15.401Recitation 15.

401Recitation
6:PortfolioChoice
LearningObjectives
R i f C t ReviewofConcepts
oPortfoliobasics
oEfficientfrontier
oCapitalmarketline
Examples
ooXYZ XYZ
oDiversification
oSharperatio
oEfficientfrontier
2010/YichuanLiu 2
Review:portfoliobasics
Aportfolioisacollectionof AportfolioisacollectionofNassets((AA
11
,,A
2
,,AA
NN
)) Nassets A
2
,,
withweights(w
1
,w
2
,,w
N
)thatsatisfy
N
o

w
i
=11
i=1
Eachasset Eachasset
~
AA
ii
hasthefollowingcharacteristics: followingcharacteristics: hasthe
oReturn:
r
i
(randomvariable)
oMeanreturn:
r
i
o
2
o
ooVarianceandstd Varianceandstd.de dev.ofret ofreturn rn:
o
i
,o
i
oCovariancewithA
j
:
o
ij
2010/YichuanLiu 3
( )
Review:portfoliobasics
Thereturnofaportfoliois Thereturnofaportfoliois
N
~ ~
r
p
=

w
i
r
i
i=1
Themean/expectedreturnofaportfoliois
E(r
pp
) =r
pp
=

N
w
ii
r
ii
i=1
Thevarianceofaportfoliois
N N
o
p
2
=

w
i
w
j
o
ij
; o
p
= o
p
2
i=1 j =1
o
ii
o ; o
ij
o
Note: Note:
o
ii
o
ii
2
; o
ij
=
ij ij
oo
ii
o
jj
2010/YichuanLiu 4
Example1:XYZ
E(r)
Variance Covariance VarianceCovariance
X Y Z
X 15% 0.090 0.125 0.144
Y 10% 0.040 0.036
Z 20% 0.625
Wh t i th t d t d i f Whatistheexpectedreturnandvarianceofa
portfolioof
a. (X,Y)withweights(0.4,0.6)? withweights(0.4,0.6)? a. (X,Y)
b. (X,Y,Z)withweights(0.2,0.5,0.3)?
c. (X,Y,Z)withweights(1/3,1/3,1/3)?
2010/YichuanLiu 5
( )
Example1:XYZ
Answer: Answer:
a.
E(r
pp
) =12%;o
pp
2
=0.08880;o
pp
=29.80%
b.
E(r
p
) =14%;o
p
2
=0.10133;o
p
=31.83%
2
c.
E((r
p
)) =15%;o
p
=0.13567;o
p
=36.83%
2010/YichuanLiu 6
Example1:XYZ
Whatistheminimumpossiblevarianceofaportfolio Whatistheminimumpossiblevarianceofaportfolio
withonlyYandZ?
E(r)
Varia
X
nceCovar
Y
iance
Z
XX 15% 15% 0 090 0.090 0 125 0.125 0 144 0.144
Y 10% 0.040 0.036
Z 20% 0.625
2010/YichuanLiu 7
Example1:XYZ
Answer: Answer:
Let(w,1w)betheweightsfor(Y,Z),then
2
2
argmin||w 00.04 04 +2 (1ww)( 0 036)+ ((1w 0 625 argmin w +2ww(1 )(0.036)+ 1 w)) 0.625||
w
Firstordercondition:
2w0.04 +2(12w)(0.036)2(1w)0.625 =0
w
*
=0.8969
Theminimumvarianceportfoliois
( ) (0.8969,0.1 0.8969,0.1031 031 )
2010/YichuanLiu 8
Example2:diversification
Supp pposethatyyourp portfolioconsistsofNeqquallyy
weightedidenticalassetsinthemarket,eachof
whichhasthefollowingproperties:
ooMean=15% Mean=15%
oStddev=20%
oCovariancewithanyotherasset=0.01
Whatistheexpectedreturnandstddevofreturnof Whatistheexpectedreturnandstddevofreturnof
yourportfolioif
oN=2?
oN=5?
oN=10?
oN=?
2010/YichuanLiu 9
. \
. \
Example2:diversification
Answer: Answer:
oExpectedreturn
E r
p
==

