Lecture 1

Lecture 1
(Chapter Seven)
Optimal Risky Portfolios
INVESTMENTS || BODIE,
Based on INVESTMENTS BODIE, KANE,
KANE, MARCUS
MARCUS
Major parts with Copyright © 2018 McGraw-Hill Education. All rights reserved.
Content
• Diversification and Portfolio Risk
• Portfolios of Two Risky Assets
• Asset Allocation with Stocks, Bonds, and Bills
• The Markowitz portfolio optimization model
7-2 INVESTMENTS | BODIE, KANE, MARCUS

The Investment Decision
• Top-down process with 3 steps:

1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class

Financial securities are risky because:
Apple Monthly returns 1990-2010
0.6
0.4
0.2
0
Feb-90
Feb-91
Feb-92
Feb-93
Feb-94
Feb-95
Feb-96
Feb-97
Feb-98
Feb-99
Feb-00
Feb-01
Feb-02
Feb-03
Feb-04
Feb-05
Feb-06
Feb-07
Feb-08
Feb-09
Feb-10
-0.2
-0.4
-0.6 Mean return: 2.5% Volatility: 14.7%
-0.8

Diversification and Portfolio Risk
• Market risk
• Risk attributable to marketwide risk sources and
remains even after extensive diversification
• Also call systematic or nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic

Portfolios reduce risk through diversification
Portfolios reduce risk through diversification

Improved
Profit analyst Product
New CEO warning recommendation recall
security A
Portfolio of
both A + B
Price
Security B
New CEO Improved
Profit Product analyst
warning recall recommendation
Time

Figure 7.1 Portfolio Risk and
the Number of Stocks in the Portfolio
Panel A: All risk is firm specific. Panel B: Some risk is systematic or marketwide.

Figure 7.2 Portfolio Diversification

Content

Portfolios of Two Risky Assets
• Expected Return: The expected return on the
portfolio is a weighted average of expected returns
on the component securities with portfolio
proportions as weights
• Portfolio risk: (variance) depends on the covariance/
correlation between the returns of the assets in the
portfolio
• Covariance and the correlation coefficient: provide a
measure of the way returns of two assets move
together (covary)

7-10
Portfolios of Two Risky Assets:
Return
• Portfolio return: rp = wDrD + wErE
• wD = Bond weight
• rD = Bond return
• wE = Equity weight
• rE = Equity return
E(rp) = wD E(rD) + wEE(rE)

Risk
• Portfolio variance:
 p2  wD2  D2  wE2 E2  2wD wE Cov  rD , rE 
•  D2 = Bond variance
•  2
E
= Equity variance
• Cov  rD , rE  = Covariance of returns for bond

and equity

Covariance
• Covariance of returns on bond and equity:
Cov(rD,rE) = DEDE
• D,E = Correlation coefficient of returns

• D = Standard deviation of bond returns
• E = Standard deviation of equity returns

Covariance
• Another way to express variance of the
portfolio:

Table 7.2 Computation of Portfolio
Variance From the Covariance Matrix

Three-Asset Portfolio

The n-security case: the variance still equals the
sum of all values in all rows and columns

Correlation Coefficients (1 of 3)
• Range of values for 1,2
 1.0    1.0
• If  = 1.0  perfectly positively correlated securities
• If  = 0  the securities are uncorrelated
• If  = - 1.0  perfectly negatively correlated securities

• The amount of possible risk reduction through
diversification depends on the correlation
• The risk reduction potential increases as
the correlation approaches -1
• When ρDE = 1, there is no diversification
 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible
P  0,
D
wE   1  wD
 D  E

Example — 50%/50% Split
Expected Return: E (rp )  w D E (rD )  wE E (rE )

 .50  8%  .50 13%  10.5%
Variance:  p2  wD2  D2  wE2  E2  2wD wE Cov  rD , rE 
 .502  122  .502  202  2  .5  .5  72  172
 P  172  13.23%
INVESTMENTS | BODIE, KANE, MARCUS
Figure 7.3 Portfolio Expected Return as a
Function of Investment Proportions

Example

Figure 7.4 Portfolio Standard Deviation as a
Function of Investment Proportions

Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation

The Minimum Variance Portfolio
• The minimum variance portfolio: the portfolio
composed of risky assets with smallest standard
deviation
• Risk reduction depends on the correlation:

• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of
either component asset
• If  = -1.0, a riskless hedge is possible

The Minimum Variance Portfolio
Finding minimum variance portfolio

 p  wD D  wE E  2wD wE Cov  rD , rE 
2 2 2 2 2
• substitute 1 - wD for wE
• differentiate respect to wD,
• set the derivative = 0

Content

The Opportunity Set of the Debt and
Equity Funds and Two Feasible CALs
Portfolio A:82% bonds
and 18% stocks
Portfolio A
E (rA )  8.9%
 A  11.45%
Portfolio B: 70% bonds
and 30% stocks
Portfolio B
E (rB )  9.5%
 B  11.70%

