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Institut for finansiering

Cand.merc.finansiering
Hovedopgave

Forfatter: Elena Kabatchenko Nielsen
Vejleder: Peter Lchte Jrgensen




EFFICIENT PORTFOLIO SELECTION
IN
MEAN-VARIANCE-SKEWNESS
SPACE

And additionally:
Can and should structured products be viewed as an independent
asset class in the portfolio of a retail investor?



RHUS HANDELSHJSKOLE, RHUS UNIVERSITET
JANUAR 2008
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Table of Contents
1. INTRODUCTION ............................................................................................................ 4
1.1. THESIS STATEMENT ..................................................................................................... 5
1.2. DELIMITATION ............................................................................................................ 6
1.3. STRUCTURE OF THE THESIS ......................................................................................... 6
2. MODERN PORTFOLIO THEORY ................................................................................ 8
2.1. MODERN PORTFOLIO THEORY, SHORTLY ..................................................................... 8
2.2. COMPUTATION OF THE EFFICIENT FRONTIER ............................................................... 9
2.2.1. Blacks Model .................................................................................................... 12
2.3. DEVELOPMENT OF MODERN PORTFOLIO THEORY ...................................................... 12
2.4. JUSTIFICATION FOR MEAN AND VARIANCE ................................................................ 14
2.5. CRITICISM OF THE MODERN PORTFOLIO THEORY ...................................................... 16
3. INTRODUCTION TO SKEWNESS .............................................................................. 18
3.1. MEASUREMENT OF SKEWNESS................................................................................... 19
3.2. ECONOMIC IMPORTANCE OF SKEWNESS .................................................................... 21
3.2.1. Theoretical Justification for Preference for Skewness ........................................ 22
3.2.2. Behavioral Justification for Preference for Skewness ......................................... 23
3.3. PROBLEMS WITH MEASUREMENT OF SKEWNESS ........................................................ 24
4. MEAN-VARIANCE-SKEWNESS PORTFOLIO ANALYSIS ..................................... 26
4.1. CHOICE OF THE ARTICLE ........................................................................................... 26
4.1.1. Short Introduction ............................................................................................. 27
4.2. NOTATION AND SOME FORMULAE .............................................................................. 28
4.3. DUALITY RESULTS .................................................................................................... 31
4.4. MINIMUM VARIANCE PORTFOLIO .............................................................................. 32
4.5. FINDING MAXIMUM SKEWNESS PORTFOLIO ............................................................... 38
5. SKEWNESS OF STOCK RETURNS ............................................................................ 45
5.1. DATA ........................................................................................................................ 45
5.2. SENSITIVITY OF SKEWNESS ....................................................................................... 46
5.2.1. Choice of Differencing Interval .......................................................................... 46
5.2.2. Initialization Point ............................................................................................. 47
5.2.3. Calculation of the Returns ................................................................................. 48
5.3. ANALYSIS OF SKEWNESS ........................................................................................... 50
5.3.1. Persistence of Skewness ..................................................................................... 52
5.3.2. Note on Skewness .............................................................................................. 53
6. EFFICIENT FRONTIER ............................................................................................... 54
6.1. DATA AND METHODS ................................................................................................ 54
6.2. STOCK CHARACTERISTICS ......................................................................................... 55
6.3. EFFICIENT FRONTIER IN MEAN-VARIANCE FRAMEWORK ........................................... 56
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6.4. EFFICIENT FRONTIER IN MEAN-VARIANCE-SKEWNESS SPACE ................................... 59
6.4.1. Minimum Variance Portfolio ............................................................................. 59
6.4.2. Maximum Skewness Portfolios ........................................................................... 61
6.4.3. Efficient Frontier in Mean-Variance-Skewness Space ........................................ 63
6.5. CONCLUSION ............................................................................................................. 65
7. STRUCTURED PRODUCTS ......................................................................................... 66
7.1. DEFINITION OF STRUCTURED PRODUCTS ................................................................... 66
7.2. APPEAL AND RISKS OF STRUCTURED PRODUCTS ....................................................... 67
7.3. CRITIC ON STRUCTURED PRODUCTS .......................................................................... 68
7.4. STRUCTURED PRODUCTS AS AN INDEPENDENT ASSET CLASS .................................... 69
8. SKEWNESS OF RETURNS ON STRUCTURED PRODUCTS ................................... 71
8.1. DATA AND EMPIRICAL METHODS .............................................................................. 72
8.2. THE ALGORITHM IN VISUAL BASIC APPLICATION (VBA) .......................................... 73
8.3. ANALYSIS ................................................................................................................. 74
8.3.1. OMXC20 ........................................................................................................... 75
8.3.2. Maersk A ........................................................................................................... 77
8.3.3. Interpretation of the Results ............................................................................... 79
8.4. STRUCTURED PRODUCTS IN THE PORTFOLIO: A COMMENT ........................................ 80
9. CONCLUSION ............................................................................................................... 81
10. FUTURE DIRECTION OF RESEARCH .................................................................. 85
11. BIBLIOGRAPHY ....................................................................................................... 87
11.1. ARTICLES .................................................................................................................. 87
11.2. BOOKS ...................................................................................................................... 91

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1. Introduction
The original idea that has motivated this thesis comes from a personal interest for
structured products as financial innovations and strong criticism of these products in
Danish business press. The question that has laid ground for the thesis is whether
structured products can be viewed as a good investment alternative for a retail investor.
In one hand, structured products seem like a very interesting investment class with some
special characteristics. In the other hand, Danish business newspaper Brsen has
published numerous articles (see for example Brsen (2003) and Brsen (2006)) about
the drawbacks of structured products: non-transparency of their characteristics to the
investors and overpricing of these products.
The fact that the price of structured products is higher than it should be in theory is
relatively easy to explain. The market for structured products in Denmark is very new,
and the issuers can take a much higher price because of the lack of competition. The other
reason is that structured products offer some features to retail investors that are not
available to them otherwise, such as participation in the derivative market and
opportunity to monetize their expectations about future price development (Satyajit,
2001). It is fair enough that issuers take a payment for that.
The other branch of criticism: non-transparency of the characteristics of structured
products is more interesting. Characteristics of structured products are different from
those of stocks and bonds, but can be very difficult to analyze because the historical data
of are often not available. There must be something about these products that is very
appealing for an investor, since they enjoyed a very high growth since their introduction
to the financial markets.
The simulations of probability distribution of returns on self-constructed structured
products have shown interesting characteristics towards asymmetry of return distribution.
Skewness, which is the measure of asymmetry of distribution, is much higher for
structured products than it is for stocks. However, if portfolios of retail investors are to be
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constructed according to the traditional portfolio theory, skewness does not play any role,
and therefore structured products will not be of much interest to the investor.
The purpose of this thesis is therefore twofold:
1. To see whether skewness is in fact an important factor for investor, and how it can
be incorporated in portfolio analysis.
2. To see whether structured products can be viewed as an independent asset class in
the portfolio of retail investor.
It is important to notice that this thesis is a theoretical project, which main purpose is to
take a look at portfolio analysis, skewness and structured products from a theoretical
standpoint. Empirical part in the thesis should be seen as an application of the introduced
theoretical framework.
1.1. Thesis Statement
The main goal of this thesis is to take a critical look on traditional / Markowitz portfolio
theory and to find out whether other portfolio models can do a better job. This goal will
be achieved by answering the following questions:
What is the reason for including only mean and variance as the main parameters
in Modern Portfolio Theory?
Should higher moments of probability distribution of returns such as skewness be
considered in portfolio analysis?
How should portfolio theory be modified if skewness is included as the third
parameter?
What shape does efficient frontier take in the three-moment portfolio model?
Do Danish stock returns exhibit skewness? Is it persistent?
If Danish stock returns are analyzed in both traditional portfolio framework and
the alternative theory including skewness, what will be the difference between the
results of the two analyses?
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The secondary goal of this thesis is to take a look on structured products as an
independent asset class. The reason for including structured products as a subject to the
thesis is their characteristics concerning skewness. Per construction return distribution on
structured products should be skewed, and it is therefore convenient to consider them in
the framework of three-moment portfolio theory. The following questions are sought to
be answered:
Can structured products at all be viewed as an independent asset class?
What are characteristics of structured products? How can they be found when
historical data are most often not available?
Can and should structured products be included in portfolio analysis?
1.2. Delimitation
A broad subject of portfolio theory is viewed in this thesis. Therefore only the basic
model is considered. It means that I am working with a static portfolio model, i.e. all
dynamic effects of portfolio modeling are not considered. Classic portfolio theory
assumes one-period investment, and it will also be the case for this thesis.
In the empirical part of the thesis, where an empirical study on stocks and structured
products is conducted, dividends and taxes are not taking into account.
Other moments of return distribution higher than skewness, e.g. kurtosis, are not
considered in this thesis, even though some studies indicate importance of kurtosis in the
investment decisions.
In the part where the discussion on structured products takes place, only one kind of
structured products is considered, namely, principle-protected equity-linked note. All
other structures are not analyzed in terms of this thesis.
1.3. Structure of the Thesis
The thesis is divided in two parts:
1. Portfolio theory and skewness: Chapters 2-6.
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Theoretical part is opened with chapter two about Modern Portfolio Theory, where the
reader is presented to the main concept and assumptions behind this theory. Later in the
chapter the assumptions are discussed and some criticism of Modern Portfolio Theory is
presented. Chapter three introduces the reader to the concept of skewness, where some
formulae are presented, followed by discussion about why skewness is an important
factor for investors. Here the sensitivity of skewness measure to some parameters is
discussed as well. Theoretical part is finished with chapter four, where three-moment
portfolio model is presented and discussed.
Empirical part of this section has two intentions:
a) Analyze skewness of Danish stock returns
b) To build the efficient frontiers in mean-variance and mean-variance-skewness
space.
Chapter five that opens the empirical part presents the skewness analysis of Danish
stock returns. The following aspects of skewness are analyzed here: Whether returns
on Danish stocks exhibit asymmetry, whether it is persistent and how unstable
skewness measure is with respect to different parameters. Chapter six presents the
second part of empirical analysis that concerns portfolio analysis. Here the efficient
frontier is constructed according to Modern Portfolio Theory using data on four
Danish stocks. Later in the same chapter practical application of three-moment
portfolio model on these four stocks is conducted.
2. Structured Products: Chapters 7-8.
Chapter seven discusses structured products and the idea about whether they can be
considered as an independent asset class in terms of portfolio analysis. Characteristics of
structured products are analyzed in chapter eight. A VBA algorithm is constructed to
simulate probability distribution of returns on structured products and different types of
embedded options are analyzed with respect to their impact on the characteristics of
structured products.
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The common conclusion of the both sections follows after theoretical parts and empirical
analysis. Thesis is finished with some suggestions to a future research in the area
analyzed in the thesis.
All the empirical work made in this thesis can be found on the enclosed CD.
2. Modern Portfolio Theory
In this part of the thesis the Modern Portfolio Theory (MPT) will be discussed. It is
assumed that the reader is familiar with the theory. The goal of this chapter is not to
summarize Modern / Markowitz Portfolio Theory, but to discuss the assumptions behind
this theory. In the class the students are taught the basic rules of MPT, i.e. how to
calculate mean return, variance, covariance between assets and how to build up efficient
frontier from a set of probability beliefs about the securities. However, these rules are for
the most accepted without a doubt, and it is intended in this thesis to take a critical look
on this widely accepted portfolio theory. The reader will also be introduced to the
notation in MPT and formulae for mean return, variance etc. This is done, because these
formulae will be used later in the empirical part of the thesis, and because they ground the
mathematical part of MPT.
2.1. Modern Portfolio Theory, shortly
Portfolio analysis consists of two parts: Analysis of securities and combination of the
securities into a portfolio. Modern Portfolio Theory deals with the second part of
portfolio analysis. Modern Portfolio Theory identifies the efficient frontier, i.e. the set of
portfolios that have highest expected return for a given level of risk, and, by duality,
minimum variance for a given expected return. Efficient frontier will be the same for all
investors. Investors risk preferences play role, when investor will pick the combination
of expected return and variance on the efficient frontier that best suites his needs.
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The following assumptions
1
are made in Modern Portfolio Theory:
1. The investor seeks to maximize his expected utility of terminal wealth
2. The investor has a single-period investment horizon
3. The investor is risk-averse
4. The investor will choose his optimal portfolios on the basis of means and standard
deviations of returns
5. Markets are perfect: transaction costs and taxes do not exist and securities are
indefinitely divisible
Modern Portfolio Theory states that diversification is the key for combination of
securities in the portfolio because correlation between securities can decrease the overall
variance / risk of the portfolio.
Markowitz builds up the Critical Line Algorithm (Markowitz, 1959, p. 310-312) that
identifies all the feasible portfolios that minimize risk for a given level of expected return.
Graph of this critical line in the expected return standard deviation space is the efficient
frontier. Most of the portfolios on this efficient frontier are well-diversified, because, as
mentioned above, diversification is a powerful tool in terms of risk reduction.
2.2. Computation of the Efficient Frontier
The Markowitz portfolio analysis is built up upon two parameters of return distribution of
assets, namely mean return and variance / standard deviation. These two moments of the
distribution are calculated in the following way
2
:
Formula 2.1. Expected return on the asset i:

=
_
]
N
]=1


Where
i

is expected return on asset i, R


ij
is actual return on asset i at time j, and N is the number of
observations.

1
Gordon & Francis, 1986, pp. 50-51
2
See for example Elton and Gruber, 2003, pp. 45-55
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Formula 2.2. Variance of the returns on asset i:
o

2
=
_ (
]
-
i

)
2 N
]=1


Where o

2
is variance of the returns on asset i, the rest of the notation is as above in formula 2.1..
Formula 2.3. Covariance between two assets i and k:
o
k
=
_ (
]
-
i

)(
k]
-
k

)
N
]=1


Where o
k
is covariance between two assets i and k, R
kj
is actual return on asset k at time j,
k

is expected
return on asset k. The rest of the notation is as in formula 2.1.
In principle, the two moments above should be investors probability beliefs about
performance of a single security. Most often, however, the expected return and variance
are calculated from the historical data. One has to be attentive to the fact that:
When past performances of securities are used as inputs, the outputs of the analysis are
portfolios which performed particularly well in the past.
3

Therefore investor should take the past figures as inputs for portfolio analysis carefully,
being attentive of the possible errors of such an approach.
The goal of portfolio analysis is to find efficient combinations, i.e. portfolios of several
securities. The expected return on the portfolio is calculated as weighted average of the
expected returns of respective securities:
Formula 2.4. Expected return on the portfolio:

= (o

)
N
=1

Where R
p

is expected return on portfolio,


i
is a weight placed on security i. The rest of the notation is as in
formula 2.1.

3
Markowitz, 1959, p. 3
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In matrix notation:
Formula 2.4.1.: Expected return on the portfolio in matrix notation.

= o

= |o
1
o
2
. o
n
] -
l
l
l
l
l

2
.
.

n
1
1
1
1
1

Where o

is a vector of weights placed on different securities, and


i

is a vector of expected returns on


securities.
Portfolio variance is a little more complicated than just weighted average of variances of
respective securities, because covariance of the securities enters the formula of portfolio
variance. Portfolio variance is calculated as:
Formula 2.5. Portfolio variance.
o
p
2
= o

2
o

2
N
=1
+o

o
]
o
]
N
=]
= o

o
]
o
]
N
]=1
N
=1

Where o
p
2
is portfolio variance, o

2
is variance of returns on asset i, o
]
is covariance between two assets.
The rest of notation as is in formulas 2.1. and 2.4.
In matrix notation:
Formula 2.5.1. Portfolio variance in matrix notation.
o
p
2
= o

H
2
= |o
1
o
2
. o
n
] - _
o
11
o
12
. o
1n
o
21
o
22
. o
2n
. .
o
n1
o
n2
. o
nn
_ -
l
l
l
l
l
o
1
o
2
.
.
o
n
1
1
1
1
1

Where M
2
is a variance-covariance matrix and the rest of notation is as in formula 2.4.1.


