Portfolio Tools

Knut P. Heen PhD

Associate Professor
Molde University College
Road Map
Based on chapter 4 in HGT
Portfolio weights
Portfolio return
Portfolio variance
The E(R)-σ diagram
The marginal variance of a portfolio
The minimum variance portfolio

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Portfolio Weights
Portfolio
A collection of assets

Portfolio weights
Percentage of wealth in each asset

Positive weights – long position

Negative weights – short position

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Portfolio Return
Asset return

Portfolio return (two-assets)

Expected portfolio return (two-assets)

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Variance & Standard Deviation
Variance

Standard deviation (volatility)

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Covariance & Correlation
Covariance

Correlation

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Portfolio Variance
The variance of a sum of two stochastic variables

Portfolio variance (two-assets)

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The E(r)-σ Diagram
Suppose we combine a risk-free asset with a risky
asset

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The E(r)-σ Diagram
E(r)

E(r2)

rf

σ2 σ

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The Portfolio’s Marginal Variance
Suppose we add a tiny asset Δ to a huge portfolio P
Original variance

New variance

Marginal variance

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The Minimum Variance Portfolio
Portfolio variance

Minimize variance with respect to x

Find minimum variance weight

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The E(r)-σ Diagram
Two risky assets

Solve variance for x

Special cases when ρ = 1 or ρ = -1 (straight line in σP)

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The E(r)-σ Diagram (-1 < ρ < 1)
E(r)

Plus square-root

r(σmin)

Minus square-root

σmin σ

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Risk-Free Asset & Risky Portfolio
E(r)

(σT, rT)

r(σmin)

rf

σmin σ

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