Asset Allocation with Two Risky Assets
• Risk-Return Trade-Off
• Investment opportunity set
• Available portfolio risk-return combinations
• Mean-Variance Criterion
• If E(rA) ≥ E(rB) and σA ≤ σB
• Portfolio A dominates portfolio B

7-30
The Sharpe Ratio
(The Reward-to-Volatility )
• Maximize the slope of the CAL for any possible
portfolio, P
• Slope of CAL is Sharpe Ratio of Risky Portfolio
• The objective function is the slope:
E rp   rf
Sp 
p

7-31
The Optimal Risky Portfolio with a Risk-
Free Asset
• Calculating Optimal Risky Portfolio
• Two risky assets
[ E (rB )  rf ] S2  [ E (rs )  rf ] B S  BS
wB 
[ E (rB )  rf ] S2  [ E (rs )  rf ] B2  [ E (rB )  rf  E (rs )  rf ] B S  BS
wS  1  wB

7-32
The Sharpe Ratio:
Example
Portfolio A
E (rA )  8.9%
 A  11.45%
E  rA   rf 8.9%  5%
SA    .34
A 11.45%
Portfolio B
E (rB )  9.5%
 B  11.70%
E  rB   rf 9.5%  5%
SB    .38
B 11.70%
Debt and Equity Funds with the
Optimal Risky Portfolio
Optimal Risky Portfolio
E (rP )  11%
 P  14.2%
E  rP   rf
SP 
P
11%  5%

14.2%
 .42

Determination of the Optimal
Overall Portfolio (1 of 7)
Investor Types
• Risk Averse Investors:

A0
• Risk-Neutral Investors:
A0
• Risk Lovers:
A0
Where A = Coefficient of risk aversion

Indifference Curves
Equally preferred
portfolios will lie in the
mean–standard
deviation plane on an
indifference curve,
which connects all
portfolio points with
the same utility value

Utility as a Function of Allocation to the
Risky Asset, y
MaxU  rf  y[ E (rP )  rf ]  1 2 Ay 2 P2
y
To find max, take derivative w.r.t. y and set equal to 0

[ E (rP )  rf ]  Ay P2  0
Solve for y
E (rP )  rf
y* 
A P2
Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4

Optimal Allocation to P
A4
E  rP   rf
y
A P2
11%  5%
  .7439
4  (14.2%) 2


The Proportions of the
Optimal Complete Portfolio (7 of 7)
Overall Portfolio
E (rP )  11% y  .7439
 P  14.2% rf  5%
E (rOverall )  y  E (rp )  (1  y )  rf
 .7439 11%  .2561 5%
 9.46%
 Overall  .7439 14.2%  10.56%
9.46%  5%
SOverall   .42
10.56%

Content

Optimal portfolio construction
Steps of portfolio construction
• Step 1: Determine the risk-return opportunities
available from the set of risky assets
• Step 2: Identify the risky optimal portfolio by
finding the portfolio weights that result in the
steepest CAL
• Step 3: choose an appropriate complete portfolio
by mixing the risk-free asset with the optimal risky
portfolio.

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Markowitz Portfolio Optimization
Model (1 of 6)
• Security selection
• Step 1: Determine the risk-return opportunities
available
• All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations

7-44
Portfolios Constructed with Three
Stocks

7-45
The Minimum-Variance
Frontier of Risky Assets

Efficient Diversification with Many
Risky Assets
• Efficient Frontier of Risky Assets
• Graph representing set of portfolios that
maximizes expected return at each level of
portfolio risk
• Three methods
• Maximize risk premium for any level standard deviation
• Minimize standard deviation for any level risk premium
• Maximize Sharpe ratio for any standard deviation or risk
premium

7-47
Efficient Diversification with Many
Risky Assets

Model (2 of 6)
• Step 2: Search for the CAL with the highest reward-to-
variability ratio  Optimal Risky Portfolio
• Optimal portfolio CAL tangent to efficient frontier
• Optimal Risky Portfolio

• Best combination of risky and safe assets to form
portfolio
• Everyone invests in P, regardless of their degree of risk

aversion
• More risk averse investors put less in P
• Less risk averse investors put more in P

7-49
The Efficient Frontier of
Risky Assets with the Optimal CAL

Model (3 of 6)
• Step 3: Capital Allocation and the Separation
Property
• Portfolio choice problem may be separated into
two independent tasks
• Determination of the optimal risky portfolio is purely
technical
• Allocation of the complete portfolio to risk-free versus
the risky portfolio depends on personal preference

7-51
Capital Allocation Lines with Various
Portfolios from the Efficient Set

Model (4 of 6)
• The Power of Diversification
• Remember:
 p2   wi w j Cov  ri , rj 
n n
i 1 j 1
• If we define the average variance and average

covariance of the securities as:

7-53
Model (5 of 6)
• The Power of Diversification
• We can then express portfolio variance as
• Portfolio variance can be driven to zero if the

average covariance is zero
• The irreducible risk of a diversified portfolio
depends on the covariance of the returns

Risk Reduction of
Equally Weighted Portfolios
Insurance
principle

The Normal Distribution
• Investment management is easier when returns are
normal
• Standard deviation is a good measure of risk when
returns are symmetric
• If security returns are symmetric, portfolio returns will
be as well
• Future scenarios can be estimated using only the
mean and the standard deviation
• The dependence of returns across securities can be
summarized using only the pairwise correlation
coefficients
Figure 5.4 The Normal Distribution
Mean = 10%, SD = 20%

Normality and Risk Measures
• What if excess returns are not normally

distributed?
• Standard deviation is no longer a complete
measure of risk
• Sharpe ratio is not a complete measure of
portfolio performance
• Need to consider skewness and kurtosis

Figure 5.5A Normal and Skewed Distributions
Mean = 6%, SD = 17%

Figure 5.5B Normal and Fat-Tailed
Distributions
Mean = .1, SD = .2

Normality and Risk Measures
• Value at Risk (VaR)

• Loss corresponding to a very low percentile of the
entire return distribution, such as the fifth or first
percentile return
• Expected Shortfall (ES)
• Also called conditional tail expectation (CTE),
focuses on the expected loss in the worst-case
scenario (left tail of the distribution)
• More conservative measure of downside risk than
VaR

Model (6 of 6)
• Optimal Portfolios and Nonnormal Returns
• Fat-tailed distributions can result in extreme
values of VaR and ES
• If other portfolios provide sufficiently better VaR

and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions

7-62
Wrap up

Lecture 1 - Chap7 BKM

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Lecture 1 - Chap7 BKM

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• Diversification and Portfolio Risk

• Portfolios of Two Risky Assets

• Asset Allocation with Stocks, Bonds, and Bills

• The Markowitz portfolio optimization model

7-2 INVESTMENTS | BODIE, KANE, MARCUS

• Top-down process with 3 steps:

7-3 INVESTMENTS | BODIE, KANE, MARCUS

Apple Monthly returns 1990-2010

-0.6 Mean return: 2.5% Volatility: 14.7%

7-4 INVESTMENTS | BODIE, KANE, MARCUS

7-5 INVESTMENTS | BODIE, KANE, MARCUS

Portfolios reduce risk through diversification

7-6 INVESTMENTS | BODIE, KANE, MARCUS

7-7 INVESTMENTS | BODIE, KANE, MARCUS

7-8 INVESTMENTS | BODIE, KANE, MARCUS

• Diversification and Portfolio Risk

• Portfolios of Two Risky Assets

• Asset Allocation with Stocks, Bonds, and Bills

• The Markowitz portfolio optimization model

7-9 INVESTMENTS | BODIE, KANE, MARCUS

7-10 INVESTMENTS | BODIE, KANE, MARCUS

E(rp) = wD E(rD) + wEE(rE)

7-11 INVESTMENTS | BODIE, KANE, MARCUS

• Cov  rD , rE  = Covariance of returns for bond

7-12 INVESTMENTS | BODIE, KANE, MARCUS

• D,E = Correlation coefficient of returns

7-13 INVESTMENTS | BODIE, KANE, MARCUS

7-14 INVESTMENTS | BODIE, KANE, MARCUS

7-15 INVESTMENTS | BODIE, KANE, MARCUS

7-16 INVESTMENTS | BODIE, KANE, MARCUS

7-17 INVESTMENTS | BODIE, KANE, MARCUS

7-18 INVESTMENTS | BODIE, KANE, MARCUS

7-20 INVESTMENTS | BODIE, KANE, MARCUS

Expected Return: E (rp )  w D E (rD )  wE E (rE )

7-22 INVESTMENTS | BODIE, KANE, MARCUS

7-23 INVESTMENTS | BODIE, KANE, MARCUS

7-24 INVESTMENTS | BODIE, KANE, MARCUS

7-25 INVESTMENTS | BODIE, KANE, MARCUS

• Risk reduction depends on the correlation:

7-26 INVESTMENTS | BODIE, KANE, MARCUS

Finding minimum variance portfolio

7-27 INVESTMENTS | BODIE, KANE, MARCUS

• Diversification and Portfolio Risk

• Portfolios of Two Risky Assets

• Asset Allocation with Stocks, Bonds, and Bills

• The Markowitz portfolio optimization model

7-28 INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

7-30 INVESTMENTS | BODIE, KANE, MARCUS

7-31 INVESTMENTS | BODIE, KANE, MARCUS

7-32 INVESTMENTS | BODIE, KANE, MARCUS

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• Risk Averse Investors:

7-35 INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

To find max, take derivative w.r.t. y and set equal to 0

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

7-40 INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

• Diversification and Portfolio Risk

• Portfolios of Two Risky Assets