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2.2.1. Blacks Model
The Blacks model is used to present the computation of the efficient frontier. The
Blacks model is chosen instead of Markowitz model because the non-negativity
constraint on the portfolio weights is removed in Blacks model, i.e. short sales are
allowed. This model is more convenient to use, as the same notation will be used later in
the thesis.
It is intended to build up the efficient frontier, i.e. to find such portfolios that have
minimum variance for a given level of expected return. This is an optimization problem,
where the objective function variance has to be minimized subject to the two
constraints, i.e. using matrix notation
4
:
Minimize: o

H
2
o
Subject to given level of expected return:
p
-

= o


And to the fact that the weights have to sum up to 1:

= (l is a unit vector).
This optimization problem is solved, i.e. weights on risky assets that constitute efficient
portfolio are found, by solving the corresponding Lagrangian function:
min
x
I =o

H
2
o +z
1
(
p
-

-o

) +z
2
( - o

)
Where z
1
and z
2
are Lagrangian multipliers.
2.3. Development of Modern Portfolio Theory
Hicks (1965) claimed in his book that economists were familiar with the idea of portfolio
theory since his article, Hicks (1935), where he argued for diversification of the
investments:

4
Gordon & Francis, p. 56
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By dividing up his (investors) capital into small portions, and spreading his risks, he
(investor) would be able to insure himself against any large total risk on the whole
amount.
5

However, Hicks (1935) did not give a proper reason for diversification, i.e. he did not
realize that correlation between assets could lead to elimination of the unsystematic risk
in the portfolio.
Another forerunner for MPT was Dickson Leavens (1945), who used variance as a
measure of risk of the bond portfolio. He showed how risk declines when the number of
bonds is increased in the portfolio, given uncorrelated bond returns.
The era of Modern Portfolio Theory was opened in 1952 with an article Portfolio
Selection by Harry M. Markowitz (Markowitz, 1952). In this article Markowitz argues
for mean-variance rule, i.e. that investor takes an investment decision based on his
probability beliefs about expected or anticipated return of the investment and dispersion /
uncertainty of returns, which is measured by variance. In this article he defines an
efficient set of portfolios calculated on the basis of mean and variance. Markowitz also
introduces the term covariance between assets, which can reduce the overall risk of the
portfolio.
Even though this article of Markowitz was a break-through, Modern Portfolio Theory did
not get a visible interest in the first years after the article was published. It was first after
the works of Tobin (1958), Sharpe (1963, 1964) and Lintner (1965) MPT got its deserved
popularity.
6

The efficient frontier when the riskless asset exists was developed first by Tobin (1958).
This model is known as Tobin separation theorem, where the set of efficient portfolios
consists of:
Portfolio X*, consisting of only risky assets
Portfolios consisting of partly X* and partly of borrowing or lending.

5
Hicks, 1935. The quote is taken from Markowitz, 1987, p. 36
6
Markowitz, 1987, p. 38
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In this way, the choice of portfolio X* is separate from the choice of borrowing or
lending. The second part of separation theorem: Choice of borrowing and lending
depends on the risk preferences of the investor.
Later Sharpe (1964) and Linther (1965) used MPT to the problem of equilibrium pricing
of capital assets. They say that because X* does not depend on the investors risk
preferences, i.e. all investors would hold the same portfolio as portfolio of risky assets,
then X* must be a market portfolio. From this assumption, a famous CAPM model for
equilibrium prices of capital assets was developed.
Thus, Markowitz portfolio theory laid the ground for many further developments in the
financial theory and is widely used in practice. However, Modern Portfolio Theory is
based upon some assumptions, where the main assumption is that mean return and
variance of asset returns are necessary and sufficient for conducting portfolio selection.
The next section discusses the reasons for taking only these two parameters in Markowitz
model.
2.4. Justification for Mean and Variance
In his work (Markowitz (1952) and Markowitz (1959)), Markowitz assumes that investor
has a set of probability beliefs about return distribution of some securities, i.e. investor
knows the expected return and the standard deviation of the return distribution on these
securities, and proposes a way to how an investor can constitute a portfolio from this set
of securities. Markowitz uses only mean and variance as the only needed characteristics
of the return distribution of securities for constructing portfolio. Markowitz says that
investor should not maximize only the expected return on his portfolio. Explanation for
that he sees in the real world, where investors do diversify. Diversification does not make
any sense, if only expected return is of consideration for the investor, as investor in this
case always would choose to invest his money in the security that gives maximum
expected return.
Markowitz says that investors also consider the dispersion of the return distribution that
most often is measured as variance/standard deviation of the returns. Thus, investors like
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expected return, and dislike variance. Therefore an investor would choose a portfolio that
maximizes expected return for a given variance, or minimizes variance for a given return.
Markowitz gives following reasoning for choosing mean and variance as the parameters
for portfolio selection:
Various reasons recommend the use of the expected return-variance of return rule, both
as a hypothesis to explain well-established investment behavior, and as a maxim to guide
ones own action. The rule serves better, we will see, as an explanation of and a guide to
investment as distinguished from speculative behavior.
7

The quote above shows that Markowitz chose mean and variance as two important
parameters for portfolio selection because those parameters seemed to him to explain the
investor behavior he could observe at the time.
In his book (Markowitz (1959)) that came after the article in 1952 he says that selection
of the criteria for portfolio analysis depends on the nature of the investor. Thus, the
criteria can be very different, as investors can have different goals with their investment.
However, Markowitz says that his book and his model are useful for all investors, for
which the following characteristics are common:
8

1. They prefer more to less, i.e. they want to maximize their return.
2. They want their return to be stable, not subject to uncertainty, i.e. Markowitz
model is not suited for speculative investors.
It is interesting to notice that it is most often said that in order for Markowitz mean-
variance model to hold at least one of the two assumptions has to hold:
1. The return distribution of the assets is normal.
2. The utility function of the investor is quadratic.
Notice that the assumptions stated above were not the first reasoning of Markowitz for
choosing mean and variance as the main criteria for portfolio selection analysis.

7
Markowitz, 1952, p. 87
8
Markowitz, 1959, p. 6
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Moreover, the assumption of the normal distribution of asset returns was first suggested
by Tobin (1958), where he stated that
The investor evaluates the future of consols (also, the future of portfolios of bonds and
other debt instruments) only in terms of some two-parameter family of probability
distributions.
9

Quadratic utility function was neither the reason to include mean and variance into
portfolio selection. Markowitz explains thoroughly in his book (Markowitz (1959)) why
quadratic utility function can be assumed for the investor, as it can be a good
approximation for other utility functions. So, the choice of quadratic utility function does
not come from empirical observation of investor behavior, but was chosen so it suited the
model.
The main conclusion from the discussion above is that Markowitz has built a theory for
portfolio selection assuming a certain preferences for the investor in his decision making
in the investment process. Even though Modern Portfolio Theory has been widely used
since 1950s, the basic assumptions behind this theory can and should be discussed.
Investor behavior should be analyzed and quantified to reach right conclusions about
investor behavior in the situations of choice.
2.5. Criticism of the Modern Portfolio Theory
In this section, it is intended to show why, at least in certain circumstances, MPT is not a
good approach to portfolio analysis. Since its origin, Modern Portfolio Theory has been
taken to another level. Nowadays different models of portfolio analysis exist, e.g.
dynamic portfolio analysis, portfolio analysis where the more real assumptions of several
periods investment horizon are included etc. These models are however not of interest to
the current thesis.

9
Tobin, 1958, p. 74
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It is necessary for this thesis to see whether the fundamental assumptions of mean-
variance approach hold, in particular whether the two moments of return distribution
indeed are sufficient for conducting a proper portfolio analysis.
According to Tobin (1958), if portfolio theory based on mean and variance of return
distribution should hold, at least one of the following assumptions has to be made:
1. Distribution of asset returns belongs to the two-parameter family, e.g. normal
distribution. If this is the case, the first two moments are sufficient to describe the
whole distribution.
2. Quadratic utility function can be assumed for the investor, i.e. investors goal is to
maximize mean return and minimize variance of return distribution. If quadratic
utility function can be assumed, the higher moments do not play any role in
investors decisions.
Return distribution of stocks in different markets have been investigated by many
researchers. Many studies show that stock returns often are not symmetrical. As an
example, following studies of asymmetry of returns can be mentioned:
a) Study of American equity returns by Beedles (1979), where he finds that the
returns are skewed, even though he finds measure of skewness being quite
unstable over the time;
b) Study of Australian equity returns by Beedles (1986), where he finds significant
positive skewness in the returns.
c) Study of Japanese equity returns by Aggarwal, Rao and Hiraki (1989), where
significant and persistent skewness and kurtosis are found.
These are only a small fraction of similar studies. These findings indicate that assumption
about normality of stock returns is based on the weak ground. It is intended in this thesis
to investigate Danish equity returns in order to see whether they exhibit skewness.
Assumption behind quadratic utility function is that investors do not care about higher
moments of distribution. However, in practice it is known that investors do care for e.g.
skewness / asymmetry of returns and would accept a slightly lower mean return in return
Efficient Portfolio Selection in Mean


for protection against losses and possibility of large gain, which is guaranteed by
positively skewed return distribution.
three that introduces the reader to third moment of return distribution
3. Introduction to Skewness
Skewness is a measure of asymmetry and a third moment of a distribution. Symmetry of
a distribution is viewed around its
distribution, the shape of distribution on the left side of the
of the shape on the right side of the
always be zero, as this distrib
distributions are characterized by existence of a few very large positive values, i.e.
right tail, and correspondingly negatively skewed distributions have a few very large
negative values, i.e. large left tai
Figure 3.1.: Positive, negative and symmetric distributions.
When distribution is symmetrical all three measures of central tendency: mean, mode
and median
11
are the same.
In the positively skewed distributions, median lies to the left of the mean value. The mean
value is larger then the median, because the extreme high positive values pool the average
estimate up. Correspondingly, in the negatively skewed distributions, the average value is
smaller than the median, because it is pooled down by few extremely large values.

10
Mode defines the most frequent value occurring in the sample
11
Median is the number that separates the higher half of the sample from the lower part
Positive Skewness
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for protection against losses and possibility of large gain, which is guaranteed by
positively skewed return distribution. These issues are discussed in
that introduces the reader to third moment of return distribution
Introduction to Skewness
Skewness is a measure of asymmetry and a third moment of a distribution. Symmetry of
a distribution is viewed around its mean. Therefore, if the skewness measure is zero for a
distribution, the shape of distribution on the left side of the mean will be a mirror image
of the shape on the right side of the mean. Thus, skewness of a normal distribution will
always be zero, as this distribution is perfectly symmetrical. Positively skewed
distributions are characterized by existence of a few very large positive values, i.e.
right tail, and correspondingly negatively skewed distributions have a few very large
negative values, i.e. large left tail. The three situations are illustrated below in figure 3.1.
Positive, negative and symmetric distributions. Source: Self-created graphs.
When distribution is symmetrical all three measures of central tendency: mean, mode
the same. However, when distribution is skewed it is no longer the case.
In the positively skewed distributions, median lies to the left of the mean value. The mean
value is larger then the median, because the extreme high positive values pool the average
Correspondingly, in the negatively skewed distributions, the average value is
smaller than the median, because it is pooled down by few extremely large values.

Mode defines the most frequent value occurring in the sample
Median is the number that separates the higher half of the sample from the lower part
Zero Skewness Negative skewness
Skewness Space
for protection against losses and possibility of large gain, which is guaranteed by
discussed in details in chapter
skewness.
Skewness is a measure of asymmetry and a third moment of a distribution. Symmetry of
the skewness measure is zero for a
will be a mirror image
. Thus, skewness of a normal distribution will
Positively skewed
distributions are characterized by existence of a few very large positive values, i.e. large
right tail, and correspondingly negatively skewed distributions have a few very large
e illustrated below in figure 3.1.

created graphs.
When distribution is symmetrical all three measures of central tendency: mean, mode
10

However, when distribution is skewed it is no longer the case.
In the positively skewed distributions, median lies to the left of the mean value. The mean
value is larger then the median, because the extreme high positive values pool the average
Correspondingly, in the negatively skewed distributions, the average value is
smaller than the median, because it is pooled down by few extremely large values.
Median is the number that separates the higher half of the sample from the lower part
Negative skewness
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3.1. Measurement of Skewness
In different sources different measures of skewness have been suggested. Karl Pearson
(1895) has been the first to introduce a method for measuring the asymmetry of a
distribution as standardized difference between the average value and mode of
distribution:
Formula 3.1. Skewness measure 1 by Pearson.
nss =
p - o
o

Where p is mean return and o is standard deviation of a distribution.
Often the mode is difficult to estimate from the samples, and the median is used instead
in the measurement of skewness:
Formula 3.2. Skewness measure 2 by Pearson.
nss =
(p -on)
o

The notation is as above in formula 3.1.
As the third moment of distribution, skewness is calculated in the similar way as mean
return and standard deviation
12
:
Formula 3.3. Skewness as the third moment of return distribution on asset i:
r on =
_(
]
-
i

)
3


Where
i

is expected return on asset i, R


ij
is actual return on asset i at time j, and N is the number of
observations.
The problem with this measure of skewness is that it is scale sensitive and cannot be used
in significance testing. Arditti (1971) was the first to suggest a measure of relative

12
It is assumed here that all returns are equally likely to occur. Alternatively the probabilities for each
return can be used in calculating skewness
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skewness: the third moment divided by standard deviation raised to the third power. In
this way, the cube of standard deviation is a scaling factor, and thus skewness for
different distributions can be compared.
Formula 3.4. Relative Skewness.
o snss =
_(

)
3

_(

)
2

,

3
2
,

The notation is as in formula 3.3.
This is the measure that is most often used in the financial literature, when e.g. stock
returns are analyzed for asymmetry. This measure is also used in statistical packages, e.g.
E-Views and Microsoft Excel. There can be made some modifications to this measure to
get an unbiased estimate of skewness. Thus in Microsoft Excel, the skewness is measured
as:
Formula 3.5. Skewness as it is measured in Microsoft Excel:
nss =

( -)( -)

o

3
N
=1

The notation is as in formulas 3.1. and 3.3. above.
The last measure of skewness is accepted and will be used throughout this thesis.
However, it is worth noticing that there exist several measures of skewness. Furthermore,
when different methods applied to a distribution, different values and even the sign of
skewness can appear. It is very important to notice, as skewness is a measure that is much
more sensitive to the way how it is measured, starting point, size of the sample etc. I will
elaborate more on this issue later in this section.


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Notice that if:
nss = _
= , n srbon s srco
> , srbon s pos s
< , srbon s no s


3.2. Economic Importance of Skewness
In this chapter it will be shown that skewness in fact is an important factor of return
distribution of the assets and cannot be ignored in the portfolio analysis. The reader will
be introduced to different studies and theories that show and prove that skewness is an
important parameter.
Despite the fact that Markowitz mean-variance portfolio selection theory is still the most
popular and used theory in both universities, banks and investment funds, more and more
authors are agreeing that the traditional portfolio theory is not sufficient. Modern
Portfolio Theory is based on the assumption that only first two central moments of the
return distributions matter. Jean (1971) gives the following three reasons to why
skewness is normally not taken in the portfolio selection analysis:
The form of utility function. If the utility function is quadratic, as assumed in
Markowitz portfolio theory, then the third derivative and all the derivatives of
higher order will be equal to zero. Therefore all the terms beyond the variance
(second derivative) in Taylor series expansion of utility function will be zero.
Distribution of the asset returns. If asset returns are normally distributed as
assumed in Markowitz portfolio theory, then the first two moments will
completely describe the distribution. That is because the distribution of returns
will then be symmetrical, and thus all moments of higher order than the variance
will be zero.
Adequacy of estimation and simplicity. When only two first moments are
considered, the optimization problem is linear and can be solved easily.
It is also important to emphasize that the skewness can be ignored in the portfolio
analysis even if the first two reasons mentioned do not hold in practice, in the case where
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investors empirically do not care about skewness in asset returns. If the (positive)
skewness of the portfolio is not appreciated by investors, it is not necessary to include
this moment in the portfolio analysis.
3.2.1. Theoretical Justification for Preference for Skewness
Consider utility function U of the investor.
If denotes the wealth of the investor,
denotes investors income
And r =


, is return on the investment
Under assumption that investors utility function depends only on the sum of his wealth
and income, the utility function can be expressed as
13
:
= ( +) = (r +)
Letting p = (r +) be expected value of the investment, the utility function can be
expressed as (p). Utility function can be represented by the infinite sum of the terms
calculated from the value of the derivatives of this function, i.e. expanded in Taylor
series:
() = |p] +

(p)
!
o
2
+

!
. +rs non r orr ons
Where Sk. is skewness of the return distribution.
It is accepted in the financial theory that any utility function has the following properties /
restrictions (e.g., Elton and Gruber, p. 214-215):
Principle of nonsatiation. This principle says that utility of (X+1) dollars will
always be larger than utility of X dollars, i.e. that investors prefer more to less.
Principle of nonsatiation requires positive first derivative of the utility function,
i.e.

