Chapter No.

7 Modern Portfolio Theory

Question No. 7
Month R D R S R R R N
1 3 2 4 4
2 7 6 10 -2
3 -2 -1 -4 7
4 1 3 3 2
5 5 4 11 2
6 -6 -4 -8 6
Solution:
a. b. c. d.
ṜD 1.33 σ D 4.76 covD,S 16.73 rD,S 0.97
ṜS 1.67 σ S 3.61 covD,R 34.93 rD,R 0.97
ṜR 2.67 σ R 7.53 covD,N -13.07 rD,N -0.84
ṜN 3.17 σ N 3.25
covS,R 26.07 rS,R 0.96
covS,N -10.53 rS,N -0.90
covR,N -20.53 rR,N -0.84
 Chapter No. 7 Modern Portfolio Theory
σ D 4.76 𝑐𝑜𝑣𝐷,𝑆 16.73
σ S 3.61 𝑟𝐷,𝑆 = = = 𝟎. 𝟗𝟕
𝜎𝐷 𝜎𝑆 4.76𝑥3.61
σ R 7.53
σ N 3.25 𝑐𝑜𝑣𝐷,𝑅 34.93
𝑟𝐷,𝑅 = = = 𝟎. 𝟗𝟕
𝜎𝐷 𝜎𝑅 4.76𝑥7.53
covD,S 16.73
covD,R 34.93 𝑐𝑜𝑣𝐷,𝑁 −13.07
𝑟𝐷,𝑁 = = = −𝟎. 𝟖𝟒
𝜎𝐷 𝜎𝑁 4.76𝑥3.25
covD,N -13.07
covS,R 26.07 𝑐𝑜𝑣𝑆,𝑅 26.07
𝑟𝑆,𝑅 = = = 𝟎. 𝟗𝟔
covS,N -10.53 𝜎𝑆 𝜎𝑅 3.61𝑥7.53
covR,N -20.53 𝑐𝑜𝑣𝑆,𝑁 −10.53
𝑟𝑆,𝑁 = = = −𝟎. 𝟗𝟎
𝜎𝑆 𝜎𝑁 3.61𝑥3.25

𝑐𝑜𝑣𝑅,𝑁 −20.53
𝑟𝑅,𝑁 = = = −𝟎. 𝟖𝟒
𝜎𝑅 𝜎𝑁 7.53𝑥3.25
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (S, R) with wS= 0.5 and wR= 0.5 rS,N -0.90
𝐸(𝑅𝑝 ) = 𝑤𝑆 𝐸(𝑅𝑆 ) + 𝑤𝑅 𝐸(𝑅𝑅 ) rR,N -0.84

𝐸(𝑅𝑝 ) = (0.5𝑥1.67) + (0.5𝑥2.67)

𝐸(𝑅𝑝 ) = 𝟐. 𝟏𝟕
𝑛 𝑛 𝑛 𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝑐𝑜𝑣𝑖,𝑗 𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖=1 𝑗 =1 𝑖=1 𝑖=1 𝑗 =1

𝜎𝑝 = ට 𝑤𝑆2 𝜎𝑆2 + 𝑤𝑅2 𝜎𝑅2 + 2𝑤𝑆 𝑤𝑅 𝜎𝑆 𝜎𝑅 𝑟𝑆,𝑅

𝜎𝑝 = ඥ(0.5)2 (3.61)2 + (0.5)2 (7.53)2 + 2(0.5)(0.5)(3.61)(7.53)(0.96)

𝜎𝑝 = ξ 3.26 + 14.17 + 13.05 = ξ 30.48 =

𝝈𝒑 = 𝟓. 𝟓𝟐
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (S, N) with wS= 0.5 and wN= 0.5 rS,N -0.90
𝐸(𝑅𝑝 ) = 𝑤𝑆 𝐸(𝑅𝑆 ) + 𝑤𝑁 𝐸(𝑅𝑁 ) rR,N -0.84

𝐸(𝑅𝑝 ) = (0.5𝑥1.67) + (0.5𝑥3.17)

𝐸(𝑅𝑝 ) = 𝟐. 𝟒𝟐
𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖=1 𝑗 =1

ට 𝑤𝑆2 𝜎𝑆2 + 𝑤𝑁2 𝜎𝑁2 + 2𝑤𝑆 𝑤𝑁 𝜎𝑆 𝜎𝑁 𝑟𝑆,𝑁

𝜎𝑝 = ඥ(0.5)2 (3.61)2 + (0.5)2 (3.25)2 + 2(0.5)(0.5)(3.61)(3.25)(−0.90)

𝜎𝑝 = ξ 3.26 + 2.64 − 5.28 = ξ 0.62 =

𝝈𝒑 = 𝟎. 𝟕𝟖
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (R, N) with wR= 0.5 and wN= 0.5 rS,N -0.90
𝐸(𝑅𝑝 ) = 𝑤𝑅 𝐸(𝑅𝑅 ) + 𝑤𝑁 𝐸(𝑅𝑁 ) rR,N -0.84

