFR) / SD of Portfolio
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 TWO - Asset Efficient Frontier
[Mean Variance Frontier of Risky and Risk-free Asset]
Tangent drawn to identify Portfolio Return
the Optimum Portfolio
25.00% where Sharpe’s Index is
highest 13.4% =Risk
18%=Return
B
20.00% 7 op
6 tim
Portfolio Return

a
ch l po Efficient
5 oi rtf
ce o Frontier
li o
15.00% 4
3
2
1
A
10.00%
L
6%
CA
6% Risk Free
5.00% Asset
σ2p = σ2a * W2a + σ2b * W2b + 2 * Cova,b * Wa * Wb [Cov a,b = ra,b * σa * σb]

0.00%
12.00% 13.00% 14.00% 15.00% 16.00% 17.00% 18.00% 19.00% 20.00% 21.00%
Portfolio Risk (σ)
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
Interpretation of Efficient Portfolio Frontier - [Mean-variance theory]
•The benefit of diversification arises when the correlation between the two
securities is less than 1. Since the correlation between securities A & B is -0.20
(which is less than 1), the effect of diversification can be seen by comparing the
curved line between the points A & B with the straight line between A & B.
•The straight line represents the risk return possibilities by combining A & B if the
correlation coefficient between the two stocks had been 1.
•Portfolio 7 represents the Minimum Variance Portfolio (MPV). It is
also termed as minimum standard deviation portfolio. Portfolio-8 is the Optimum
Portfolio since this carry highest Sharpe index value.
•The curved line bends backward between Portfolio-A & Portfolio-6 (the minimum
variance portfolio). This means that for a portion of the feasible set, standard
deviation decreases although expected return increases.
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Optimal Portfolio Choice
(Most Efficient Portfolio considering Port folio Risk and Portfolio return]
▪The optimal portfolio consists of a risk-free asset and an optimal
risky asset portfolio.
▪The optimal risky asset portfolio is at the point where the CAL is
tangent to the efficient frontier.
▪This portfolio is optimal because the slope of CAL touching at the
highest point of the efficient frontier, which means we achieve
the highest returns per additional unit of risk.
▪- Tangent slope is also called the risk reward line
CAL = Capital Allocation Line
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Selection of Optimum Portfolio
[Optimal portfolio choice]
▪Optimum portfolio (OP):
a) To determine the OP, on the efficient frontier, investor’s
risk return trade-off must be known.
b) Each investors have their own preferences and risk taking
capabilities – based on that, Indifference curves (IC) can
be drawn – the IC curve which makes a tangent point on
the efficient frontier – is the Optimum portfolio for that
investor.
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Correlation = +1 Correlation = -1
A B Expecte Expecte Risk of Risk Portfolio Portfolio A B Expected Expected Risk of Risk Portfolio Portfolio
d return d return A of B Risk Return return of return of A of B Risk Return
of A of B A B
1 0 0.12 0.2 0.2 0.4 20.00% 0.12 1 0 0.12 0.2 0.2 0.4 20.00% 0.12

0.9 0.1 0.12 0.2 0.2 0.4 22.00% 0.128 0.9 0.1 0.12 0.2 0.2 0.4 14.00% 0.128

0.8 0.2 0.12 0.2 0.2 0.4 24.00% 0.136 0.8 0.2 0.12 0.2 0.2 0.4 8.00% 0.136

0.75 0.25 0.12 0.2 0.2 0.4 25.00% 0.14 0.75 0.25 0.12 0.2 0.2 0.4 5.00% 0.14

0.6 0.4 0.12 0.2 0.2 0.4 28.00% 0.152 0.6 0.4 0.12 0.2 0.2 0.4 4.00% 0.152

0.5 0.5 0.12 0.2 0.2 0.4 30.00% 0.16 0.5 0.5 0.12 0.2 0.2 0.4 10.00% 0.16

0.3 0.7 0.12 0.2 0.2 0.4 34.00% 0.176 0.3 0.7 0.12 0.2 0.2 0.4 22.00% 0.176

0.25 0.75 0.12 0.2 0.2 0.4 35.00% 0.18 0.25 0.75 0.12 0.2 0.2 0.4 25.00% 0.18

0 1 0.12 0.2 0.2 0.4 40.00% 0.2 0 1 0.12 0.2 0.2 0.4 40.00% 0.2

Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu
 Diversification Ratio

Maximum diversification was introduced by Choueifaty (2006) along with the concept of a
Diversification Ratio (DR). Choueifaty (2006) claimed that portfolios with maximal DRs were maximally
diversified and that such portfolios provided an efficient alternative to market cap-weighted portfolios.
https://www.tandfonline.com/doi/pdf/10.1080/23322039.2018.1427533?needAccess=true
Department of Commerce, Near 9th Block MIT Campus, Manipal 576 104, Karnataka, India, Ph. No: 0820 2925342  Email: doc.office@manipal.edu