>

13
See for example an article of Scott and Horvath (1980)
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Risk aversion. Investors preference for risk is usually discussed in terms of fair
gamble. In fair gamble, the expected value of a gamble is exactly equal to its
cost
14
. Risk aversion means that investors would reject a fair gamble, and would
prefer safe return rather than a risky game with the expected value of the safe
return. It is normally considered that investors would exhibit risk aversion. Risk
aversion require negative second derivative of the utility function:

<
Scott and Horvath (1980, p. 917) show that given the two principles of utility function,
the third derivative of the utility function should be positive. Thus, investors who prefer
more to less and are risk-averse should prefer positively skewed return distributions.
Furthermore, most evidence shows that investors exhibit decreasing absolute risk
aversion, i.e. when the wealth increases, the dollar amount invested in the risky assets
increases, which means decreasing risk aversion. Absolute risk aversion can be expressed
as:
() =
-

()

()

If investors exhibit decreasing absolute risk aversion, then () should be less than zero.
This means that the third derivative of utility function should be positive:

() =
-

() -

() -

() - (-

())
|

()]
2
< -

() >
If the third derivative is positive, the investors must have positive preference for
skewness.
3.2.2. Behavioral Justification for Preference for Skewness
It is intuitively easy to see why skewness should be an important factor for investors.
Clearly, investors would have preference for positive skewness, i.e. larger probability for
extremely large gains and limited loss. Preference for positive skewness can also explain
behavior of people that buy lottery tickets. Return distribution of lottery tickets is largely

14
See for example, Elton and Gruber, 2003, p. 215
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skewed to the right: there is a possibility of a very large gain, and the loss is limited to the
price of the lottery ticket.
On the other hand, people have aversion towards negative skewness. This aversion
explains why most people buy insurance: expected value of gain on insurance is negative
due to the costs of the insurance company. But insurance protects people from extremely
large losses, and people are willing to pay for that.
As for investment decisions, Alderfer and Bierman (1970) have initiated empirical study
in order to find out whether investors choose the investment alternatives that have ceteris
paribus higher skewness.
The goal of the study by Alderfer and Bierman (1970) was to see whether individuals
behave according to the assumption implicit in the mean-variance framework. Their main
hypothesis was that moments of higher order, in particular skewness, play role in the
investment decisions.
The participants faced several investment alternatives, where some of the alternatives had
similar mean and risk characteristics, but very different skewness of the return
distribution. The study has showed clear preference of the participants for the positive
skewness, even if positive skewness was associated with a lower mean return, i.e. people
were willing to pay for positive skewness.
3.3. Problems with Measurement of Skewness
It has been shown above that, both theoretically and practically, skewness as the third
moment of the distribution should be considered in portfolio analysis. This means that
skewness should probably be included as a third parameter in the portfolio theory, so that
efficient frontier is built up in mean-variance-skewness space. However, as it will be
shown below, one has to be very careful when working with skewness measure, as it
tends to be much more unstable parameter than mean and variance.
Fogler and Radcliffe (1974) have shown in their study that skewness is a very sample
sensitive measure that depends both on choice of differencing interval and initialization
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point. Fogler and Radcliffe (1974) have investigated data on DJIA
15
on the period 1954-
1963, where they have looked at annual, semiannual and quarterly data. Furthermore they
have looked at skewness measure
16
when the initialization points are different, i.e. the
data sample starts at different dates. The results of this study show that relative skewness
differs considerably with choice of differencing intervals. While annual return data in
1954-1963 are positively skewed, the semiannual and quarterly data show quite opposite
result, namely, negatively skewed returns. Skewness varies also with choice of
initialization point, i.e. the results have shown that mean and variance remain more or
less at the same level, while skewness measure is much less stable.
Beedles (1979) discusses further the results of the study by Fogler and Radcliffe (1974).
He provides theoretical explanation for such variations of skewness. In his article Beedles
(1979), where he investigates asymmetry of American equity returns, Beedles says that
the stability of skewness measure depends on whether the process generating R
t
, i.e.
returns, is stable and stationary. If the process is not stationary, the skewness measure
will be erratic and highly sample sensitive. Furthermore, he emphasizes that skewness
measure depends on whether returns are calculated as log-returns or simple arithmetic
returns. Skewness of log-returns will always be smaller than skewness of arithmetic
returns, because of the difference of the construction of the returns. However, in the study
of Beedles (1979) he finds out that skewness measure varies much more than expected
for returns calculated in these different ways.
Thus, when the skewness is utilized in some model, e.g. portfolio analysis or asset
pricing, the researcher has to be careful with respect to the choice of the following
factors:
a) Differencing intervals: annual, semiannual, monthly etc. data
b) Log-returns or arithmetic returns
c) Check stability of skewness with respect to starting dates

15
Dow Jones Industrial Average
16
They used relative skewness as measure of skewness as it shown in section 3.1., formula 3.5.
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4. Mean-Variance-Skewness Portfolio
Analysis
It has been shown above that investors consider mean, variance and skewness in their
investment decisions. Investors will choose those investment alternatives that have higher
mean, lower variance, and higher positive skewness. Thus, investment alternatives have
to be ordered on the basis of all three parameters, as portfolios will not be efficient in
mean-variance-skewness space, if only mean and variance are considered. In this section
the mean-variance-skewness model for portfolio selection is presented.
4.1. Choice of the Article
This section of the thesis presents portfolio analysis in mean-variance-skewness
17
space
and is based on the article by Athayde and Flres Jr. (2004). This article was chosen
among other articles on the same subject, because it presents a general solution to
portfolio optimization problem in mean-variance-skewness space. The article was written
in 2004, but the model described in the article is becoming more and more
acknowledged. One of the authors, Renato Flres Jr. says
18
that the model developed in
this article is mentioned nowadays in any modern book on portfolio theory, i.a. in
Satchell and Scowcroft (2003) and it is also used in i.a. Banque de France. On this basis I
believe that the model in the article has gained some recognition and that its results are
trustworthy.
In this section the reader will be introduced to the findings made in this article. However,
it is not intended to just make a summary of the article, but to explain and understand the
theory and the research made in the article. Some results and propositions of the article
will be cited closely to the text and the references are made, but afterwards each result
and proposition is explained and commented.

17
In the article of Athayde and Flres Jr., 2004, the three-moment space is defined as space defined by
mean excess returns, standard deviation and cubic root of skewness. However, I will call mean-variance-
skewness or MVS for convenience purpose.
18
From the correspondence with Mr. Renato Jr. Flres
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4.1.1. Short Introduction
The main assumption in this article is that investors like odd moments (mean, skewness)
and dislike even moments (variance, kurtosis). This assumption is based on the article by
Scott and Horvath (1980).
The main result of this paper is calculation of optimal portfolio weights, i.e. calculation of
the efficient frontier in three-dimensional space. The authors assume that the investors
consider the first three moments of the asset returns, that there exists a riskless asset and
short sales are allowed. The authors of this paper focus on the general solution, and
therefore no constraints are imposed on the portfolio weights, which might be necessary
in the real life.
The efficient set of portfolios is presented in the three-dimensional space, where the
dimensions are: excess expected return, standard deviation and cubic root of skewness as
shown in the figure 4.1. below:





Figure 4.1.: Three-moment space as defined by mean excess return, standard deviation and cubic
root of skewness. Source: self-made drawing.
This article presents a general solution to the problem and assumes the existence of the
optimum. Given the highly non-linear nature of the problem, there can be situations,
where the solution is not valid. Those situations are, however, not considered in this
paper. The goal is to find such portfolio set that maximizes skewness for a given return
and variance. It is shown in the paper that the same set presents portfolios that produce
the highest return for given skewness and variance, and the lowest variance for given
return and skewness (see Athayde and Flres Jr., 2004, p. 1337). Therefore this efficient
Excess Return
Standard deviation
Vnss
3

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set will be efficient in the three-moment space for all three parameters, i.e. investors will
not be able to find portfolio that gets better on one parameter without getting worse on
another.
4.2. Notation and some formulae
When the portfolio analysis is extended to include three moments of distribution, the
additional formulae besides those introduced in section 2.2. are needed. Namely the
formula by which the portfolio skewness can be calculated is necessary for such analysis.
Similar to the portfolio variance, portfolio skewness is not just a weighted average of
third moments of asset returns. As assets tend to move together, their returns cannot be
assumed independent. For calculation of portfolio skewness, not only skewness of returns
is needed, but also coskewness between returns. Coskewness is a measure of curvelinear
interaction that occurs in the joint statistical distribution of asset returns
19
. In this way
intuitive understanding of coskewness is similar to that of covariance between assets.
However, it is important to notice that skewness-coskewness matrix is represented by a
cubic shape as opposite to variance-covariance matrix that has a quadratic shape.
Notice that in portfolio analysis, skewness of asset returns is calculated as the third
moment of distribution and not as relative skewness. Calculation of third moment was
shown previously in section 3.1. with formula 3.3.
Coskewness between N assets is calculated as:
Formula 4.1. Coskewness between N assets:
osnss = |(

-
i

)(
]
-
]

)(
k
-
k

)] =
_ (

-
i

)(
]
-
]

)(
k
-
k

)
N
,],k


Where
i

is expected return on asset i, R


j
is actual return on asset i at time j, and N is the number of
observations.
Portfolio skewness is calculated as:

19
See for example, Simonson p. 383
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Formula 4.2. Portfolio Skewness:
o
P
3 = |
p
-
p

]
3
= o

o
]
o
k
|(

-
i

)(
]
-
]

)(
k
-
k

)]
N
,],k

Where R
p
is actual return on the portfolio, i.e. weighted average of returns at time t of all assets entering in
the portfolio,
P

is expected return on the portfolio, o

, o
]
on o
k
are weights with which assets i, j, and k are
entering the portfolio. The rest of the notation is as in formula 4.1. above.
In order to estimate portfolio skewness, the coskewness matrix for the assets is needed.
Coskewness matrix is actually a tensor, a cube of size NNN. However, it can be very
cumbersome and time-consuming to work with these dimensions. The authors are
suggesting transforming NNN cube into NN
2
matrix, i.e. slice the coskewness cube
and put the matrices together in order to get NN
2
matrix.
If there are two assets (1) and (2), the coskewness matrix will be as following (Athayde
and Flres Jr., p. 1338):

o
111
o
112
o
211
o
212
o
121
o
122
o
221
o
222

Where for example, o
121
is coskewness between asset 1 and 2 and so on.
Notice that only four elements in this matrix are different, as
112
=
121
=
211
and so on,
i.e. there is a lot of symmetry, and only
n +

elements (coskewnesses) should be


estimated and not n
3
.
In case of N assets, coskewness matrix is as following (Satchell and Scowcroft, 2003, p.
247):
H
3
= _
o
111
o
121 .
o
1n1
o
112
o
122
. o
1n2
o
11n
o
12n
. o
1nn
o
211
o
221 .
o
2n1
o
212
o
222
. o
2n2
o
21n
o
22n
. o
2nn
........................ .
o
n11
o
n21 .
o
nn1
o
n12
o
n22
. o
nn2
o
n1n
o
n2n
. o
nnn
_
If M
31
denotes a coskewness matrix between the first asset (first slice of the cube) and all
the other assets, the overall coskewness matrix can be viewed as follows:
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H
3
= ||H
31
], |H
32
], |H
33
] .|H
3n
] ]
In the case of small number of assets entering the portfolio, the coskewness matrix can in
principle be calculated in Microsoft Excel (see file MV Optimization, Sheet
Calculation of Coskewnesses in the folder Portfolio Optimization the enclosed CD).
However, when number of assets is large, calculation of coskewness matrix should not be
done manually.
The following notation is used throughout the article:
o e
n
is a vector of portfolio weights
x is a vector of expected excess returns
M
1
is a vector of mean returns
M
2
is a variance-covariance matrix
M
3
is coskewness matrix
R
p
is expected return on portfolio
o
P
2 is portfolio variance
o
P
3 is portfolio skewness
r
f
is the risk-free interest rate

The characteristics of the portfolio are found in the following way, assuming that the
vector of portfolio weights, o e
n
, is known:
Formula 4.3. Mean return of the portfolio:

P
= x
Formula 4.4. Variance of the portfolio:
o
P
2 = N
2


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Formula 4.5. Skewness of the portfolio
o
P
3 = oH
3
(o o)
Where stands for Kronecker product
20
.
4.3. Duality Results
The goal of portfolio analysis is finding the efficient set of portfolios, i.e. in the mean-
variance framework the portfolio variance is minimized given some constraints on
portfolio weights and desired return on the portfolio. Thus, the goal is optimization
problem. In order to find optimal portfolio weights and efficient frontier in the three-
dimensional space, the authors need some auxiliary results to solve a much more difficult
optimization problem. In this section, these auxiliary results will be introduced, but not
proved as it does not have any influence of the end result. The references to the article or
respective book(s) will be made, if the reader wants to get acquainted with the proofs.
Duality Result 1: This duality result is taken from Panik, 1976 (Theorem 9.12, p. 210)
and concerns finding extremum of a function when there is a single equality constraint.
This result states that the minimum of a function f(x) constrained by a single equality
condition -() = is related to the maximum of g(x), constrained by the objective
function

-() = .
This duality result is needed to ensure that the portfolios that are found by minimizing
variance for a given level of return are the same that maximize expected return for a
given level of variance.
Duality Result 2: This duality result is proved in the article and concerns finding
extremum of a function when there are two equality constraints. This result is necessary
for further analysis, because the goal is to maximize skewness while there are restrictions
on both mean return and variance of the portfolio. Duality Result 2 is called Duality
Lemma in the article.

20
Kronecker product is a special product of two matrices of arbitrary sizes. Thus, if A is (nm) matrix and B
is (pq) matrix, then C=A B is a (npmq) dimensional matrix and is defined as: C=(a
ij
B). For further
references, see for example Bellman, p. 235.
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Duality Lemma (Athayde and Flres Jr., p. 1338): Let f(x), g(x) and h(x) be real,
continuously differentiable functions of class C
2
on an open set A R
n
. If x* e A is a
strong (local) minimum of f(x), subject to -() = and

- () = , where and

are scalars, with corresponding Lagrange multiplier values given by


1
and
2
,
1
>0,
and strict second-order conditions
THEN
x* e A is also a strong (local) maximum of g(x) subject to (
-
) - () = and

- () = , with respective Lagrange multiplier values


1
x
1
and -
x
2
x
2
.
This duality result is needed for finding efficient frontier in the three-moment space, as it
ensures that efficient frontier will simultaneously: a) minimize variance for given return
and skewness; b) maximize return for given variance and skewness and c) maximize
skewness for given variance and return.
4.4. Minimum Variance Portfolio
The first step in constructing efficient frontier in three-dimensional space is rather
theoretical. A solution found to portfolios that minimize variance for given expected
portfolio return and given portfolio skewness. This chapter is not to be used as a guide to
constructing efficient frontier in practice, but merely a part that provides necessary
theoretical results.
The solution of optimization problem in mean-variance framework is also started from
this step. The goal is to find the efficient set, that is the set of portfolio that give the
highest expected return for given variance, or correspondingly the lowest variance for a
given return. By defining expected returns, a set of portfolios that produce minimum
variance for this given return is found. In mean-variance-skewness space the two
parameters: expected return and skewness are fixed from the beginning, and a set of
portfolios with minimum variance is found.
Define expected return of portfolio as E(r
p
), and portfolio skewness as o
p
3.
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Method of Lagrangian multipliers is used to solve this optimization problem:
Minimize variance: oH
2
o
Subject to following constraints:
Given return: (r
p
) = o
i
+r
]
, and
Given skewness: o
p
3 = oH
3
(o o)
Minimum variance portfolio can be found by minimizing the Lagrangian function:
min
u
I = oH
2
o +z
1
|(r
p
) -(o
i
+r
]
)] + z
2
|o
p
3 -oH
3
(o o)]
First-order conditions for the solution of this problem require that the derivatives of this
Lagrangian with respect to ,
1
and
2
are set to be equal zero.
oI
oo
= ,
oI
oz
1
= on
oI
oz
2
=
Vector = H
1
-|]r
]
denotes a vector of mean excess returns.
Number = (r
p
) -r
]
defines the given (predefined) excess return of the portfolio.
With the two definitions above the first-order conditions (derivatives set to zero) are
expressed as follows:
Formula 4.3. First-order conditions:
oI
oo
= - H
2
o = z
1
+ z
2
H
3
(o o)
oI
oz
1
= - = o
oI
oz
2
= - o
p
3 = oH
3
(o o)


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The Lagrange multipliers
1
and
2
can be found from the above expressions as:
Formula 4.4. Lagrangian multipliers:
z
1
=

4
-
2
o
p
3

4
-(
2
)
2

2
, z
2
=

0
o
p
3 -
2

4
-(
2
)
2

Where:
Formula 4.5. Calculation of A
0

0
= H
2
-1

Formula 4.6. Calculation of A
2

2
= H
2
-1
H
3
(o o)
Formula 4.7. Calculation of A
4

4
= (o o)H
3
H
2
-1
H
3
(o o)
Thus to find the solution vector of weights, for minimum variance portfolio, the
Lagrangian multipliers expressed by formula 4.4. have to be substituted into formula 4.3.
Thus, the solution to this optimization problem has to satisfy the following equation
(system of equations):
Formula 4.8. Solution to minimization problem:
H
2
o =

4
-
2
o
p
3

4
-(
2
)
2
+

0
o
p
3 -
2

4
-(
2
)
2
H
3
(o o)
As it can be seen from (4), the system is highly non-linear in . However, when the is
found for a series of given mean excess return and skewness, the optimal (minimum)
variances can be calculated by pre-multiplying (4) by vector o.
Formula 4.9. Optimal variance:
oH
2
o = o

4
-
2
o
p
3

4
-(
2
)
2
+ o

0
o
p
3 -
2

4
-(
2
)
2
H
3
(o o)
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As it was stated above: = o
i
and o
p
3 = oH
3
(o o). Therefore the following
expression for variance is simplified by these formulas:
Formula 4.9.1. Modification of formula 4.8.:
o
p
2 =

4

2
-
2
o
p
3 +
0
(o
p
3)
2

4
-(
2
)
2

Thus, the solution for minimum variance portfolio when expected return and skewness
are given, has been found. When the two parameters expected return and skewness
are changed, the minimum variance frontier can be obtained.
To proceed further in the attempt to finding efficient set in three-moment space, the
authors of the article, make the following proposition:
A positive real number k is fixed, and all pairs (, o
p
3) such that o
p
3 =
3

3
are
considered. Remember that R is a mean excess return of a portfolio and o
p
3 is portfolio
skewness. The first sentence states that from all portfolios considered, the only chosen are
those where o
p
3 =
3

3
for a given k. The number k can vary, as it will be shown later.
Three-moment space is considered in this article, where the three axes are: mean excess
return, R, standard deviation, o, and standardized skewness, y
3
- cubic root of skewness.
From the assumption above, the only points considered in the axis of standardized
skewness are those characterized by o
p
3 =
3

3
or
3
=
Proposition 1
21
: For a given k, let o define the minimum variance portfolio
22
when
= and
3
=
23
. Correspondingly, denote o
p
3 , z
1

on z
2

as variance and
Lagrange multipliers of this minimum variance portfolio,
THEN

21
Athayde and Flres Jr., 2004, p. 1340
22
Weights of this portfolio are calculated from the formula 4.8.
23
It means that the minimum variance portfolio will be different when k is changed.
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For all optimal (minimum variance) portfolios related to skewness/return pairs such that
o
p
3 =
3

3
or
3
= :
24

The solution to (4) will be o = o with corresponding minimum variance
o
p
2 = o
p
2
2
and Lagrange multipliers (3) z
1
= z

1
and z
2
= z

2
s
The two funds separation property is valid.
This proposition is proved in the article. However, this proof is omitted from this paper
because it is the result that has the main importance for understanding this article.
The result of this proposition is that once the number k is fixed, the direction is settled in
mean return-skewness space. See the visual presentation of this stand below in the figure
4.2.:





Figure 4.2.: Graphical presentation of proposition 1. Source: self-created graph.
As it is illustrated in the figure 4.2. above and presented in proposition 1, all minimum
variance portfolios in a particular direction specified by choice of number k, are
multipliers of the starting portfolio o. In the article it is stated that along these lines the
only thing that changes is the proportion of risky portfolio o and a riskless asset. Thus,
the authors say that the two fund separation property holds. That is, investors will hold a
combination of riskless asset and a market portfolio, so that the unit sum condition holds.

