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EC 3314 - Problem Set 4

Detailed solution for the maximizations


November 6, 2014

Prepared by Francisco Oteiza for Pedro Bordalos Fall 2014 EC3314 Course. Errors
abound, Im sure.

1 Notation
For simplicity, lets call Ei E[ri ] for i = {p, s, b} and Cov(s, b) Cov(rs , rb ).

2 Minimum Variance Portfolio


Let MVP be the minimum variance portfolio
M V P = wmvp S + (1 wmvp ) B
We begin from the formula for the variance of any portfolio composed of two assets
(stocks, S, and bonds, B):
2 = w2 s2 + (1 w)2 b2 + 2 Cov(s, b) w (1 w)
Since we are looking for the combination of B and S that has the lowest variance, we
will minimize with respect to w, that is, the weight assigned to stocks, and look for the
FOC. With the expression of the weight that constitutes the MVP, then estimating the
MVPs expected return and s.d. is straightforward (see Solutions to PS4).
min 2 = w2 s2 + (1 w)2 b2 + 2 Cov(s, b) w (1 w)
2
= 2ws2 2b2 + 2wb2 + 2Cov(s, b) 4wCov(s, b) = 0
w
ws2 b2 + wb2 + Cov(s, b) 2wCov(s, b) = 0
w(s2 + b2 2Cov(s, b)) = b2 Cov(s, b)
wmvp =

b2 Cov(s, b)
s2 + b2 2Cov(s, b)

In the first step above I first distributed the square (1 w)2 before applying the
differentiation. I then proceeded normally and used the chain rule for the term with the
covariance.

2.1 Optimal Risky Portfolio


Let P be the optimal risky portfolio.

P = wp S + (1 wp ) B
As discussed in class, here we shall be looking at the Sharpe ratio, that is, how much
a portfolio pays (in terms of the risk premium) for every unit of risk we expose ourselves
to. So lets first calculate the Sharpe ratio of a portfolio composed of these two risky
assets (our old friends S and B):

Sp =
Sp =

Ep rf
p
(w2 s2

wEs + (1 w)Eb rf
+ (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2

And now we will proceed as before but this time we will look for the combination of
S and B that maximizes the portfolios Sharpe ratio.

max Sp =

(w2 s2

wEs + (1 w)Eb rf
+ (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2

We will have to apply the quotient rule, so the first thing we will do is define the
terms. Recall that the quotient rule states the following:
g(x)
h(x)
g 0 (x)h(x) g(x)h0 (x)
then f 0 (x) =
h(x)2
if f (x) =

So if we call the Sharpe ratio defined above f (w), and define:


g(w) = wEs + (1 w)Eb rf and
h(w) = (w2 s2 + (1 w)2 b2 + 2 w (1 w) Cov(s, b))1/2
Now,
g 0 (w) = Es Eb

And in the same way, we find the derivative of h(w):


h0 (w) =

1 (2ws2 2b2 + 2wb2 + 2Cov(s, b) 4wCov(s, b))


2 (w2 s2 + (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2

h0 (w) =

ws2 b2 + wb2 + Cov(s, b) 2wCov(s, b)


(w2 s2 + (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2

h0 (w) =

w(s2 + b2 2Cov(s, b)) b2 + Cov(s, b)


(w2 s2 + (1 w)2 b2 + 2 w (1 w) Cov(s, b))1/2

h0 (w) =

w(s2 + b2 2Cov(s, b)) b2 + Cov(s, b)


p

In the last step above, for simplicity we have expressed the denominator as h(w) = p ,
but we will get back to this later. In the same way, we will for now write h(w)2 = p2 .
Now get ready, here comes a tricky part:
f 0 (w) =

g 0 (w)h(w) g(w)h0 (w)


h(w)2

(Es Eb )p (wEs + (1 w)Eb rf )(


S p
=
w
p2

w(s2 +b2 2Cov(s,b))b2 +Cov(s,b)


)
p

Now we can set the FOC for the maximization, that states that S
w = 0 and this will
make our life much easier, since we can quickly remove the denominator of the expression
above.

0 = (Es Eb )p (wEs + (1 w)Eb rf )(

w(s2 + b2 2Cov(s, b)) b2 + Cov(s, b)


)
p

0 = (Es Eb )p2 (wEs + (1 w)Eb rf )(w(s2 + b2 2Cov(s, b)) b2 + Cov(s, b))


Now go get coffee. Ready?
Ok, now we will replace p2 = w2 s2 + (1 w)2 b2 + 2 w (1 w) Cov(s, b) in the expresion above, and expand all the brackets. You will arrive at an expression with many
(many!) terms but you will notice that you can cancel many of them out. After this
cancelling procedure, you should arrive at the following:
0 = Es b2 wEs b2 + wEs Cov(s, b) wEb s2 Eb Cov(s, b) wEb Cov(s, b)
+ wrf s2 rf b2 + wrf b2 + rf Cov(s, b) 2wrf Cov(s, b)
w((Es rf )b2 + (Eb rf )r2 (Es + Eb 2rf )Cov(s, b)) = (Es rf )b2 (Eb rf )Cov(s, b)
w =

(Es rf )b2 (Eb rf )Cov(s, b)


(Es rf )b2 + (Eb rf )r2 (Es + Eb 2rf )Cov(s, b)

And this is the expression we had to arrive at (check in the PS solutions). Success!
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