N
1
0.15 E((r )) 0 15 ==00.15 15
i=1
N
oVariance
o r

0.2

0.01
|
0.2
|
|
+ )
0.01
( ) =
N
2
+
N
=N

2
|
N(N 1
p
i=1
N
2
i=1 jj =i
N
2
\

N
2
.
N
2
=
0.04
+
|

1
1
|
|
0.01 =0.01+
0.03
N
\
N
.
N
2010/YichuanLiu 10
( )
Example2:diversification
Answer: Answer:
oN=2:
2
E(r
pp
) =15%;o
pp
=0.0250;o
pp
=15.81%
oN=5:
15%;o
2
= o =12 65% EE((rr
p
)) ==15%;o
p
=00.0160 0160;;o
p
=12.65%
oN=10:
2
E
p
)
p
2
0.0130;
p
11 40% E((r ) =15% 15%;o =0 0130 o =11.40%
oN=:
22
E((r
p
)) =15%;o
p
=0.0100;o
p
=10.00%
2010/YichuanLiu 11
Example2:diversification
S
t
a
n
d
a
r
d

D
e
vv
i
a
t
i
o
n

o
f

RR
e
t
u
r
n

20%
18%
16%
14% 14%
12%
10%
8%
6%
4% 4%
2%
0%
0 5 10 15 20 25 30
N
2010/YichuanLiu 12
Review:diversification
20%
14%
16%
18%
R
e
t
u
r
n
Idiosyncraticriskcanbediversifiedaway;
investorsarenotcompensatedforsuchrisk
10%
12%
14%
v
i
a
t
i
o
n

o
f

Rinvestorsarenotcompensatedforsuchrisk.
4%
6%
8%
a
n
d
a
r
d

D
e
v

Systematicriskcannotbediversifiedaway;
investorsarecompensatedwithhigher
0%
2%
4%
S
t
p g
expectedreturns.
0 5 10 15 20 25 30
N
2010/YichuanLiu 13
Review:efficientfrontier
Giventwoassets,wecanformportfolioswith Giventwoassets,wecanformportfolioswith
weights(w,1w).Aswevaryw,wecanplotthepath
ofthemeanreturnandstandarddeviationof
returnoftheresultingportfolio.
Theshapeofthepathdependsonthecorrelation
b t th t betweenthettwoassets.
Whenthecorrelationislow,alargeportionofasset
returnvariationcomesfromidiosyncraticriskthat returnvariationcomesfromidiosyncraticriskthat
canbediversifiedaway.
2010/YichuanLiu 14
14
13
12
11
10
9
8
7
6
5
0 2 4 6 8 10 12 14 16 18 20
Standard Deviation (%)
p = -1
p = 0
p = .30
p = 1
D
E
E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)
Review:efficientfrontier
= 1
perfectlycorrelated
noriskreductionpotential
1 << 1
imperfectlycorrelated
someriskreductionpotential
=1 1
perfectlynegativelycorrelated
mostriskreductionpotential
Image by MIT OpenCourseWare.
2010/YichuanLiu 15
Review:efficientfrontier
Wecanrepeatthepreviousexercisefor WecanrepeatthepreviousexerciseforNNassets: assets:
2010/YichuanLiu 16
Efficient Frontier
Global Minimum
Variance Portfolio
Individual Assets
Minimum-Variance Frontier
E(r)

Image by MIT OpenCourseWare.

( )

Review:efficientfrontier
Theefficientfrontiercanbedescribedbyafunction Theefficientfrontiercanbedescribedbyafunction
*(r
p
),whichminimizestheportfoliostddevgiven
anexpectedreturn:

N
w =1
N N i
*
o (r ) min

w
i
w
jj
o
ijj
s.t.

i
N
=1
pp
{{w
i
}}
i=1 j =1

w
i
r
i
=r
p

i=1
Analyticalsolutionfor*((rr
p
)ispossiblebutdifficult )ispossiblebutdifficult Analyticalsolutionfor
toderive.
2010/YichuanLiu 17
Review:capitalmarketline
Efficientfrontier+riskfreeasset=CML Efficientfrontier+risk freeasset CML
Efficient Frontier
Risk-Free
Asset
Market Portfolio
Risk
E
x
p
e
c
t
e
d