24
The number k is remained fixed, and the expected return, R, changes. Only portfolios with skewness

3
= are considered, and between them the optimal ones are chosen.
y
3

k-direction

1
R
k
R
kR
o
o = o
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When k changes the solution to the minimum variance portfolio also changes. In the
mean-variance-skewness space, the optimal standard deviation as a function of excess
return is a straight line defined by:

p
2 =

p
2
x
Vk
2
+1
.
Figure 4.3. presents solutions for
p
2, i.e. standard deviation, for a single direction
defined by k.





Figure 4.3.: Solutions for standard deviations in three-moment space. Source: Self-created graph.
When the k directions vary the whole of optimal variance portfolios arises. They can in
principle have different forms illustrated in the article (Athayde and Flres Jr., 2004, p.
1342). The normal and ideal case is taken from the article and presented in the figure 4.4.
below. The other cases are not considered relevant for this thesis.





Figure 4.4.: Ideal shape of the optimal three-moment set in mean-standard deviation-standardized
skewness space. Source: Athayde and Flres Jr., 2004, p. 1342
k-direction
y
3

R
y
2

R
y
3

Y
2

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As it can be seen from the two figures above and figure 2 in the article of Athayde and
Flres Jr., the shape of the optimal set has a homothetic property. Homothecy means such
transformation of space that enlarges distances with respect to a fixed point. This fixed
point is the point of intersection of the three axes. This is very important as it means that
the directions that give the highest (and lowest) mean return and skewness, are
independent of the level of standard deviation. That is, if the highest return/skewness is
found for some level of standard deviation, the same line/direction will give the highest
return/skewness for all other levels of standard deviation
25
. The next problem is to find
those directions that give the highest return and skewness. This problem is discussed in
the next section.
4.5. Finding Maximum Skewness Portfolio
In the classical Markowitz portfolio theory the duality result is used as well. The duality
result used there is that the efficient set consists of portfolios that have minimum variance
for a given return, or correspondingly (duality) that have maximum return for a given
level of variance. Construction of the efficient in mean-standard deviation-standardized
skewness set requires understanding of the three following propositions
26
:
Proposition 1: Inspired by Markowitz, the authors find the solution to the classical
optimization problem in mean-variance space. The solution to that is the celebrated
Capital Market Line as in Markowitz. However when this line is situated in the three-
moment space, the corresponding skewness and number k can be found. If it is assumed
(calculated) that the skewness of optimal portfolios is not zero then the associated
skewness and number k to the solution above (CML) can be found. By finding this
solution, the direction k associated with the highest return for a given level of standard
deviation has been found. This k is called k
R.

25
Proposition 2, Athayde and Flres Jr., p. 1343
26
Propositions 3 and 4, Athayde and Flres Jr., p. 1343 and p. 1348
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Proof
27
: Consider a classical optimization problem in mean-variance space: Minimize
variance for a given level of expected return of the portfolio.
Minimize: oH
2
o
Subject to the return constraint: = o
Notice that no constraints are placed on the weights, i.e. on the vector . In the mean-
variance framework the additional constraint would that the weights add up to 1.
Minimize Lagrangian function:
Formula 4.9. Lagrangian function:
min
u
I = oH
2
o + z
1
( -o
i
)
First-order conditions are:
Formula 4.11. First-order conditions
oI
oo
= on
oI
oz
1
=
This gives:
Formula 4.12. Derivative of Lagrangian with respect to o:
oI
oo
= H
2
o - z
1
= = H
2
o = z
1

And:
Formula 4.13. Derivative of Lagrangian with respect to Lagrangian multiplier:
oI
oz
1
= -o
i
= = = o
i


27
Proofs of this and the following two propositions are necessary as they explain the optimization
problem and the formulas in these proofs are used later in the calculation of the efficient frontier
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Using formulas 4.11 and 4.12, the Lagrangian multiplier can be found and it is equal to:
Formula 4.14. Lagrangian multiplier:
z
1
=

0

Where A
0
is calculated by formula 4.4.
When the multiplier is found, the vector of portfolio weights,
R
,
28
can be calculated from
formula 4.12.:
Formula 4.15. Weights on minimum variance portfolio:
o
R
=

0
H
2
-1

The variance of this portfolio can be calculated now when the
R
is known:
Formula 4.16. Variance on the optimal/efficient portfolio:
o
R
2 = oH
2
o =
o
i
z

=

2

0

The standard deviation as a function of expected excess return defines the Capital Market
Line in the mean-variance space as in Markowitz portfolio analysis with unlimited
riskless lending and borrowing. In the Markowitz theoretical framework only
expected/average return and variance were the factors necessary to build up the optimal
portfolio. In this framework, the skewness of the portfolios will be zero.
However, when this portfolio is considered in the three-moment framework and when the
skewness of assets entering the portfolio is not zero, the associated skewness can be
calculated for this portfolio.
The skewness of this optimal portfolio is found as:
Formula 4.17. Skewness of the efficient portfolio in mean-variance space:

28
This is the optimal portfolio associated with highest expected excess returns
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o
P
3
= oH
3
(o o) =

3

0
3
H
3
(@), r = H
2
-1

The standardized skewness is the cubic root of the expression above. Remember that k is
a ratio of standardized skewness to the expected excess return. Thus, associated k can be
calculated as:
Formula 4.18. Direction k:

R
=

R
3

=
H
3
( )
3

0

Where
R
3 is cubic root of portfolio skewness as calculated by formula 4.15. above.
As it can be seen from formula 4.16. the direction k
R
is invariant, and all maximum mean
returns lie in the same direction in mean-variance space. The situation is illustrated in the
figure 4.5. below:






Figure 4.5.: Optimal portfolios with highest possible excess returns for a given level of variance.
Source: self-made drawing.
Proposition 2: In the same way as proposed in proposition 1 the direction k that gives
optimal portfolios with highest skewness for a given level of standard deviation is found.
The minimization problem solved is one where variance is minimized subject to
skewness. This k is denoted k
S
.
Proof: The similar steps to those in proposition 1 have to be done. Variance has to be
minimized subject to skewness constraint.
R
y
3

y
2

Capital Market Line in MV space
k - direction in MVS space
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Minimize: oH
2
o
Subject to the skewness constraint: o
p
3 = oH
3
(o o)
Minimize Lagrangian function:
Formula 4.19. Lagrangian function.
min
u
I = oH
2
o +z
1
(o
p
3 -oH
3
(o o))
First-order conditions are:
Formula 4.20. First-order conditions:
oI
oo
= on
oI
oz
1
=
Thus:
Formula 4.21. Derivative of Lagrangian with respect to :
oI
oo
= H
2
o - z
1
H
3
(o o) = H
2
o = z
1
H
3
(o o)
And:
Formula 4.22. Derivative of Lagrangian to Lagrangian multiplier:
oI
oz
1
= o
p
3 -o
iM
3
(o o) = o
p
3 = oH
3
(o o)
From formulas 4.19 and 4.20 above, the value of Lagrangian multiplier can be found a
S
29
:
Formula 4.23. Lagrangian multiplier:
z
1
=
2c
p
3
3A
4
.

29
In this part of the paper the intermediate results are omitted. However, I have checked them in the
article and as there are no mistakes in the derivation of the expressions for Lagrangian multipliers etc., the
reader is directed to the article of Athayde and Flres Jr. (2004) to look at the intermediate results.
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When the value of multiplier is known, the vector of weights
S
30
can be found from
formula 4.19:
Formula 4.24. Solution to the optimization problem:
o
S
=
o
S
3

4
S
H
2
-1
H
3
(o
S
o
S
)
As it can be seen from formula 4.22., the solution to this optimization problem is defined
by a highly non-linear system.
When given skewness is equal to 1, the solution to this system will be:
Formula 4.25. Solution to the optimization problem when skewness is equal to 1:
o
S
=

4
S
H
2
-1
H
3
(o
S
o
S
)
Homothecy implies that all the other solutions are linearly related to the solution defined
by formula 4.25., i.e.
Formula 4.26. Condition of homothecy:
o
S
= o
S
o
S
3
3
= o
S

S
3
Optimal variance is thus, also by condition of homothecy:
Formula 4.27. Optimal variance:
o
S
2 = o
S
2 (
S
3)
2

These portfolios are found in variance-skewness space. However, associated expected
return, when skewness is equal to 1 can be found as usual:
Formula 4.28. Expected return when skewness is equal to 1:

= o
i


30
Optimal portfolio with the highest skewness
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Expected returns of the portfolios associated with different levels of portfolio skewness
are given as:

S
=
S

S
3
Associated direction k is invariant, i.e. independent of level of variance and is found as:
=


Proposition 3: It is furthermore proved in the article that if k
R
is the direction associated
with the highest return line (CML) and k
S
is the direction associated with the highest
skewness line, which is supposed to be unique
THEN

S

R
, i.e. the angle of the highest skewness line is greater than the one of the highest
return line.
In the figure 4.6. below the two lines - efficient frontiers that maximize return and
skewness for the given level of variance are presented.







Figure 4.6.: Illustration of efficient frontier in mean-variance-skewness space. The efficient frontier is
the area between Max Return and Max Skewness lines. Source: Athayde and Flres Jr., 2004, p. 1342
Y
3

Max Return
Max Skewness
Y
2

R
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The efficient frontier in mean-variance-skewness place, i.e. set of all portfolios where
investor cannot get any better at one parameter without getting worse at another, is the
surface limited by these two lines. In the article, it is stated that:
Within the region between the two canonical lines the lemma applies to both possible
inversions, namely, maximize skewness, given the same mean and the optimum variance,
or maximize mean excess return given the same skewness and the optimum variance.
31

5. Skewness of Stock Returns
In the theoretical part of thesis in section 3.4. it has been shown that skewness is a
parameter that is important to investor, and should be considered in the portfolio analysis.
Studies on stock returns in different countries (e.g. Beedles (1979 and 1986), Aggarwal,
Rao and Hiraki (1989)) showed significant asymmetry in stock returns. The problem with
skewness measure, as it was shown in section 3.5. is, however, that this measure can be
highly sensitive to the different parameters.
It is therefore intended in this section of the thesis to conduct a study on Danish stock
returns. The main goals of this analysis are:
1. To see whether skewness of Danish stock returns is a measure that is sensitive to:
a. Choice of differencing interval
b. Starting dates
c. Calculation of stock returns: log or arithmetic
2. To see whether Danish stock returns exhibit significant asymmetry and in case of
positive result, whether this asymmetry is persistent across time.
5.1. Data
To conduct empirical analysis of skewness, the monthly data on the stocks from
OMXC20
32
index in the period 1987-2007
33
are used. Similar to the study by Beedles

31
Athayde and Flres Jr., 2004, p. 1349
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(1986) each stock with data available for at least 25 monthly returns is taken into
analysis, i.e. only TrygVesta is not taken into analysis, as there are only 24 monthly
returns are available. In the part, where sensitivity of skewness to the initialization point
and persistence of skewness for single stocks are analyzed, only companies with
historical data available for 20 years are taken into consideration.
5.2. Sensitivity of Skewness
In this section, sensitivity of skewness towards different parameters will be analyzed.
5.2.1. Choice of Differencing Interval
In section 3.5., the study by Fogler and Radcliffe (1974) has shown that choice of
differencing interval can have an effect on the size and even the sign of skewness. For
this part of analysis, annual, monthly, weekly and daily data of the 18 stock returns have
been analyzed. Here, returns were calculated as simple arithmetic returns:
Formula 5.1. Formula of arithmetic returns:
r =

-
-1

-1

Where P
i
is the price of the stock at date i.
Skewness is calculated as relative skewness from the section 3.1. with formula 3.5. The
results are shown below in table 5.1:






32
OMXC20 is the price index of the 20 most sold Danish stocks in Copenhagen Stock Exchange. All stocks
in OMXC20 index can be seen in the Attachment 1
33
Notice that not all stocks have return data for all the years
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Daily Weekly Monthly Yearly
Carlsberg -0.228 0.210 0.103 0.364
Coloplast 0.309 0.301 0.400 0.531
Danisco -0.376 -0.012 0.033 -0.142
Danske Bank 0.870 1.069 0.766 0.716
D/S Torm 1.432 1.248 1.175 1.325
DSV -0.400 0.092 0.332 -0.211
FLSmidth 0.370 0.295 0.322 0.224
Genmab -3.627 -1.869 -0.200 -0.235
GN Store Nord 0.018 0.779 -0.117 0.281
Lundbeck -0.499 -0.177 0.418 1.116
Maersk A -0.106 0.501 0.630 1.270
Maersk B 0.762 0.658 0.597 1.165
NKT Holding 0.56 0.27 -0.87 -0.8
Nordea -0.027 -0.543 -0.345 -0.602
Novozymes 0.588 0.246 -0.165 0.080
Sydbank -0.137 1.381 1.349 0.202
Topdanmark 0.030 0.327 0.556 0.170
Vestas 1.148 0.572 -0.267 0.429
William Demant 0.482 0.864 0.271 0.708
Average 0.061 0.327 0.262 0.347
Table 5.1.: Analysis of skewness on Danish stock returns with different differencing intervals.
Skewness is calculated in E-Views as relative skewness. The formula used in E-Views is slightly different
from that stated in section 3.1., formula 3.5. and is as following: nss =
1
N
_

i
-
c

3
N
=1
, where
o = s
_
( - )

, is an unbiased estimator for the standard deviation. This formula gives approximately
the same results as with formula 3.5. from section 3.1.
From the table 5.1. above, it can be seen that average skewness has at least the same sign
and for all differencing intervals and approximately the same magnitude for weekly,
monthly and annual stock returns.
Thus, although skewness measure does seem to vary across differencing intervals, at least
average skewness for the 19 stocks is of the same sign and for the case of weekly,
monthly and annual data is of the same magnitude.
5.2.2. Initialization Point
Fogler and Radcliffe (1974) have showed in their study that skewness can change
dramatically with change of the initialization point, i.e. starting date of the returns. To see
whether this is the case for Danish stock returns, the ten stocks with monthly return data
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available for ten years have been chosen. Similar to the study of Fogler and Radcliffe
(1974) initialization point was changed quarterly, i.e. four dates were used as starting
dates for skewness analysis. The results can be seen in the table 5.2. below, where only
average skewness is presented.
Date Average Skewness
12/31/1987 0.467
3/31/1988 0.476
6/30/1988 0.465
9/30/1988 0.460
Table 5.2.: Skewness analysis for ten Danish stock returns, when initialization points are changed
quarterly. Here skewness is calculated as relative skewness in Microsoft Excel by formula 3.5. from
section 3.1.
Only the results for average skewness of the 10 stocks are presented in the table 5.2.
above. However, in the folder Skewness of Stocks on the enclosed CD the reader can
find analysis for all ten stocks, and there it can be seen that as well as in the table 5.2.
above, the skewness for all ten stocks does not seem to differ significantly with change in
the initialization point.
Even though the results from the table 5.2. above do not show significant difference
between skewness measures, when the data start at different points in time, it is worth to
notice that skewness would be different, if in the stock returns were very volatile during
1987-1988. Large deviations from the mean return do have big impact on skewness
measure.
5.2.3. Calculation of the Returns
The third problem with measurement of skewness stated in Fogler and Radcliffe (1974) is
that it depends on the way the returns are calculated. It has been shown that skewness of
log-returns is smaller than that of arithmetic returns. This result is quite logical, as
continuously compounded return distribution is asymmetrical, and thus positive and
negative returns are not the same. Positive arithmetic return will become smaller, when it
is calculated as log return, and negative return will be larger (in absolute terms) if it is
calculated as log return. Logarithmic return or continuously compounded return is
calculated as:
Efficient Portfolio Selection in Mean


Formula 5.2. Formula of log
The notation is as in formula 5.1.
Monthly return data for all 18 stocks from OMXC20
The returns are calculated as arithmetic and as log returns. The results for average mean
return, standard deviation and skewness for both types of returns are presented in the
table 5.3. below.