𝐸(𝑅𝑝 ) = (0.5𝑥2.67) + (0.5𝑥3.17)

𝐸(𝑅𝑝 ) = 𝟐. 𝟗𝟐
𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖=1 𝑗 =1

𝜎𝑝 = ට 𝑤𝑅2 𝜎𝑅2 + 𝑤𝑁2 𝜎𝑁2 + 2𝑤𝑅 𝑤𝑁 𝜎𝑅 𝜎𝑁 𝑟𝑅,𝑁

𝜎𝑝 = ඥ(0.5)2 (7.53)2 + (0.5)2 (3.25)2 + 2(0.5)(0.5)(7.53)(3.25)(−0.84)

𝜎𝑝 = ξ 14.18 + 2.64 − 10.28 = ξ 6.54 =

𝝈𝒑 = 𝟐. 𝟓𝟔
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (D, S) with wD= 0.5 and wS= 0.5 rS,N -0.90
rR,N -0.84
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (D, R) with wD= 0.5 and wR= 0.5 rS,N -0.90
*ASSIGNMENT rR,N -0.84
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 r
D,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 2 Security portfolio (D, N) with wD= 0.5 and wN= 0.5 rS,N -0.90
*ASSIGNMENT rR,N -0.84
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 rD,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 3 Security portfolio (D, S, R) with wD= 0.2, wS= 0.3 and wR= 0.5 rS,N -0.90
𝐸(𝑅𝑝 ) = 𝑤𝐷 𝐸(𝑅𝐷 ) + 𝑤𝑆 𝐸(𝑅𝑆 ) + 𝑤𝑅 𝐸(𝑅𝑅 )
rR,N -0.84
𝐸(𝑅𝑝 ) = ሺ0.2𝑥1.33ሻ + ሺ0.3𝑥1.67ሻ + (0.5𝑥2.67)

𝐸(𝑅𝑝 ) = 𝟐. 𝟏𝟎
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 rD,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 3 Security portfolio (S, R, N) with wS= 0.2, wR= 0.3 and wN= 0.5 rS,N -0.90
𝐸(𝑅𝑝 ) = 𝑤𝑆 𝐸(𝑅𝑆 ) + 𝑤𝑅 𝐸(𝑅𝑅 ) + 𝑤𝑁 𝐸(𝑅𝑁 ) rR,N -0.84
𝐸(𝑅𝑝 ) = ሺ0.2𝑥1.67ሻ + ሺ0.3𝑥2.67ሻ + (0.5𝑥3.17)

𝐸(𝑅𝑝 ) = 𝟐. 𝟕𝟐
 Chapter No. 7 Modern Portfolio Theory
Question No. 7 ṜD 1.33 σ D 4.76 rD,S 0.97
Solution: ṜS 1.67 σ S 3.61 rD,R 0.97
e. Expected Portfolio Return= ? ṜR 2.67 σ R 7.53
rD,N -0.84
Portfolio Risk= ? ṜN 3.17 σ N 3.25
rS,R 0.96
Assume 3 Security portfolio (D, S, N) with wD= 0.2, wS= 0.3 and wN= 0.5 rS,N -0.90
*ASSIGNMENT rR,N -0.84
Question No. 6
12 %
16
4
6

Solution: a. Expected Portfolio Return= ? Portfolio Risk= ?

Assume 2 Security portfolio (1, 2) with w1= 1, w2= 0 (∑w= w1 + w2= 1)
𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸(𝑅2 ) = ሺ1𝑥12ሻ + ሺ0𝑥16ሻ = ૚૛Ψ

𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖 =1 𝑗 =1

𝜎𝑝 = ට 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟1,2

𝜎𝑝 = ඥ(1)2 (4)2 + (0)2 (6)2 + 2ሺ1ሻሺ0ሻሺ4ሻሺ6ሻሺ0.70ሻ

𝜎𝑝 = ξ 16 + 0 + 0 = ξ 16 = ૝Ψ
Question No. 6
12 %
16
4
6

Solution: b. Expected Portfolio Return= ? Portfolio Risk= ?

Assume 2 Security portfolio (1, 2) with w1= 0.75, w2= 0.25 (∑w= w1 + w2= 1)
𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸(𝑅2 ) = ሺ0.75𝑥12ሻ + ሺ0.25𝑥16ሻ = ૚૜Ψ

𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖=1 𝑗 =1

𝜎𝑝 = ට 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟1,2

𝜎𝑝 = ඥ(0.75)2 (4)2 + (0.25)2 (6)2 + 2ሺ0.75ሻሺ0.25ሻሺ4ሻሺ6ሻሺ0.70ሻ

𝜎𝑝 = ξ 9 + 2.25 + 6.3 = ξ 17.55 = ૝Ǥ૚ૢΨ

Question No. 6
12 %
16
4
6

Solution: c. Expected Portfolio Return= ? Portfolio Risk= ?