R
e
t
u
r
n
2010/YichuanLiu 18
Image by MIT OpenCourseWare.
5
4
Example3:Sharperatio
TheSharpperatiomeasurestherewardrisktradeoffofan
assetoraportfolio.Itisdefinedas
rr
f
S= S
o
ThehigherSharperatio,themoredesirableanasset/a
pportfoliois.Supposer
ff
=5%.Whatisthepportfolioof(( , A,B) pp )
withthehighestSharperatio?
E(r) E(r)
COVVAR
A B
A 15% 0.090 0.015
B 10% 0.040
2010/YichuanLiu 19
Example3:Sharperatio
Answer: Answer:
wr
A
+ (1w)r
B
r
f
max S max
p
w w
w
2
oo
A
2
+22w((1ww))o
AB
++ 1w)
2
o
B
2
w + w1 o ((1 w) o
Method1:gridsearch
S t id f 1. Setupagridforw,e.g.,w=0,0.1,0.2,,1.0
Thefinerthegrid,themoreaccuratetheresult
2. CalculatetheSharperatioforeachw
3. FindthemaximumSharperatio.
2010/YichuanLiu 20
Example3:Sharperatio
Method1:gridsearch Method1:gridsearch
w 1w r
p
r
f

p
S
p
0 1 0.0500 0.2000 0.2500
0.1 0.9 0.0550 8 0.1897 8 0.2899
0.2 0.8 0.0600 0.1844 0.3254
0.3 0.7 0.0650 0.1844 0.3525
0.4 0.6 0.0700 0.1897 0.3689
0.5 0.5 0.0750 0.2000 0.3750
0.6 0.4 0.0800 0.2145 0.3730
0.7 0.3 0.0850 0.2324 0.3658
0.8 0.2 0.0900 0.2530 0.3558
0.9 0.1 0.0950 0.2757 0.3446
1 0 0.1000 0.3000 0.3333
2010/YichuanLiu 21
=
Example3:Sharperatio
0.40
0 34
0.36
0.38
Maximum:
0.30
0.32
0.34
w*=0.52
E(r)=12.60%
=20.26%
MaxS=0 3752
0.26
0.28
MaxS 0.3752
0.20
0.22
0.24
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
2010/YichuanLiu 22
To:
Example3:Sharperatio
Method2:ExcelSolver Method2:ExcelSolver
A B C D E
1 E(r) AssetA AssetB
2
AssetA
AssetB AssetB =1B3 =1 B3
0.15
0 1 0.1
=B3
0.09
0 015 0.015
=B4
0.015
0 04 0.04
3
44
5
r
p
r
f
=f

p
=g
S
=C7/D7
6
7
f:SUMPRODUCT(B3:B4,C3:C4) 0.05
g: SQRT(B3*D2*D3+B3*E2*E3+B4*D2*D4+B4*E2*E4) g: SQRT(B3*D2*D3+B3*E2*E3+B4*D2*D4+B4*E2*E4)
Solver
Set Target Cell ll:
$E$7
Equal To: Equal
Max
By Changing Cell:
$B$ $B$3
2010/YichuanLiu 23
Example3:Sharperatio
Method2:ExcelSolver Method2:ExcelSolver
A B C D E
1 E(r) ( ) AssetA AssetB
2
AssetA
A tB AssetB
0.52
8 0.48
0.15
0.1
0.52
0.09
0.015
0.48
0.015
0.04
3
4
5
r
p
r
f
0.076

p
0.202583
S
0.375154
6
7
2010/YichuanLiu 25
( ) ( ) ( ) ( ) ( ) ( )( )
Example3:Sharperatio
Method3:analyticalsolution Method3:analyticalsolution
oFullderivation:
2 2 2 2 2 2
r ( )
1
1
o

1
( o ( o
cS
=
(
A
r
B
) o
p

2
(
p
) 2w
A
+ 21 2w)
AB
2(1 w)o
B
)(r
p
r
f
)
1
2
1
2
cw
((o ))
p
2 2 2 2 2 2
(r
A
r
B
)(wo
A
+ 2w(1 w)o
AB
+ (1 w) o
B
)(wo
A
+ (1 2w)o
AB
(1 w)o
B
)(wr
A
+ (1 w)r
B
r
f
)
=
o
2
p
= 00 =
2 2 2 2 2 2
0 = (r
A
r
B
)(wo
A
+ 2w(1 w)o
AB
+ (1 w) o
B
)(wo
A
+ (1 2w)o
AB
(1 w)o
B
)(wr
A
+ (1 w)r
B
r
f
)
2 2 2 2 2 2
= (r
A
r
B
)(wo
A
+ 2w(1 w)o
AB
+ (1 w) o
B
)(wo
A
+ (1 2w)o
AB
(1 w)o
B
)(w(r
A
r
B
)+ r
B
r
f
)
2 2 2
= (r
AA
r
BB
)(wo
AB AB
+ (1 w)o
BB
)(wo
AA
+ (1 2w)o
AB AB
(1 w)o
BB
)(r
BB
r
ff
)
2 2 2 2 2
= |(r
A
r
B
)o
B
(o
AB
o
B
)(r
B
r
f
)||(r
A
r
B
)(o
B
o
AB
)+ (o
A
2o
AB
+o
B
)(r
B
r
f
)|w
2 2 2
= |(r
A
r
f
)o
B
(r
B
r
f
)o
AB
|+|(r
A
r
f
)(o
B
o
AB
)+ (r
B
r
f
)(o
A
o
AB
)|w
2
ww
*
=
(r
A