Average Re
Average Std. Deviation
Average Skewness
Table 5.3.: Characteristics of Danish stock returns, when returns are calculated as arithmetic and
log-returns.
Figure 5.1. below shows graphically the difference in skew
calculated as arithmetic and log
Figure 5.1.: Skewness for Danish stock returns when returns are calculated as arithmetic and log
returns.

34
Except TrygVesta
-4
Efficient Portfolio Selection in Mean-Variance-Skewness Space
January, 2008
Page 49 of 95
Formula of log-returns:

The notation is as in formula 5.1.
Monthly return data for all 18 stocks from OMXC20
34
are taken into this p
The returns are calculated as arithmetic and as log returns. The results for average mean
return, standard deviation and skewness for both types of returns are presented in the
Arithmetic Returns Log-returns
Average Return 1.66% 1.17
Average Std. Deviation 9.30% 9.35
Average Skewness 0.262 -0.333
: Characteristics of Danish stock returns, when returns are calculated as arithmetic and
below shows graphically the difference in skewness when returns are
calculated as arithmetic and log-returns for each stock:
: Skewness for Danish stock returns when returns are calculated as arithmetic and log

-2 0 2
Carlsberg
Coloplast
Danisco
Danske Bank
D/S Torm
DSV
FLSmidth
Genmab
GN Store Nord
Lundbeck
Maersk A
Maersk B
NKT Holding
Nordea
Novozymes
Sydbank
Topdanmark
Vestas
William Demant
SK, log
SK, arithmetic
Skewness Space
are taken into this part of analysis.
The returns are calculated as arithmetic and as log returns. The results for average mean
return, standard deviation and skewness for both types of returns are presented in the
returns
1.17%
9.35%
0.333
: Characteristics of Danish stock returns, when returns are calculated as arithmetic and
ness when returns are

: Skewness for Danish stock returns when returns are calculated as arithmetic and log
SK, arithmetic
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Table 5.3. and figure 5.2. above both show that indeed choice of how the returns are
calculated has a much bigger impact on skewness measure as it does on the measure of
mean return and standard deviation. Average skewness is positive for returns that are
calculated arithmetically, but negative when returns are calculated as log-returns.
5.3. Analysis of Skewness
The main goal of this analysis is to see whether probability distribution of Danish stock
returns is asymmetric. For this purpose both arithmetic and log-returns are analyzed. In
the first part of this analysis it is intended to use data for all 19 stocks from OMXC20
with minimum 25 monthly observations.
The monthly returns are chosen for the analysis for several reasons: a) because the main
subject of this thesis is static portfolio analysis, where one month is often assumed as
investment horizon; b) many previous studies on skewness use monthly data; c) section
5.2.1. showed that skewness for at least the half of Danish stock returns is similar
between different differencing intervals.
Skewness of stock returns is calculated as relative skewness using Excel formula, and it is
assumed that return distribution is skewed is skewness is larger than 0.3 (or smaller than -
0.3)
35
. The results of this analysis are presented in the table 5.4. below:
Arithmetic Returns Log-returns
Average Skewness

0.262 -0.333
% Positive Skewed 52.6% 21.05%
% Negatively Skewed 10.52% 31.58%
Table 5.4.: Analysis of Danish stock returns on the asymmetry of probability distribution.
As it can be seen from the table above, it is difficult to say anything wise about skewness
on these stock returns. If the returns are calculated as simple returns, half of the stocks
exhibit positive skewness, while it is not at all the case with log-returns, where more
stocks are negatively skewed than positively skewed.

35
Se e.g. Sun and Yan, 2003, p. 1113
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Another way to decide whether return distribution is skewed is to check for the normality
of the distribution with help of Jarque-Berra test. In normal distribution skewness is equal
to zero. Therefore if distribution is not normal according to Jarque-Berra test, then it is
skewed. In the table 5.5. below the test for normality of probability distribution of
arithmetical and log-returns is presented. All stocks with historical price data for
minimum 25 months are taken into this analysis. The normality of returns is therefore
analyzed in different time length, where the longest time period is 20 years.
Company Simple Returns Log-returns
Carlsberg 0.425* 0.456*
Coloplast 0.0000 0.0004
Danisco 0.0003 0.0000
Danske Bank 0.0000 0.0000
D/S Torm 0.0000 0.0000
DSV 0.0000 0.0000
FLSmidth 0.0000 0.0033
Genmab 0.0000 0.0000
GN Store Nord 0.0075 0.0000
Lundbeck 0.0052 0.0024
Maersk A 0.0000 0.0000
Maersk B 0.0000 0.0000
NKT Holding 0.0000 0.0000
Nordea 0.090* 0.003
Novozymes 0.620* 0.180*
Sydbank 0.0000 0.0000
Topdanmark 0.0000 0.0006
Vestas 0.488* 0.0010
William Demant 0.0001 0.0000
% of normally distributed 21% 11%
Table 5.5. Normality of monthly returns. Normality is checked with help of Jarque-Berra test, which is a
standard output from E-Views. The table shows p-values of Jarque-Berra test for the returns on each stock.
The null hypothesis in this test is that returns are normally distributed, therefore a low p-value (less than
0.05) indicates rejection of the null hypothesis at 95% level, and thus indicates returns that are not normally
distributed. The % numbers in the lowest row show the percentage of the stocks that have normally
distributed returns.
It can be seen from the table 5.5. above shows that majority of the stocks, whether they
are measure as simple or log returns are not normally distributed, and thus can be skewed.
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5.3.1. Persistence of Skewness
If skewness should enter in portfolio analysis, the investor should have some expectations
about skewness of a particular stock. Usually, when it concerns mean return and variance,
these expectations come from historical estimates of these parameters. For example, it is
assumed by investor that highly volatile stock in the past will exhibit similar volatility in
the future, and the same assumption can be made about mean return. But is it possible to
make such predictions about skewness of stock returns? The goal of this second part of
skewness analysis is to be able to answer this question for Danish stocks.
Arithmetic and log-returns of 10 Danish stock returns with available data for 20 years
will be used in this part.
The time period of 20 years is divided into four sub-periods five years. Skewness will
be estimated in each period for each stock. The purpose is to see how many stocks exhibit
positive skewness
36
in different sub-periods. Table 5.6. below shows percentage of stocks
which returns exhibited significant positive skewness in the four sub-periods and in the
overall period: 1987-2007.
Period Interval Simple Returns Log Returns
Overall 1987-2007 70.0% 20.0%
1 1987-1992 50.0% 30.0%
2 1992-1997 60.0% 30.0%
3 1997-2002 30.0% 30.0%
4 2002-2007 50.0% 20.0%
Table 5.6.: Skewness for simple and log returns for different time periods. Table shows the percentage
of stock returns that exhibit positive significant (above 0.3) skewness.
The table 5.6. shows that at least in three out of four sub-periods over half of the stocks
exhibit positively skewed returns, when returns are calculated as arithmetic returns. For
the case of log-returns, approximately 20-30% exhibited positively skewed returns.
Even though it seems as if the same percentage of the stocks exhibit positively skewed
returns over the years, it is not clear whether the same stocks keep on having positively
skewed returns, or does the skewness change its sign over the time?

36
This is because as it has been shown previously, investors would like to have stocks that exhibit positive
skewness
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The table 5.7. below shows percentage of stocks that exhibit positively skewed returns in
several time periods, i.e. persistence of skewness.
Time periods Simple Returns Log Returns
1-2 40.0% 0.0%
2-3 0.0% 0.0%
3-4 10.0% 0.0%
1-2-3 0.0% 0.0%
2-3-4 0.0% 0.0%
1-2-3-4 0.0% 0.0%
Table 5.7.: Persistence of skewness through adjacent time periods. Table shows the percentage of stock
returns that exhibit positive significant (above 0.3) skewness in the number of time periods indicated in the
column to the left. Time periods are marked as following: 1
st
time period: 1987-1992; 2
d
time period: 1992-
1997; 3
d
time period: 1997-2002 ad 4
th
time period: 2002-2007.
From the table 5.7. above it can be seen that skewness does not persist, neither in the case
of simple, nor log-returns.
These findings are similar to those of other studies of skewness, e.g. Singleton and
Wingender (1986), where it was found that while frequency of skewness remains of the
same level, the skewness does not persist across time periods. Therefore it does not seem
that historical skewness can be used as an estimate or as prediction of skewness of the
future stock returns.
5.3.2. Note on Skewness
Skewness is quite a controversial subject in the academic papers. In one hand, several
studies show that skewness should matter in the investors decisions, but in the other
hand skewness is a measure that is not easy to deal with. If skewness should be included
in portfolio theory and in pricing theory of stocks, it should be a reliable measure.
However, as it has been stated above, skewness depends often on many things, such as
differencing interval, initialization points etc., and it is confusing. Moreover, it is very
important to be able to measure whether return distributions are significantly skewed or
not, and whether skewness persists across time. Both subjects are however very difficult
to deal with. When deciding on whether distribution is skewed, many researchers have
used the test of normality, i.e. if normality hypothesis is rejected, than, they assume, the
distribution must be skewed. But this is not necessarily so, distribution can be non-
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normal, but symmetrical. The same problem is with measuring persistence of skewness.
In several studies, researchers have looked at skewness measures in different time
periods, and counted in how many time periods stock returns exhibit positive skewness,
as I have done in my study. However, this is a very rude approximation of finding
persistence of skewness. Some researchers suggest different methods for a more correct
procedure to finding whether skewness is persistent.
In this thesis, I have done a very simple study on skewness, because the main purpose of
this paper is not a deep research on skewness, which could make a subject of its own, but
portfolio analysis. Thus, it is important to the purpose of this thesis to take a standpoint to
whether return distribution of Danish stocks can be assumed normal, and to take a
shallow look at how persistence of skewness can be measured. However, if one has to
deal with this subject in practice, this matter should be studied more closely.
6. Efficient Frontier
The goal of this section is to make an empirical application of portfolio models described
above. Efficient frontiers in both mean-variance and mean-variance-skewness space will
be built up, and the comparison will be drawn between shapes, impacts etc. of both
frontiers.
6.1. Data and Methods
Both frontiers will be built up from four stocks: Carlsberg, Danisco, Maersk A and
TopDanmark.
These four stocks are chosen in such way, so two of them have positively skewed
monthly log returns (Maersk A and TopDanmark) in the period 2002-2007, one has
negatively skewed returns (Carlsberg), and one have returns that can approximately be
described with normal probability distribution (Danisco). This is because that a
hypothesis of this analysis is that stocks with positively skewed returns will have a larger
weight in maximum-skewness portfolio than they would have in traditional portfolio
model.
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A little number of stocks has been chosen because the algebra of these models, especially
in mean-variance-skewness space, is very cumbersome. Such models shall in principle be
solved in an optimization program. Because I dont have such a program, all the
calculations will be made in Microsoft Excel. The number of stocks is not of a big
importance in this thesis, as the purpose is to show different algorithms to building up
efficient frontiers, and analyze the difference between the two methods.
6.2. Stock Characteristics
The four stocks chosen have the following characteristics presented in the table 6.1.
below:
No. of
observations =
60
Mean
Return Std. Deviation Skewness Jarque-Berra
Monthly Annualized Monthly Annualized
Statistic/p-
value
CARLSBERG 1.33% 15.94% 6.01% 20.81% -1.0389 21.3 (0.000)
DANISCO 0.70% 8.36% 5.56% 19.25% 0.0563 0.215 (0.897)
MAERSK A 2.15% 25.75% 8.62% 29.87% 0.4192 4.64 (0.09)
TOPDANMARK 2.38% 28.56% 6.19% 21.45% 0.2879 1.466 (0.48)
Table 6.1.: Descriptive statistics for stocks chosen for portfolio analysis. The data used for the table are
monthly log-returns of the four stocks. Skewness is calculated as relative skewness, Jarque-Berra statistics
are calculated in E-views.
It has been stated in section 5.3. above that the majority of monthly log-returns of Danish
stocks from OMXC20 cannot be considered to be normally distributed according to
Jarque-Berra test. Some of the stocks had return distribution that could be considered
significantly asymmetric according to the measure of significant asymmetry from Sun,
Yan (2003). Thus, as it can be seen from the table 6.1. above, Carlsberg and Maersk A
have significantly skewed return distributions. Probability distribution of monthly returns
on Topdanmark is also positively skewed, even though it can be assumed to be normally
distributed according to Jarque-Berra statistics on 5% that is presented in the table 6.1.
Returns on Danisco are those that can be mostly assumed to follow normal distribution,
as the p-value from Jarque-Berra statistic is very high: 0.89.
These four stocks will be analyzed in both analyses, and thus, a comparison can be made
between the two portfolio models. As it has been stated above, the hypothesis of this
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analysis is that different combinations of these stocks will be optimal / efficient when
they are used in mean-variance model versus to when they are used in mean-variance-
skewness model.
6.3. Efficient Frontier in Mean-Variance Framework
The inputs needed for finding efficient frontier in mean-variance framework are: vector
of expected return on assets, covariance matrix and risk-free interest rate. In this case:
Expected returns:
Company Monthly mean return
CARLSBERG 1.33%
DANISCO 0.70%
MAERSK A 2.15%
TOPDANMARK 2.38%

Covariance matrix:
CARLSBERG DANISCO MAERSK A TOPDANMARK
CARLSBERG 0.003549578 0.000903325 0.001222234 0.000853754
DANISCO 0.000903325 0.003036268 0.001663012 0.001081837
MAERSK A 0.001222234 0.001663012 0.007312934 0.001695729
TOPDANMARK 0.000853754 0.001081837 0.001695729 0.003770627

Risk-free interest rate is assumed to be 4.5%.
In the traditional portfolio theory the efficient frontier with a riskless asset is found in two
steps. In the first the efficient frontier consisting of only risky assets is built up. This is
done by minimizing portfolio variance subject to expected return on portfolio and to the
fact that the weights have to sum up to one. The second step is to introduce a risk-free
asset, and to find efficient frontier that is a straight line starting at the risk-free interest
rate with the greatest slope as defined by formula 6.1. below
37
:


37
E.g., Elton and Gruber, 2003, p. 100
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Formula 6.1. Sharpe ratio:
0 =

P

-
P
o

Where
P

is expected return on the portfolio, R


F
is risk-free interest rate and is standard deviation of
portfolio returns.
In the mean-variance space the optimization problem can be solved by Lagrangian
multiplier technique relatively easy, as this is a linear optimization problem. For different
levels of expected returns, minimum variances are found and, correspondingly, so are the
weights on the risky assets. When levels of expected returns vary, different levels of
optimal variance emerge. When we have series on expected returns and variance/standard
deviation, the efficient frontier can be graphically illustrated by plugging these values in
mean-standard deviation space.
The second step is to find slope (formula 6.1. above) for different levels of expected
returns and standard deviations. This slope is known as Sharpe ratio or reward-to-
variability ratio and is used in valuation of portfolio performance. The portfolio with
greatest Sharpe ratio is the market portfolio, as this is the portfolio that every investor
wants to hold, as it maximized excess return per unit of risk.
The efficient frontier with a riskless asset is the line that goes through risk-free interest
rate and market portfolio.
The efficient frontier from the four stocks in mean-standard deviation space is calculated
in the folder Portfolio Optimization, file MV Optimization, Sheet Efficient
Frontier that can be found on the enclosed CD and is presented in the figure 6.1. below.
Efficient Portfolio Selection in Mean


Figure 6.1.: Efficient frontier in mean
there is riskless borrowing and lending available to the investor. The blue line presents efficient frontier
consisting of only risky assets.
In this case the market por
chosen for the analysis. It is, of course, not the case in real life, where, in principle, all
available assets can be set in the portfolio framework.
Below, in the figure 6.2. the weights on ri
Figure 6.2.: Portfolio weights in market portfolio.
is defined by Sharpe ratio, i.e. ratio of excess return of portfolio to its standard deviation
It can be seen from the figure above that above 26.5
shorted, and the money has to be invested 26
largest amount of money: 77
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
0 0.05
-40%
-20%
0%
20%
40%
60%
80%
100%
Efficient Portfolio Selection in Mean-Variance-Skewness Space
January, 2008
Page 58 of 95
icient frontier in mean-variance space. The read line presents efficient frontier when
there is riskless borrowing and lending available to the investor. The blue line presents efficient frontier

In this case the market portfolio consists of combination of only four stocks that were
chosen for the analysis. It is, of course, not the case in real life, where, in principle, all
available assets can be set in the portfolio framework.
the weights on risky assets in the market portfolio are shown.
: Portfolio weights in market portfolio. Market portfolio is the one that has
is defined by Sharpe ratio, i.e. ratio of excess return of portfolio to its standard deviation
m the figure above that above 26.5% of Danisco stocks have to be
the money has to be invested 26% in Carlsberg, 23% in Maersk, and
largest amount of money: 77% has to be invested in Topdanmark.
0.1 0.15 0.2 0.25 0.3
Stocks
Efficient Frontier
CML
Weights in Market Portfolio
Weights in Market
Portfolio
Skewness Space