Assume 2 Security portfolio (1, 2) with w1= 0.5, w2= 0.5 (∑w= w1 + w2= 1)
𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸(𝑅2 ) = ሺ0.5𝑥12ሻ + ሺ0.5𝑥16ሻ = ૚૝Ψ

𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖=1 𝑗 =1

𝜎𝑝 = ට 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟1,2

𝜎𝑝 = ඥ(0.5)2 (4)2 + (0.5)2 (6)2 + 2ሺ0.5ሻሺ0.5ሻሺ4ሻሺ6ሻሺ0.70ሻ

𝜎𝑝 = ξ 4 + 9 + 8.4 = ξ 21.4 = ૝Ǥ૟૜Ψ

Question No. 6
12 %
16
4
6

Solution: d. Expected Portfolio Return= ? Portfolio Risk= ?

Assume 2 Security portfolio (1, 2) with w1= 0.25, w2= 0.75 (∑w= w1 + w2= 1)
𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸(𝑅2 ) = ሺ0.25𝑥12ሻ + ሺ0.75𝑥16ሻ = ૚૞Ψ

𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖 =1 𝑗 =1

𝜎𝑝 = ට 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟1,2

𝜎𝑝 = ඥ(0.25)2 (4)2 + (0.75)2 (6)2 + 2ሺ0.25ሻሺ0.75ሻሺ4ሻሺ6ሻሺ0.70ሻ

𝜎𝑝 = ξ 1 + 20.25 + 6.3 = ξ 27.55 = ૞Ǥ૛૞Ψ

Question No. 6
12 %
16
4
6

Solution: e. Expected Portfolio Return= ? Portfolio Risk= ?

Assume 2 Security portfolio (1, 2) with w1= 0.05, w2= 0.95 (∑w= w1 + w2= 1)

𝐸(𝑅𝑝 ) = 𝑤1 𝐸(𝑅1 ) + 𝑤2 𝐸(𝑅2 ) = ሺ0.05𝑥12ሻ + ሺ0.95𝑥16ሻ = ૚૞ǤૡΨ

𝑛 𝑛 𝑛

𝜎𝑝 = ඩ ෍ 𝑤𝑖2 𝜎𝑖2 + ෍ ෍ 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝑟𝑖,𝑗

𝑖=1 𝑖 =1 𝑗 =1

𝜎𝑝 = ට 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1 𝜎2 𝑟1,2

𝜎𝑝 = ඥ(0.05)2 (4)2 + (0.95)2 (6)2 + 2ሺ0.05ሻሺ0.95ሻሺ4ሻሺ6ሻሺ0.70ሻ

𝜎𝑝 = ξ 0.04 + 32.49 + 1.6 = ξ 34.13 = ૞Ǥૡ૝Ψ

 18

Portfolio Return Risk 16

1 12 4 14
2 13 4.19
12
3 14 4.63 Return
10
4 15 5.25
5 15.8 5.84 8

0
3.5 4 4.5 5 5.5 6
Risk
 Portfolio Selection & Asset Allocation
Building a Portfolio using Markowitz Principles
To select an optimal portfolio of financial assets using the Markowitz analysis, investors
should:
1. Identify optimal risk-return combinations (the efficient set) available from the set of
risky assets being considered by using the Markowitz efficient frontier analysis.
2. Select the optimal portfolio from among those in the efficient set based on an
investor’s preferences.
Identify optimal Risk-return combinations
The Attainable set of Portfolios
All possible portfolios.

Efficient Portfolio
A portfolio with the highest level of expected return for a given level of risk or a portfolio
with the lowest risk for a given level of expected return

Efficient Set
The set of portfolios generated by the Markowitz portfolio model

Efficient Frontier
The Markowitz tradeoff between expected portfolio return and portfolio risk showing all
efficient portfolios given some set of securities
Portfolio Selection & Asset Allocation
Efficient Frontier
• The envelope curve that contains the best of all these possible combinations is referred to
as the efficient frontier.
• Specifically, the efficient frontier represents that set of portfolios (efficient portfolios) that
has the maximum rate of return for every given level of risk or the minimum risk for every
level of return.
• Thus, we would say that Portfolio A in Exhibit dominates Portfolio C because it has an equal
rate of return but substantially less risk. Similarly, Portfolio B dominates Portfolio C because
it has equal risk but a higher expected rate of return.
The Efficient Frontier and Investor Utility Curve
• An individual investor’s utility curves specify the trade-offs he or she is willing to make
between expected return and risk.
• The curve in Exhibit shows that the slope of the efficient frontier curve decreases steadily as
we move upward. This implies that adding equal increments of risk as we move up the
efficient frontier gives diminishing increments of expected return.
• The optimal portfolio is the efficient portfolio that has the highest utility for a given investor.
• A conservative investor’s highest utility is at Point X in Exhibit where the U2 curve just
touches the efficient frontier.
• A less risk-averse investor’s highest utility occurs at Point Y, which represents a portfolio on
the efficient frontier with higher expected returns and higher risk than the portfolio at X.
Capital Market Theory & Asset Pricing Models
Capital Market Theory
• Capital market theory is an extension of portfolio theory
• Introduction of Risk free asset in portfolio leads to change in
efficient frontier