2
r
f
)o
B
(r
B
r
f
)o
AB
22 2
(
A
r
f
)(
B

AB
)+ r
B
r
f
))(o
A
o
AB
)) (r )(o o ) (( (
= 0.52
2010/YichuanLiu 26
Example3:Sharperatio
Method3:analyticalsolution Method3:analyticalsolution
oResultonly:
Thegeneralsolutionforthe2assetSharperatio
i i ti bl i maximizationproblemis
2
(r r )o (r r )o
ww
*
=
((r
A
r
f
))((
A
o
B
22

f
o
AB
B
))+ ((r
B
B
r
f
f
))((o
AB
A
22
o
AB
))
2010/YichuanLiu 27
Example4:efficientfrontier
GiventheriskyassetsAandBintheprevious GiventheriskyassetsAandBintheprevious
question,whatistheefficientfrontier?
E(r)
COV VAR COVVAR
A B
A 15% 0.090 0.015
B 10% 0.040
Given5%riskfreerate whatisthecapitalmarket Given5%risk freerate,whatisthecapitalmarket
line?
2010/YichuanLiu 28
Example4:efficientfrontier
Tablefromthepreviousquestion: Tablefromthepreviousquestion:
w 1w r
p p
0 1 0.1000 0.2000
0.1 0.9 0.1050 0.18897
0.2 0.8 0.1100 0.1844
0.3 0.7 0.1150 0.1844
0.4 0.6 0.1200 0.1897
0.5 0.5 0.1250 0.2000
0.6 0.4 0.1300 0.2145
0.7 0.3 0.1350 0.2324
0.8 0.2 0.1400 0.2530
0.9 0.1 0.1450 0.2757
1 0 0.1500 0.3000
2010/YichuanLiu 29
Example4:efficientfrontier
Scatterplotof(r
p
,
p
)pairs: Scatterplotof(r
p
,
p
)pairs:
0.14
0.16
Efficientfrontier
0.12
0.14
0.08
0.10
Inefficientportion
ofthefrontier
0.06
0.04
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35
2010/YichuanLiu 30
Example4:efficientfrontier
Capitalmarketline: Capitalmarketline:
0.14
0.16
Tangencyportfolio:
w=0.52
0.12
0.14
E(r)=12.60%
=20.26%
MaxS=0.3752
0.08
0.10
0.06
CMListhelinepassingthrough(0,0.05)and
tangenttotheefficientfrontier.
0.04
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35
2010/YichuanLiu 31
Example4:efficientfrontier
Themoralofthestory: Themoralofthestory:
oTheCMListangenttotheefficientfrontieratthe
tangencyportfolio.
oTh t tf li i th tf li f i k t th t oThetangencyportfolioistheportfolioofriskyassetsthat
maximizestheSharperatio.
oTheslopeoftheCMListhemaximumSharperatio.
oRationalinvestorsalwaysholdacombinationofthe
tangencyportfolioandtheriskfreeasset.The
proportiondependsoninvestorsriskpreferences. proportiondependsoninvestors riskpreferences.
2010/YichuanLiu 32
SneakPeak:CAPM
The Thetangencyportfolioisthe isthemarketportfolio portfolio.. tangencyportfolio market
Anassetssystematicriskismeasuredbybeta,which
isdefinedasthecorrelationofitsreturnandthe
marketreturn,normalizedbythevarianceofmarket
return:
o
im
||
i
=
im
2
o
m
Sinceinvestorsareonlyycomppensatedforsyystematic
risk,assetreturnisanincreasingfunctionofbeta:
~ ~
E(r
i
) =r
f
+ |
i
(r
i
r
f
)
2010/YichuanLiu 33
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15.401 Finance Theory I
Fall 2008
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