The read line presents efficient frontier when
there is riskless borrowing and lending available to the investor. The blue line presents efficient frontier
tfolio consists of combination of only four stocks that were
chosen for the analysis. It is, of course, not the case in real life, where, in principle, all
sky assets in the market portfolio are shown.

the one that has largest slope that
is defined by Sharpe ratio, i.e. ratio of excess return of portfolio to its standard deviation (formula 6.1.)
% of Danisco stocks have to be
% in Maersk, and the
Stocks
Efficient Frontier
CML
Weights in Market
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6.4. Efficient Frontier in Mean-Variance-Skewness
Space
To build up an efficient frontier in three-moment space, I will proceed in the way that is
suggested by Athayde and Flres Jr. (2004). The inputs needed for this part of analysis
are: monthly log-returns on the four assets, risk-free interest rate, variance-covariance
matrix and coskewness matrix. All the inputs, besides coskewness matrix were already
constructed and used in section 6.3. above. The coskewness matrix is constructed as
suggested by Athayde and Flres Jr. (2004). Coskewness matrix with four assets is of
size 4*16 and can be seen in the folder Portfolio Optimization, file MVS
Optimization, Sheet Coskewness Matrix on the enclosed CD. It is not taken in the
paper, because of its size.
6.4.1. Minimum Variance Portfolio
The first step in this optimization problem is to find the line of efficient portfolios in
mean-variance space. This repeats Markowitz optimization algorithm:
Minimize variance of the portfolio with respect to the constraints of full investment
(weights sum up to one) and of expected return. When expected returns vary, the solution
to this optimization problem will also vary, and thus efficient frontier will be built.
As mentioned in section 4.6., this efficient frontier in mean-variance space repeats
Markowitz solution and constitutes the known Capital Market Line. Given the way the
objective function is formulated, the solution to this optimization problem will be weights
on risky assets. Thus, along the whole efficient frontier (CML) the only thing that
changes is how much investor borrows or lends. The proportion in the risky assets (that
constitute market portfolio) will remain constant.
Weights on risky assets in market portfolio are found by the formula 4.14 (section 4.6.),
as following:
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o
R
=

0
H
2
-1
= _
.
-.9
.
.8
_
The weights are calculated under assumption of expected return equal to 2%. It can be
seen that weights on the risky assets approximately the same as in the previous section
6.3.
The next step is to find skewness and direction k, associated with this efficient frontier
38
.
Skewness is calculated by the formula 4.15., as following:
o
R
3 = oH
3
(o o) =

3

0
3
H
3
(@), r = H
2
-1

The cubic root of skewness that corresponds to the weights calculated above is equal to
0.023. The associated k-direction is equal to the ratio of cubic root of skewness to the
expected return and in this case is equal to 1.17.
Now it is possible to construct efficient frontier (minimum variance given the expected
return, and by duality largest return given variance level) in three-moment space, as we
have return, variance and associated skewness. The figure 6.3. below shows minimum
variance efficient frontier in three-moment space.

38
Remember that it is assumed that skewness matters and is not zero for different assets.
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0.00
0.02
0.04
0.06
0.08
0.10
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.0
0.5
1.0
1.5
2.0


S
t
d
.

D
e
v
.
S
k
e
w
n
e
s
s
R
e
tu
rn

Figure 6.3.: Minimum Variance/Maximum Return Efficient Frontier in Mean-Variance-Skewness
space. The graph is constructed from actual data that can be found in the folder Portfolio Optimization,
file MV Optimization, Sheet Maximum Return Portfolio on the enclosed CD. The graph is constructed
in OriginPro.

6.4.2. Maximum Skewness Portfolios
The next step is to find maximum skewness efficient frontier, i.e. set of portfolios in
variance-skewness space that have minimum variance for a given level of skewness, and,
by duality, maximum skewness for a given level of risk.
The optimization problem now is as following:
Minimize variance subject only to skewness. When skewness is equal 1, portfolio
weights can be found as:
o
S
=

4
H
2
-1
H
3
(o
S
o
S
)
I have found portfolio weights when skewness is equal to one with help of the function
Solver in Microsoft Excel (see folder Portfolio Optimization, file MVS
Optimization, Sheet Maximum Skewness Portfolio on the enclosed CD).
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When skewness is equal to one, the weights on the four stocks are as follows:
o
S
= _
-.
-.9
.8
.8
_
It can be seen from the expression above that a large proportion of Danisco stock shall be
shorted, and large proportions of Maersk A and TopDanmark shall be purchased in order
to achieve portfolio skewness equal to one. This is due to the low skewness of these four
stocks.
All other portfolios are easy to construct, because, the homothecy implies that weights on
the portfolios with different skewness are just:
o
S
= o
S
o
S
3
3
= o
S

S
3
When skewness is equal to 0.05, which is more realistic assumption for the case of these
stocks, the weights are calculated as:
o
S
= _
-.
-.9
.8
.8
_ - . = _
-.
-.
.
.
_
So, just by varying levels of expected skewness, we can get proportion on how much we
have to invest in a single asset to get the desired portfolio skewness. As in the previous
case, the weights that emerge from the solution above are weights on the risky assets,
which remain constant in the whole efficient frontier. The only thing that changes is the
amount of money invested in risk-free asset.
Once the efficient frontier in skewness-variance space is derived, we can calculate the
associated return on these portfolios. The return associated with skewness equal to 1 can
be found as:
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= o
i
= |-. -.9 .8 .8] - _
.9
.
.
.
_ = .8
Returns on portfolios with different skewness can be found (by condition of homothecy)
as:

S
=
S

S
3
Thus, expected portfolio return with associated skewness of 0.05 is:

S
= .8 - . = .
Associated k-direction is found as:

S
=

=

.8
= .
By varying skewness, the efficient frontier associated with maximum skewness for a
given level of risk is found in mean-variance-skewness space.
6.4.3. Efficient Frontier in Mean-Variance-Skewness Space
Now that we have two efficient frontiers associated with maximum return and maximum
skewness for a given level of risk, it is time to construct an overall efficient frontier in
three-moment space.
I have calculated efficient frontier of the four stocks in three-moment space. In the figure
6.5. below the efficient frontier calculated from the actual data can be seen.
Efficient Portfolio Selection in Mean


0.00
0.02
0.00
0.05
0.10
0.15
0.20
0.25
0.30
S
t
d
.

D
e
v
.
Figure 6.5.: Efficient Frontier of the four analyzed stocks in mean
figure was constructed in OriginPro
In section 6.3. in the figure
mean-variance space were sho
with 77% of the money has
stocks, 26% - in Carlsberg, while 26.5
stock.
In the figure 6.6. below, th
be seen.
Figure 6.6.: Weights on risky assets in the market maximum skewness portfolio.
-400%
-200%
0%
200%
400%
Efficient Portfolio Selection in Mean-Variance-Skewness Space
January, 2008
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0.02
0.04
0.06
0.08
0.10 0.0
0.5
1.0
1.5
2.0
Maximum Return
Maximum Skewness
S
k
e
w
n
e
s
s
R
e
tu
r
n
: Efficient Frontier of the four analyzed stocks in mean-variance-skewness space.
OriginPro.
in the figure 6.2. the weights on the four stocks in the market portfolio in
variance space were shown, and there we could see that Topdanmark dominated
with 77% of the money has to be invested in it, 23% should be invested in Maersk A
in Carlsberg, while 26.5% of the money should be shorted with Danisco
below, the weights on risky assets in maximum skewness portfolio can
: Weights on risky assets in the market maximum skewness portfolio.
Weights in Maximum Skewness Portfolio
Weights in Maximum
Skewness Portfolio
Skewness Space
Maximum Return
Maximum Skewness

skewness space. The
the weights on the four stocks in the market portfolio in
wn, and there we could see that Topdanmark dominated
% should be invested in Maersk A
% of the money should be shorted with Danisco
maximum skewness portfolio can

: Weights on risky assets in the market maximum skewness portfolio.
Weights in Maximum
Skewness Portfolio
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From this figure it can be seen that most of the money shall be placed in Maersk, as this
is the stock with maximum skewness. The combination of the assets is quite different
from that in mean-variance market portfolio.
6.5. Conclusion
The assumption behind this empirical part of analysis is the importance of skewness in
the investment decisions. Thus, the goal has been to see how to build efficient frontier in
three-moment space and how it is different from that in two-moment space, where only
mean and variance are of significance for investors. The empirical analysis, which was
meant as an illustration of the theory described in previous chapters, has shown that
efficient frontier in three-moment space differs from that in two-moment space. In mean-
variance-skewness space efficient frontier is represented by a surface that is formed
between two lines, representing efficient frontiers in corresponding mean-variance and
skewness-variance space. In order to choose an optimal portfolio for a single investor, he
has to state his preferences concerning return, risk and skewness characteristics of his
portfolio that can be summed up in his utility function.
I have shown in the beginning of the section 5.3. that average skewness of monthly log-
returns of the stocks in Danish index OMXC20 is slightly negative, and only 17% are
shown to exhibit significant positive asymmetry. Therefore, the effect may not be very
large, and it can also be seen in the analysis in the way that skewness stays in a very low
level, even with large possibilities for shorting stocks and borrowing at risk-free interest
rate.
My conclusion is therefore that portfolio analysis in three-moment space would be more
suited if assets with a larger skewed returns are included. The same wish have several
other authors that work with three-moment portfolio models (see e.g. Konno and
Yamamoto, 2005, p. 422).
The next session looks therefore at financial products that per construction have
positively skewed returns principal-protected equity-linked structured products. This is
done in order to analyze their characteristics, to see whether they can be viewed as an
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independent investment class and whether they can be utilized in the portfolio
framework.
7. Structured Products
It is of interest of this thesis to look at structured products as an independent asset class
with its own characteristics that differ from those on stocks and bonds. The problem with
structured products is that it is a difficult subject to generalize, because they are synthetic
products, and their characteristics depend highly on the creativity of the issuers.
However, I think that structured products constitute a very interesting category of
financial instruments that can have a particular interest in terms of portfolio theory, where
three moments of return distribution are considered. The following structures are
considered:
Principal-protected notes, where investor is guaranteed to get the whole principal
back. I look exclusively at this type of structured products because this structure
guarantees positive skewness of returns on these products.
Equity-linked notes. I consider equity-linked notes, because this structure is simpler to
work with than other kinds of structured products. I believe, however, that my
empirical analysis can in principle be applied to many other kinds of structured
products.
7.1. Definition of Structured Products
39

Structured products or derivative embedded securities consist of combination of a fixed
income debt security (typically 0% coupon bond) and a derivative element that can be
either an option or a forward contract. The bond part of the product is needed to
guarantee payback of the principal at the maturity, and the derivative part gives the
desired exposure to e.g. equity market. Structured products can be linked to different
types of underlying, such equity, interest rates, commodities and currencies.

39
The following section is inspired by Satyajit, 2001
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Structured products are characterized by a high degree of customization. As structured
products are created by issuers, they can take any shape the customer needs. There are
many kinds of structured products offered in the market, and the investor can choose the
product that best suits his preferences towards risk, return etc. To choose structured
product that has a desired risk-return profile, the investor can be attentive of following
features of the product:
Coupon: can be partly of fully at risk. If there are no coupons on the product, the
risk is higher.
Redemption value: can partly or fully at risk. Principal-protected products offer,
however, full protection of the principal.
The type of derivative instruments: forward or option
In the case where the derivative element is option contract: is written or purchased
option? Call or put?
The degree of leverage
7.2. Appeal and Risks of Structured Products
Structured products have enjoyed a high growth rates in the recent years in many
countries, also in Denmark. Structured products are very appealing for a risk-averse
investor, as they guarantee that investor only can suffer a limited loss in the worst-case
scenario. But there are other important reasons for their popularity especially among
retail investors
40
:
Structured products allow participation of retail investors in the derivative
markets because of the affordable price and access into the markets, not easily
available for retail investors.
Customization: Structured products allow investors to engineer highly customized
risk-return profiles for investors seeking exposure to market price movements.
Investor can choose the products that can generate exposures consistent with
objectives of the investor.

40
Inspired by Satyajit, 2001 and article in Structured Products, 2006
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Accounting and taxation reasons.
Diversification: Structured products can help investor to get access to some asset
classes that investor otherwise do not have access to.
Structured products can seem as a dream investment from the arguments listed above, as
the loss is limited and the gain is not. However, as e.g. Danish business newspaper
Brsen emphasize in numerous articles (see for example, articles Brsen (2003) and
Brsen (2006)) investors are often not aware of the risks underlying structured products,
and in this case, when investors do not understand what they are buying, they can get
very disappointed when the product does not return what they expected. Thus, investors
have to be careful and attentive to the following risks when they are considering investing
in structured products
41
:
Although it is intended from the issuers side to avoid credit risk that exists on
the bond part, it is still there. Therefore, investors in principle bear both market
and credit risk.
Principal protection is only achieved at the maturity, structured products are most
often very illiquid, and investor can loose much more than just possible upside if
he wants to get out of this investment before maturity.
High management and transaction fees and thus less money for the option part.
Lack of transparency and risk disclosure. Products can get very complex, and
investors often do not understand what the real probability of a positive return on
these products.
7.3. Critic on Structured Products
The biggest critic of structured products and this is pretty much the largest issue
discussed in the academic articles is whether the price on structured products is fair. As
structured products often are not transparent to the investor, issuing these products can be
a very lucrative business for the issuers, as they can take large management fees.

41
Article Structured Products a Prescription for All?, Structured Products, 2006
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Academic research in this area shows that most often structured products are overpriced
and if it was possible, the investor would be much better off is he himself constructed the
product by buying bond and option on the relevant underlying. As an example of such
research on pricing of structured products, I will mention two studies, even though many
more similar studies for different markets have been made.
The first study was a research of Stoimenov and Wilkens (2004) about pricing of
structured products in German market. The results from this study were that structured
products were sold to the price which was 3-5% higher than theoretical price. Interesting
thing to notice here is that the more complex a product was, the larger price premium was
taken on the product.
Similar study was conducted on Danish structured products in the master thesis by
Srensen and Overgaard (2004) where the authors have found out that investors often pay
11% above the fair value of the product
42
. However, the bigger competition is on the
market, the closer the price will get to its theoretical value plus issue costs.
7.4. Structured Products as an Independent Asset
Class
As stated above, there are some pros and cons to investing in structured products. The
question in the light of this thesis is whether structured products can be viewed as a
separate investment class on the same level as stocks and bonds.
In practice, some investment advisers and banks have begun to recommend investing a
certain part of the portfolio in structured products. Thus, in the article Structured
Products a Prescription for All?, John Lim (2006) says:
Since structured products are tailored to investors' risk appetite, as long as investors
are made fully aware of the associated risks and potential pitfalls, they should form an
integral part of any portfolio
43


42
Srensen and Overgaard, 2004, p. 68
43
Structured Products, 2006
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Also in the article On the tour in banks supermarket
44
(11.11.2006) in the Danish
business newspaper Brsen, three banks were asked to compose a portfolio for a certain
investor, and they all were not reluctant to offer structured products as a part of the
portfolio.
Of course, an objective reader would take these recommendations with a grain of salt.
The banks are often the issuers of these products, and they would surely try to sell them
to their clients. It is interesting to see theoretically, whether structured products can be
viewed as a separate investment class or not.
Structured products is a term defining a majority of different financial products. The
common feature for all these products
45
is that they consist of a bond part and an option
part, i.e. offer principal protection and participation in the upside of the equity markets.
As such combinations, structured products get some special characteristics that are not
common for either stocks or bonds. In particular, they should exhibit higher skewness per
construction, as they offer limited loss and, at least in theory, unlimited potential gain.
From the theoretical stand point, structured products are superfluous products, as they can
be replicated by stocks and bonds. As it has been stated above, structured products
consist of a bond part, which can purchased by the investor by himself, and an option
part, which in theory can be replicated by a long position in risk-free asset and a short
position in a stock
46
. Therefore, if continuous hedging was possible, the investor could
create structured products by himself combining stocks and bonds.
In reality, however, this is not achievable for a retail investor. Partly because he does not
always have access to the same asset classes as can be offered by structured products, and
partly because continuous hedging would be a very expensive strategy for a retail
investor.
The second problem with structured products as an independent asset class is the great
variability of structured products. Structured products can have very different structures,

