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Contents
1 2 3 Combining risk-free asset with one-risky asset Combining two risky assets Optimal portfolios 3.1 Two risky assets case . . . . . . . . . . . . . . . . 3.2 The general case . . . . . . . . . . . . . . . . . . . 4 9 14 14 20
Recap
Estimating expected returns and variance-covariance matrix. Finding expected returns and standard deviations of the returns of given portfolios.
In this class we will use the techniques from class 4 to determine optimal portfolios.
Risk-return tradeo
We can further summarize the risk-return trade-o by noting that w = p /0.3, and E[RP ] = = 0.08 + 0.12w 0.12 0.08 + p = 0.08 + 0.4p 0.3
In general, given a risky asset with expected return E [Ri ] and standard deviation SD(Ri ) this can be written as (E [Ri ] Rf ) E[RP ] = Rf + p SD(Ri ) i.e. the expected return is a linear function of the standard deviation of the portfolio, with slope (E(Ri ) Rf ) . SD(Ri )
Finance, Bridge Program 2005 5
Questions
If you would like to tolerate a risk of 20%, what portfolio should you invest in? Equate the standard deviation of the portfolio to 20%: w0.3 = 0.2; so that w = 2/3 or 67% in the risky asset. If you would like to earn a return of 10%? Equate the expected return of the portfolio to 10%: w0.2 + (1 w)0.08 = 0.10 so that w = 1/6 16.7% in the risky asset.
Finance, Bridge Program 2005 8
The expected return is then: E[RP ] = 0.20w + (1 w)0.25 = 0.25 0.05w. For the variance calculation we need some more work: Var(RP ) = w2 (0.30)2 +(1w)2 (0.40)2 +2w(1w)(0.30)(0.40)0.5; So that: p = w2 (0.30)2 + (1 w)2 (0.40)2 + 2w(1 w)(0.30)(0.40)0.5
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Sample portfolios
Weight w 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 E[RP ] 0.250 0.245 0.240 0.235 0.230 0.225 0.220 0.215 0.210 0.205 0.200 p 0.400 0.376 0.354 0.334 0.317 0.304 0.295 0.289 0.288 0.292 0.300
Variance starts going up at w 0.77, and expected return goes down: the mean-variance ecient portfolios are those with w 0.77. Finance, Bridge Program 2005 10
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(5 20E [RP ])2 (0.30)2 + (20E [RP ] 4)2 (0.40)2 +2(5 20E [RP ])(20E [RP ] 4)(0.30)(0.40)0.5
Note that this can be expressed (by solving a quadratic) with E [RP ] on the left hand side (which makes plots easier).
2 Note: write x for E [RP ] and y = P when thinking about the above equation.
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Questions
If you would like to tolerate a risk of 30%, what portfolio should you invest in? Equating the standard deviation to 0.30, we have that we should invest w 54% in asset A. If you would like to earn a return of 30%? Equating the expected return of the portfolio to 0.30 we have that w = 100%, short asset A and invest twice your wealth in asset B.
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Since 3/8 > 1/3 we see that for any portfolio of the risk-free and asset A there exists a portfolio of the risk-free and asset B which does better. Therefore if we could only invest in these assets in isolation we would prefer asset B. Finance, Bridge Program 2005 15
Sharpe ratios
Given an asset with returns Ri , the quantity E [Ri ] Rf si = SD(Ri ) is called the Sharpe ratio of asset i. Note that if asset i is a portfolio, we can use the same denition and talk about the Sharpe ratio of a given portfolio. The Sharpe ratio is the slope of the line in the previous equations: therefore if we had to choose between A and B in isolation the problem boils down to looking at which of the two assets has a higher Sharpe ratio. With Rf = 4%: sA = 0.533 and sB = 0.525, so asset A is actually preferred under this scenario.
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Optimal portfolios
The interesting question is what happens if we can invest arbitrary amounts in each asset. Consider a given portfolio characterized by w. We can easily compute the Sharpe ratio of this portfolio. Finding the optimal portfolio boils down to nding the portfolio with the highest Sharpe ratio (a graphical argument comes in handy). Literally it solves E [RP ] Rf max w SD(RP ) Since we have explicit expressions for E [RP ] and SD(RP ) the above is a well-dened problem (analytically challenging, but in principle straightforward). In the assignment one can check that the optimal portfolio of risky assets is w 48.3% and 1 w 51.7%. Finance, Bridge Program 2005 17
A handy graph
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Questions
If you would like to tolerate a risk of 20%, what portfolio should you invest in? x(0.306) = 0.2 65.3% in the optimal risky portfolio. In other words: put about 34.7% in the risk-free asset, 31.5% in asset A and 33.8% in asset B. If you would like to earn a return of 25%? x0.226 + (1 x)0.1 = 0.25, or x 1.19 in the risky portfolio. In other words: put about 57.5% in asset A, 61.6% in asset B, and borrow an amount equivalent to 19.2% Very important remark: the optimal portfolio of risky assets is independent of the investors preferences for risk (dierent risk-aversion implies dierent mixes between the riskless asset and this optimal fund of risky assets).
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Recap
The optimal portfolio is given by a combination of the risk-free asset and a fund of the other (risky) assets. The optimal fund is obtained by maximizing the Sharpe ratio of the portfolio of risky assets.
Upcoming
Thinking about risk in a portfolio context. How to determine discount rates for assets as a function of their risk.
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