44
Brsen, 11
th
November 2006, original title P turen I bankernes supermarked
45
At least for those that are considered in this thesis: principal-protected equity-linked notes
46
See for example Hull, 2006, p. 243
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with different types of embedded options and different underlyings. It might be better to
view different groups of structured products as independent asset classes instead of
generalizing them and making only one asset class for all structured products. In this
thesis, I take a look on principal-protected equity-linked structured notes, but I believe
that similar analysis can be done with different types of structures.
I am well aware of the pitfalls underlying the problem with taking structured products
into portfolio analysis. However, I believe that the reasons I gave above are sufficient for
experimenting with structured products as an independent asset class in the portfolio
framework.
8. Skewness of Returns on Structured
Products
Analysis of the OMXC20 the biggest by turnover Danish stocks has shown that about
half of the stocks exhibit positive asymmetry if the returns are measured as simple
arithmetic returns. However, the size and sign of such asymmetry vary over time, and
even though the mean-variance-skewness portfolio analysis would still increase the
performance of the portfolio, the investor cannot be sure that the stock will keep its
positively skewed returns over the investment period.
The goal with this chapter is to prove a quite obvious fact that including structured
products in the portfolio would increase expected skewness for sure. The investor can be
certain of increasing the skewness of his portfolio when the structured products are
included.
Why is it obvious that structured products can be characterized by high positive
skewness?
The answer is: per construction. As it has been mentioned previously, positively skewed
return distributions are characterized by limited possibility of loss and small probability
of a large gain. The average of the return is in principle lower than that of the normal
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distribution, but it is pulled up by few very large observations. The structure of principle-
protected structured products ensures that the investor will at least get the principal back
at the maturity which means that the loss is limited, and the option part give the
possibility of participation in the upside movement of equity prices, which enlarges right
tail of return distribution.
Even though, the answer is obvious, it is important and interesting to see how the first
three moments of the return distribution vary when the different parameters and the
structure of the structured product are changed. It is necessary to take a look at these
changes, as it can provide a ground for an investment choice, when investor seeks to
maximize expected return and skewness, while minimizing variance of the portfolio.
8.1. Data and Empirical Methods
The history of Principal-Protected Notes in the Danish market does not go very far back
in the past, which means that the data for structured products are not easily available. The
products are normally not very liquid, as they are usually constructed very uniquely, and
that is the other reason for lacking empirical data on these products. However, it is still
possible to produce a distribution of the expected returns on the chosen structured
products. This comes from the fact that a structured product is a derivative on some
underlying, that is quite liquid and typically has a long history and thus return data are
available. Of these historical data the expected return, and historical standard deviation
(volatility) of the underlying can be estimated using the usual formul. Then the
underlying can be simulated with the estimated parameters and given expiry date. Given
the structure of the product, the payoff from the product can be estimated, and after that -
the return on the product.
The Law of Large Numbers ensures that the produced return distribution would be very
close to the real return distribution, assuming that enough of simulations are produced.
The procedure of the simulation will be explained in more details later in this section.
From this simulated return distribution, the expected return (mean), volatility of the data
and skewness can be estimated. For this purpose a macros Generate has been created in
the Visual Basic Application.
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The field of structured products in Denmark is still in its development phase. New
structures come to the market every day. The structure of the product has indeed an
impact on the characteristics of the product, such as mean, risk and asymmetry. In the
following, the main tendencies in the field of the structured products have been chosen.
The inspiration comes from the review of the structured bonds offered to Danish
investors by GarantiInvest
47
. Structures are sorted by the type of the embedded option in
the product.
1. Embedded call. Call option is most often used in structured products, as it gives a
good story that attracts investors. In this chapter a call will be compared to a put
option in terms of the expected characteristics of the structured product.
2. Asian option. Asian options are typically cheaper than vanilla options because of
the reduced volatility. Cheaper options give a higher participation rate, which is
important in the marketing of the products, as it makes the product more
attractive.
8.2. The Algorithm in Visual Basic Application (VBA)
The common algorithm has first been constructed in VBA
48
, which then could be
adjusted to changes in the structure of the analyzed product. The purpose of this
algorithm is to extract the return distribution of the constructed structured product. The
further analysis of the mean, variance, skewness etc. has been done in Microsoft Excel
using the usual Excel formulas. It is possible to create a function in VBA that would
automatically spit out the values of the first three moments. The reason for choosing to
construct macros/sub instead of function is that it is often interesting to see the histogram
of the return distribution, and it is only possible if the whole return distribution is
available in Excel. The procedure of the basic algorithm is as following:
1. The inputs: historic mean return and volatility of underlying, expiry of the
structured product, the value of the underlying on the trade date, strike which is

47
See their website: www.garanti-invest.dk
48
See the basic algorithm in the attachment 2
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equal to the value of the underlying on the trade date as option is issued at-the-
money, issue price, participation rate and number of paths (simulations).
2. Black-Scholes model, i.e. lognormal walk is assumed for the movement of the
underlying stock price, i.e. stock price in t+1 can be described as:
t+1
=
t
-

((-0.5c
2
)-At+cVAtN(0,1))
. The drift and the volatility used in this simulation are
estimated from the historical return data of the underlying.
3. Participation rate is calculated as: =
1-c
-rT
C

0
, where r is a risk-free interest
rate, T is time to expiry of the structured product, C is the fair price of the call
option.
4. In the basic algorithm it is assumed that the product has a vanilla call option as
embedded option, i.e. the option is not path-dependent, which means that it is only
necessary to simulate stock price at the expiry time.
5. At the expiry the payoff of the option is calculated as max (
1
-
0
, ).
6. The payoff on the structured product is calculated as
1
= + - -
max (
S
T
-S
0
S
0
, ), where P is principal, R is participation rate, S
T
is the value of the
underlying at expiry and S
0
is the value of the underlying at the trade date.
7. The return on the structured product is calculated as:
SP
T
-SP
0
SP
0
, where SP
0
is the
issue price of the structured product, and SP
T
is the value of the structured product
at expiry. The annual return is then calculated as return divided by expiry.
The stored annual returns are then analyzed in the Excel, where the mean return on the
structured product is calculated, as well as volatility, skewness, minimum and maximum
value and the histogram of the return distribution is produced. The basic algorithm can be
found in the attachment 2 and modifications can be found in the folder Structured
Products on the enclosed CD.
8.3. Analysis
In this analysis the return distribution of four structured products will be simulated. The
differences between the four products are the type of embedded options and the
underlying. I assume constant interest rate of 4.5% in the whole life period of the product;
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the same underlyings for vanilla and Asian call to make the two products comparable.
Two underlyings will be taken with different volatilities to see what impact volatility of
the underlying has on characteristics of the product. The underlyings used for this
analysis are index OMXC20 and Maersk A stock. Characteristics of the underlyings are
historical estimates for the period 2002-2007. It is furthermore assumed that issue price
of the structured product is equal to the principal, and no management fee is included in
the price of the product. This is a quite rude simplification, but as the main purpose is too
look at skewness characteristics of structured products, this assumption will not harm the
results.
This analysis will be structured in such a way that at first all four structured products will
be presented when returns on the product are calculated as log returns and arithmetic
returns, i.e. following products are constructed and analyzed:
a) Product with embedded vanilla call written on OMXC20.
b) Product with embedded vanilla call written on Maersk A stock.
c) Product with embedded Asian call written on OMXC20.
d) Product with embedded Asian call written on Maersk A stock.
The second part of the analysis is the interpretation of the simulations made in the first
part. The analysis is finished by a conclusion that sums up the results.
8.3.1. OMXC20
A vanilla option is one of the most expensive option types that can be embedded in a
structured product. The reason for that is the fact that e.g. vanilla call option gives the
investor right to participate in the total upside of the stock price increase, and its volatility
replicates the volatility on the underlying. Usually, the participation rate on a structured
product with embedded vanilla option will be lower than that on the comparable product
with e.g. with Asian features.
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In this case of simulation of a structured product Danish index OMXC20
49
stock are used
as the underlying. The mean drift and standard deviation are estimated from the historical
monthly data (annualized) for the period 2002-2007
50
. The spot is the closing price of the
index in 30th of November 2007. The issue price is assumed to be 100% of the principal,
which again is simplification as the investors normally have to pay for management fee
and other costs of the structured product. The structured product is assumed to expire in
three years
51
. The participation rate has been calculated, using the Black-Scholes formula
for pricing derivatives. Option is assumed to be issued at-the-money at the trading date.
In the table 8.1. below the inputs to the simulations and the outputs in form of descriptive
statistics of a given structured product are presented:
Inputs Outputs
Underlying: OMXC20 index Descriptive Statistics
Common Characteristics Vanilla Call
Spot 471.76 Simple Returns Log Returns
Strike 471.76 Mean 17.3% 13.2%
Issue price 100 Median 16.0% 13.1%
Principal 100 Skewness 0.849 0.240
Mean drift 0.175 Variance 0.011 0.005
Std. Deviation 0.144 Std. Deviation 10.6% 6.7%
Expiry 3 Minimum 0.0% 0.0%
No of paths 50,000 Maximum 82.7% 41.6%

Vanilla Call Asian Call
Participation rate 75% Simple Returns Log Returns
Mean 14.6% 11.6%
Asian Call Median 13.7% 11.5%
Participation rate 117% Skewness 0.641 0.155
Variance 0.008 0.004
Std. Deviation 8.9% 6.1%
Minimum 0.0% 0.0%
Maximum 62.6% 35.2%

Table 8.1.: Inputs and outputs of simulation of returns on structured product with embedded vanilla
and Asian call options written on the index OMXC20.The spot price in the column Common
characteristics is the closing price of OMXC20 on 30
th
of November 2007. Participation rate is calculated
as described in the VBA algorithm.

49
OMXC20 is the index of the 20 largest Danish companies listed on the Copenhagen Stock Exchange.
50
Estimation of the characteristics for the underlying can be found in folder Structured Products, File
Underlyings for SP on the enclosed CD
51
Three years as time to expiry will be used in the other simulations. That is done so to make the
comparison between different products possible.
Efficient Portfolio Selection in Mean


The figure 8.1. below shows the histograms of the produced return distribution for both
vanilla and Asian embedded call option, when the returns are calculated as both simple
and log returns.
Figure 8.1.: Histograms of simple and log
Asian call options written on the index OMXC20.
These simulations of the return distribution of a structured product with embedded call
option on the index OMXC20 were made in order to see at skewness characteristics of
these products. The measure of mean return of the products is disturbed, because no
management fee is assumed, which is not realistic in life. It can be seen that skewness of
returns distributions on the structured product is always positive as expected, and it is
quite large, especially for the structured product with
8.3.2. Maersk A
Maersk stock returns are more volatile than returns on the index, and therefore different
characteristics can be assumed from simulation of returns of this structured product.

0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
4
2
%
4
8
%
OMXC20. Vanilla Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
OMXC20. Asian Call.
Simple Returns.
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January, 2008
Page 77 of 95
hows the histograms of the produced return distribution for both
vanilla and Asian embedded call option, when the returns are calculated as both simple
: Histograms of simple and log-returns of structured product with embe
written on the index OMXC20.
These simulations of the return distribution of a structured product with embedded call
option on the index OMXC20 were made in order to see at skewness characteristics of
measure of mean return of the products is disturbed, because no
management fee is assumed, which is not realistic in life. It can be seen that skewness of
returns distributions on the structured product is always positive as expected, and it is
, especially for the structured product with embedded vanilla call option.
Maersk A
Maersk stock returns are more volatile than returns on the index, and therefore different
characteristics can be assumed from simulation of returns of this structured product.
4
8
%
5
4
%
6
0
%
6
6
%
7
2
%
7
8
%
8
4
%
OMXC20. Vanilla Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
OMXC20. Vanilla Call.
Log Returns.
3
6
%
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
OMXC20. Asian Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
OMXC20. Asian Call.
Log Returns.
Skewness Space
hows the histograms of the produced return distribution for both
vanilla and Asian embedded call option, when the returns are calculated as both simple


returns of structured product with embedded vanilla and
These simulations of the return distribution of a structured product with embedded call
option on the index OMXC20 were made in order to see at skewness characteristics of
measure of mean return of the products is disturbed, because no
management fee is assumed, which is not realistic in life. It can be seen that skewness of
returns distributions on the structured product is always positive as expected, and it is
embedded vanilla call option.
Maersk stock returns are more volatile than returns on the index, and therefore different
characteristics can be assumed from simulation of returns of this structured product.
3
6
%
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
OMXC20. Vanilla Call.
Log Returns.
3
6
%
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
OMXC20. Asian Call.
Log Returns.
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Inputs and outputs from the simulations are shown in the table 8.2. below:
Inputs Outputs
Underlying: OMXC20 index Descriptive Statistics
Common Characteristics
Vanilla
Call
Spot 59,800
Simple
Returns Log Returns
Strike 59,800 Mean 14.9% 10.8%
Issue price 100 Median 10.9% 9.4%
Principal 100 Skewness 1.819 0.844
Mean drift 19.9% Variance 0.024 0.008
Std. Deviation 27.0% Std. Deviation 15.4% 9.1%
Expiry 3 Minimum 0.0% 0.0%
No of paths 50,000 Maximum 138.6% 57.8%

Vanilla Call Asian Call
Participation rate 52%
Simple
Returns Log Returns
Mean 11.9% 9.2%
Asian Call Median 9.4% 8.2%
Participation rate 78% Skewness 1.402 0.729
Variance 0.013 0.006
Std. Deviation 11.5% 7.7%
Minimum 0.0% 0.0%
Maximum 97.6% 45.6%
Table 8.2.: Inputs and outputs of simulation of returns on structured product with embedded vanilla
and Asian call options written on the Maersk A stock. The spot price is the closing price of Maersk A
stock on 30
th
of November 2007. Participation rate is calculated as described in the VBA algorithm.





Efficient Portfolio Selection in Mean


The figure 8.2. below shows the histograms of the produced return dist
vanilla and Asian embedded call option, when the returns are calculated as both simple
and log returns.
Figure 8.2.: Histograms of simple and log
Asian call options written on the index OMXC20.
8.3.3. Interpretation of the
Simulations of the probability distribution of returns on self
products can be used in the analysis of the
case skewness of the return distribution
The following conclusions c
Skewness of simple and log
From the tables 8.1.,8.2. and figures 8.1., 8.2 above
is much smaller than skewness of simple returns. This supports the previous research on
skewness on stock returns. However, in the case of structured products, skewness rema
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
4
2
%
Maersk A. Vanilla Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
Maersk A. Asian Call.
Simple Returns.
Efficient Portfolio Selection in Mean-Variance-Skewness Space
January, 2008
Page 79 of 95
The figure 8.2. below shows the histograms of the produced return dist
vanilla and Asian embedded call option, when the returns are calculated as both simple

: Histograms of simple and log-returns of structured product with embedded vanilla and
the index OMXC20.
Interpretation of the Results
Simulations of the probability distribution of returns on self-constructed structured
used in the analysis of the characteristics of structured products
of the return distribution.
The following conclusions can be made from the results above:
Skewness of simple and log-returns:
8.1.,8.2. and figures 8.1., 8.2 above it is clear that skewness of log
is much smaller than skewness of simple returns. This supports the previous research on
. However, in the case of structured products, skewness rema
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
7
2
%
Maersk A. Vanilla Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
4
2
%
Maersk A. Vanilla Call.
Log Returns.
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
Maersk A. Asian Call.
Simple Returns.
0%
5%
10%
15%
20%
0
%
6
%
1
2
%
1
8
%
2
4
%
3
0
%
3
6
%
Maersk A. Asian Call.
Log Returns.
Skewness Space
The figure 8.2. below shows the histograms of the produced return distribution for both
vanilla and Asian embedded call option, when the returns are calculated as both simple


returns of structured product with embedded vanilla and
constructed structured
of structured products in this
it is clear that skewness of log-returns
is much smaller than skewness of simple returns. This supports the previous research on
. However, in the case of structured products, skewness remains
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
7
2
%
Maersk A. Vanilla Call.
Log Returns.
3
6
%
4
2
%
4
8
%
5
4
%
6
0
%
6
6
%
Maersk A. Asian Call.
Log Returns.
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positive in both cases. This is an important thing to notice, as structured products always
will be characterized by positive skewness because of their special structure. If investor is
interested in having products in his portfolio with positively skewed returns, structured
products can be a suitable product, as he can be sure of their skewness characteristics as
opposite to skewness characteristics of stock returns.
Volatility of the underlying:
Volatility of the underlying has a large impact on skewness, as it increases the probability
of very high returns and here structured products have its greatest advantage, as their
structure limits the probability of a very large loss. Both these factors increase skewness
dramatically. For example, if we compare OMXC20 index with volatility of 14.4% and
Maersk A stock with volatility of 27% as underlying for structured products, we can see
that skewness of log returns on structured product with embedded vanilla call on
OMXC20 is 0.24, while it is 0.844 on structured product written on Maersk A stock.
Type of option:
Option types that lower the volatility of the underlying produce structured products with
lower skewness of return distribution. Skewness measure shows the probability of very
high returns. Option types, as e.g. Asian option, lower this probability, and thus lower
skewness of returns on structured products with embedded option of this type. From the
figures 8.1. and 8.2. it can be seen that probability distribution of returns on structured
product is much less right skewed in the case of embedded Asian option as opposite to
the case of embedded vanilla call option.
8.4. Structured Products in the Portfolio: a Comment
It is important to notice that there is an important difference between return distribution
of structured products as I look at it in this chapter and return distribution of stocks. In the
case of structured products, I am looking at probability distribution of returns at expiry,
i.e. what return an investor can hope to get if he holds the product until expiry. As
opposite to that, return distribution on stocks can be measured daily, monthly, annually
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etc., because a stock is a liquid product and can be sold anytime at the market price. It is
not the case with structured products, as they most often are very illiquid.
However, if structured products are to be used in the portfolio models, the monthly
returns are needed, because it is necessary to find correlation between the assets. I have
tried to simulate monthly returns for structured products, making a rude assumption that
they are as liquid as stocks, and therefore can be sold anytime at the market price. The
characteristics of monthly returns on structured products are however quite different than
that on the return distribution when product is held until expiry. To take fully advantage
of structured products in the portfolio, investor should hold the product until expiry, and
the portfolio model has to be extended to a longer investment horizon.
9. Conclusion
The purpose of this thesis was to take a critical look at traditional Markowitz portfolio
theory and see on other portfolio models that will do a better job for a retail investor, and
to take a look on structured products as an independent asset class.
The following questions have been answered in the first part of the thesis concerning
portfolio theory:
What is the reason for including only mean and variance as the main parameters in
Modern Portfolio Theory?
Markowitz has argued in his article and book (Markowitz (1952) and Markowitz (1959))
that in reality investors diversify their investments, and therefore they do not only
consider expected return on the investment, as in this case they would choose to invest all
their money in one asset that give the highest expected return. Therefore other moments
must be included, such as dispersion of the distribution. Markowitz has limited himself to
looking on only mean and variance because including higher moments in the portfolio
requires more cumbersome calculations that were not easily done in the time.
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Should higher moments of probability distribution of returns such as skewness be
considered in portfolio analysis?
It is widely accepted among financial researchers that higher moments of return
distribution matter in the investment decisions. I have seen at the third moment of return
distribution as a factor important to the investor. In theory, positive skewness is valuable
to the risk-averse investor with decreasing absolute risk aversion. Furthermore, empirical
studies have shown that investors prefer those investment alternatives that offer higher
skewness, even if it means lower expected return, i.e. they are willing to pay for
additional skewness in the return distribution. Because of these reasons, I believe that
skewness should be included as the third parameter in the portfolio model.
How should portfolio theory be modified if skewness is included as the third parameter?
If skewness is included as the third parameter, the efficient frontier should be seen in
three-moment space that consists of expected return, standard deviation and cubic root of
skewness. Efficient frontier consists of the portfolios that:
Have highest expected return for given level of volatility and skewness
Have lowest volatility for given level of expected return and skewness
Have highest skewness for given level of expected return and volatility
What shape does efficient frontier take in the three-moment portfolio model?
According to the theory built in the article of Athayde and Flres Jr. (2004) the efficient
frontier is the surface in three-moment space between two lines, each of them
representing efficient frontier in mean-variance and skewness-variance space.




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Efficient frontier has the following shape in three-moment space:







The area between the red and blue line in the figure above is the surface that constitutes
efficient frontier.
Do Danish stock returns exhibit skewness? Is it persistent?
Skewness is different for returns measured as simple and log returns. Approximately half
of the analyzed stocks exhibit significant positive skewness when returns are measured as
simple returns, while only 21% of the stocks have positively skewed returns, when
returns are measured as log returns. Skewness can furthermore not be considered to be
persistent, as it varies significantly in different time periods.
If Danish stock returns are analyzed in both traditional portfolio framework and the
alternative theory including skewness, what will be the difference between the results of
the two analyses?
The efficient frontier in three-moment space is the area between the two lines as shown in
the figure above. The first line represents efficient frontier that is equal to that in mean-
variance framework. The second line is efficient frontier with maximum skewness for a
given level of volatility. The weights on market portfolio in the second efficient frontier
are different from those for market portfolio in mean-variance space. More weight is put
on the assets with higher skewness. Thus, if skewness is an important factor to the
Y
3

Max Return
Max Skewness
Y
2

R
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investor, the portfolio that is efficient in mean-variance model will not be efficient in the
three-moment portfolio framework.
The second part of the thesis considers structured products as an independent asset class.
Structured products are considered in this thesis because per construction these products
should exhibit higher skewness than stocks. Following questions have been answered:
Can structured products at all be viewed as an independent asset class?
The problem with structured products as an independent asset class is that structured
products are superfluous assets in the traditional financial theory, as they can be
replicated by stocks and bonds under assumption of continuous hedging. However, in the
case of retail investor, continuous hedging is not possible because of the high costs.
Moreover, retail investor most often cannot construct structured product by himself,
because it can be expensive and not possible to participate in the derivative market in the
same way as institutional investors can. Because of these reasons, I believe that structured
products can be viewed as a separate investment class for a retail investor.
What are characteristics of structured products? How can they be found when historical
data are most often not available?
Probability distribution of returns on structured product at the expiry can be simulated by
simulating the underlying by Monte-Carlo method. This is due to the fact that the
underlying is most often a stock or an index that have long historical data, and therefore,
under assumption that the underlying is following log-normal walk from Black-Scholes
model, it is possible to simulate the price of the underlying at the expiry in case of
embedded vanilla option, or at different dates in case of Asian option. It has been shown
that skewness of structured products, as expected, is always positive and high, especially
when the underlying is a highly volatile asset.
Can and should structured products be included in portfolio analysis?
Important feature of portfolio models is the comovement of the assets, i.e. covariance and
coskewness. In principle, the investor should have a set of probability beliefs about this
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comovement of the assets. In practice, covariance and coskewness are calculated from the
historical data on the available assets. The problem with structured products is their
uniqueness and illiquidity, which means that it is not directly possible to estimate
comovement of structured products with other assets. It can be a good idea to include
structured products in the portfolio of retail investors, as they have desirable
characteristics concerning skewness, but this is the area that needs to be developed more
before it is possible to see how structured products can enter in the portfolio models.
10. Future Direction of Research
Especially in the case when structured products or other financial assets with high
positive skewness are included as available asset classes, the three-moment portfolio
model can be a powerful tool for the investor. With this thesis I have shown that investors
in fact prefer assets with positively skewed return distributions, and that, for the case of
retail investor, structured products can be viewed as an independent asset class that will
introduce higher skewness into the portfolio.
However, this area requires further research in order to incorporate structured products
into portfolio and to make three-moment portfolio model more usable in the real world. I
suggest research in following areas:
As it has been shown in the thesis, skewness of the return distribution is a measure
that is much more sensitive to the different parameters than mean and variance. If it
has to be included in the portfolio model, one has to be sure that is measured
correctly and reflects the true characteristics of return distribution of the assets that
are of interest to the investor. Some work has been done in this area, e.g. Sengupta
and Zheng (1997), Lau, Wingender, and Amy Lau (1989) that has suggested more
correct ways to measuring skewness and persistence of skewness. However, I feel
that further research is needed in order to get skewness as an expected parameter in
portfolio models.
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I have looked in this thesis on structured products as an asset class that exhibit some
interesting skewness characteristics, and the further research is needed to find out
how precisely one can estimate comovement between structured products and other
assets.
In this thesis only third moment of return distribution has been considered as the
moment higher than variance. However, some studies show that e.g. kurtosis also of
importance to the investor, as it can be viewed as a better measure of risk than
variance, as it shows probability of large losses. Thus, Athayde and Flres Jr. have
expanded their model suggested in this thesis to included kurtosis (see the book
Advances in Portfolio Construction and Implementation by Satchell and
Scowcroft, chapter 10, 2003).




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11. Bibliography
11.1. Articles

Aggarwal, Rao and Hiraki, 1989
Raj Aggarwal, Ramesh P. Rao and Takato Hiraki, 1989, Skewness and Kurtosis in
Japanese Equity Returns: Empirical Evidence, The Journal of Financial Research, Vol.
XII, No.3
Alderfer & Bierman, 1970
Clayton P. Alderfer & Harold Bierman, 1970,Choices with Risk: Beyond the Mean and
Variance, Journal of Business, Vol. 43, Issue 3, p. 341
Arditti, 1967
Fred D. Arditti, 1967, Risk and the Required Return on Equity, Journal of Finance,
Vol.22, Issue 1, p. 19-36
Arditti, 1971
Fred D. Arditti, 1971, Another Look at Mutual Fund Performance, Journal of
Financial and Quantitative Analysis, Vol. 6, Issue 3, p. 909-912
Arditti, 1975
Fred D. Arditti, 1975, Skewness and Investors Decisions: A Reply, Journal of
Financial and Quantitative Analysis, Vol. 10, Issue 1, p. 173
Athayde & Flres Jr., 2004
Gustavo M. de Athayde, Renato G. Flores Jr., 2004, Finding a maximum skewness
portfolio a general solution to three-moments portfolio choice, Journal of Economic
Dynamics and Control, Vol. 28, pp. 1335-1352
Beedles, 1979
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William L. Beedles, 1979, On the Asymmetry of Market Returns, Journal of Financial
and Quantitative Analysis, Vol. 14, Issue 3
Beedles, 1986
William L. Beedles, 1986, Asymmetry in Australian Equity Returns, Australian
Journal of Management, Vol. 1, Issue 1
Brsen, 2003
Simon Nielsen, 2003,Investorer kritiserer komplekse obligationer, Brsen
Brsen, 2006
Simon Nielsen, 2006, Broget marked for garantiprodukter, Brsen
Fogler & Radcliffe, 1974
H. Russel Fogler & Robert C. Radcliffe, 1974, A Note on Measurement of Skewness,
Journal of Financial and Quantitative Analysis, Vol.9, Issue 3, p. 485
Francis, 1975
Jack Clark Francis, 1975, Skewness and Investors Decisions, Journal of Financial
and Quantitative Analysis, Vol.10, Issue 1, p. 163
Hicks, 1935
John Hicks, 1935, A Suggestion for Simplifying the Theory of Money, Economica,
New Series, Vol. 2, No. 5, pp. 1-19
Jean, 1971
William H. Jean, 1971, The Extension of Portfolio Analysis to Three or More
Parameters, Journal of Financial and Quantitative Analysis, Vol. 6, Issue 1, p. 505
Konno & Yamamoto, 2005
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Hiroshi Konno & Rei Yamamoto, 2005, A Mean-Variance-Skewness Model: Algorithm
and Applications, International Journal of Theoretical and Applied Finance, Vol. 8, No.
4, pp. 409-423
Lau, Wingender and Amy Lau, 1989
Hon-Shiand Lau, John R. Wingender and Amy Hing-Ling Lau, 1989, On Estimating
Skewness in Stock Returns, Management Science, Vol. 35, No.9
Leavens, 1945
Dickson H. Leavens, 1945, Diversification of Investments, Trusts and Estates, Vol. 80,
No. 5, pp. 469-473
Lintner, 1965
John Lintner, 1965, Security Prices, Risk and Maximal Gains from Diversification,
Journal of Finance, Vol. XX, No. 4, pp. 587-615
Markowitz, 1952
Harry Markowitz, 1952, Portfolio Selection, Journal of Finance, Vol.7, pp. 77-91
Pearson, 1895
Karl Pearson, 1895, Contributions to the Mathematical Theory of Evolution. II. Skew
Variations in Homogeneous Material, Philosophical Transactions of the Royal Society
A, Vol. 186, pp. 343-414
Scott & Horvath, 1980
Robert C. Scott & Philip A. Horvath, 1980, On the Direction of Preference for Moments
of Higher Order then the Variance, Journal of Finance, Vol. XXXV, No. 4
Sears & Trennepohl, 1983
R. Stephen Sears & Gary L. Trennepohl, 1983, Diversification and Skewness in Option
Portfolios, Journal of Financial Research, Vol. 6, No. 3
Sengupta and Zheng, 1997
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Jati K. Sengupta and Yijuan Zheng, 1997, Estimating Skewness Persistence in Market
Returns, Applied Financial Economics, Vol. 7, pp. 549-558
Sharpe, 1963
William F. Sharpe, 1963, A Simplified Model for Portfolio Analysis, Management
Science, Vol. 9, No. 2, pp. 277-293
Sharpe, 1964
William F. Sharpe, 1964, Capital Asset Prices A Theory of Market Equilibrium Under
Conditions of Risk, Journal of Finance, Vol. XIX, No. 3, pp. 425-442
Simonson, 1972
Donald G. Simonson, 1972, The Speculative Behavior of Mutual Funds, Journal of
Finance, Vol. 27, Issue 2, p. 381
Structured Products, 2006
John Lim, 2006, Structured Products: a Prescription for All? Structured Products, Vol.
17
Sun, Yan, 2003
Qian Sun, Yuxing Yan, 2003, Skewness Persistence with Optimal Portfolio Selection,
Journal of Banking & Finance, no. 27, pp. 1111-1121
Srensen and Overgaard, 2004
Rune Srensen, Kristian Overgaard, 2004, Analyse af aktieindekserede obligationer,
Master Thesis, Aarhus Business School
Tobin, 1958
James Tobin, 1958, Liquidity Preference as Behavior Towards Risk, The Review of
Economic Studies, Vol. 25, No. 2, pp. 65-86

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11.2. Books

Bellman, 1970
Richard Bellman, 1970,Introduction to Matrix Analysis, McGraw-Hill Book
Company, Second Edition,
Elton & Gruber, 2003
Edwin J. Elton, Martin J. Gruber, Stephen J. Brown, William N. Goetzmann, 2003,
Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, Inc., Sixth
Edition,
Gordon & Francis, 1986
Gordon J. Alexander and Jack Clark Francis, 1986, Portfolio Analysis, Prentice Hall,
Third Edition,
Hicks, 1965
John Hicks, 1965, Capital and Growth, Oxford: Clarendon, First Edition
Hull, 2006
John C. Hull, 2006, Options, Futures and Other Derivatives, Prentice Hall, Sixth
Edition
Markowitz, 1959
Harry M. Markowitz, 1959, Portfolio Selection. Efficient Diversification of Investments
John Wiley & Sons, Inc., First Printing,
Markowitz, 1987
Harry M. Markowitz, 1987, Mean-Variance Analysis in Portfolio Choice and Capital
Markets, Basil Blackwell, First Printing,
Panik, 1976
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Michael J. Panik, 1976, Classical Optimization: Foundations and Extensions, North-
Holland Publishing Company
Satchell and Scowcroft, 2003
Stephen Satchell and Alan Scowcroft, 2003, Advances in Portfolio Construction and
Implementation, Butterworth-Heinemann, First Edition
Satyajit, 2001
Das Satyajit, 2001, Structured Products and Hybrid Securities, John Wiley & Sons,
Inc. (Asia), Second Edition
Wilmott, 2007
Paul Wilmott, 2007, Paul Wilmott introduces Quantitative Finance, John Wiley &
Sons, Inc., Second Edition

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Attachment 1
Companies in OMXC20 index and Index Shares. Source: www.omxgroup.com
Full Name Last %
A.P. Mller - Mrsk A 49800.00 4.84

A.P. Mller - Mrsk B 50400.00 5.0

Carlsberg B 566.00 1.43

D/S Norden 480.00 5.26

DSV 97.50 2.36

Danisco 330.00 0.15

Danske Bank 172.75 0.73

FLSmidth & Co. 446.50 1.94

GN Store Nord 27.40 3.01

Genmab 310.50 -8.14

Lundbeck 119.50 0.42

NKT Holding 388.50 2.37

Nordea Bank 70.00 0.36

Novo Nordisk B 292.50 0.86

Novozymes B 393.00 1.03

Sydbank 187.00 2.75

Topdanmark 763.00 0.79

TrygVesta 383.50 0.13

Vestas Wind Systems 479.00 1.59

William Demant Holding 349.50 1.16


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Attachment 2
VBA code to simulation of returns on structured product.
Embedded option: Vanilla call. Underlying: OMXC20. Returns are calculated as
arithmetic returns.
Sub Generate()
Dim MultFactor As Double
Dim dW As Double
Dim CallPayoff As Double
Dim n As Long 'it is a path variable
Dim Get_Return As Double
Dim underlying_new As Double
Dim Spot As Double
Dim Strike As Double
Dim Issue_Price As Double
Dim Principal As Double
Dim Expiry As Single
Dim Performance As Single
Dim Short_Rate As Single
Dim Volatility As Double
Dim Number_Paths As Long
Dim Participation As Double
Dim Mean_Drift As Double

' The inputs are placed in Worksheet 1 in the predefined cells

Spot = Worksheets("Sheet1").Range("C3").Value
Strike = Worksheets("Sheet1").Range("C4").Value
Issue_Price = Worksheets("Sheet1").Range("C5").Value
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Principal = Worksheets("Sheet1").Range("C6").Value
Mean_Drift = Worksheets("Sheet1").Range("C7").Value
Volatility = Worksheets("Sheet1").Range("C8").Value
Expiry = Worksheets("Sheet1").Range("C9").Value
Participation = Worksheets("Sheet1").Range("C10").Value
Number_Paths = Worksheets("Sheet1").Range("C11").Value

' Clear the column in the worksheet 2, where the returns are to be placed
Worksheets("Sheet2").Range("A1:A65535").ClearContents

For n = 1 To Number_Paths 'simulation begins
underlying_new = Spot
dW = (Expiry ^ 0.5) * NormSRnd() ''generates the scaled normal random variable
MultFactor = Exp((Mean_Drift - Volatility * Volatility * 0.5) * Expiry)
underlying_new = underlying_new * MultFactor * Exp(Volatility * dW)
CallPayoff = Payoff(underlying_new, Strike, 1)
Get_Return = ((Principal + Principal * Participation * CallPayoff / Spot - Issue_Price) / Issue_Price) /
Expiry
Worksheets("Sheet2").Cells(n, 1).Value = Get_Return
Next n
' Sheet 2 is activated
Worksheets("Sheet2").Activate
End Sub

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