Modern

portfolio theory
 Recap of last module
• How to optimally split investment b/w a risk-free asset and a
risky ‘portfolio’
• Utility function – subjective and varies from individual to individual
based on one’s propensity to take (avoid) risk.

• Capital Allocation Line – One risk-free asset and a risky

portfolio.

• Capital Market Line – Using well diversified portfolios in CAL.

 Key Takeaways…
• Constructing a risky portfolio.

• The optimal risky portfolio.

• Modern portfolio theory.

• Applications.

• Reference Textbook Chapter: Chapter 7

 The Investment Decision
• Step one – identifying how much of my money goes into a risky
portfolio and how much goes into a risk-free asset (mutual
funds/equity vs FD).

• Step two – Within the risky portfolio, where do I park my

money w.r.t. asset classes? (equity/debt/derivative/forex)

• Step three – Within an asset class, how do I select securities?

 Let’s talk risk
• Market Risk
• What is happening to your stock-market challenge now?
• Regardless of the choice of securities, do you find days of uniform stock
crashes?
• Welcome to market risk, risk attributable to market wide risk sources and
remains even after extensive diversification.
• Also called ‘systematic’ or ‘non-diversifiable’.

• Firm-specific risk
• Think of those poor souls who held shares of Enron or Sathyam or Lehman
Brothers or Kingfisher Airlines when some real news about these firms came
out!!!
• Risk that can be eliminated by diversification
• Called diversifiable or non-systematic risk.
 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.
Portfolio Diversification
 Let’s start with two risky assets

• Portfolio risk (variance) depends on the 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)
 Portfolios returns with two risky assets

• Assume you choose to invest in a debt fund and equity fund

• Portfolio return: rp = wDrD + wErE
• wD = Bond weight
• rD = Bond return
• wE = Equity weight
• rE = Equity return

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

 Portfolio risk with two risky assets

• Portfolio variance:
s p2 = wD2 s D2 + wE2s E2 + 2wD wE Cov ( rD , rE )
s D2
• = Bond variance
sE2

= Equity variance
Cov ( rD , rE )
•

•
• = Covariance of returns for bond and equity
 Let’s go back to statistics!
• Covariance of returns on bond and equity:
Cov(rD,rE) = rDEsDsE

• rD,E = Correlation coefficient of returns

• sD = Standard deviation of bond returns
• sE = Standard deviation of equity returns
Revisiting the correlation co-efficient
• Range of values for r1,2
- 1.0 > r > +1.0
• If r = 1.0, the securities are perfectly positively
correlated
• If r = - 1.0, the securities are perfectly negatively
correlated
 Correlation and diversification

• When ρDE = 1, there is no diversification

s P = wEs E + wDs D

• When ρDE = -1, a perfect hedge is possible

s
• In reality can you find this? D
wE = = 1 - wD
s D +s E
Computation of Portfolio Variance From the
Covariance Matrix
 An Example

Debt Fund Equity Fund

Expected Return 8% 13%
Standard Deviation 12% 20%
Covariance 72
Correlation Coefficient 0.3

Using WD = 0 and WE = 1 and going up to WD = 1 and WE = 0 with increments

of 0.1, estimate the portfolio expected returns and portfolio standard
deviation. Use correlation values of -1, 0, 0.3 and1.0.

Increase the weightage to both debt and equity to greater than 1 values and
extend the tables. Plot the final results as expected returns vs weights and
standard deviation vs weights.
Portfolio Expected Return
Portfolio Standard Deviation
 The Minimum Variance Portfolio
• The minimum variance portfolio is the portfolio composed of the
risky assets that has the smallest standard deviation; the
portfolio with least risk
• The amount of possible risk reduction through diversification
depends on the correlation:
• If r = +1.0, no risk reduction is possible
• If r = 0, σP may be less than the standard deviation of either
component asset
• If r = -1.0, a riskless hedge is possible
 Optimal Weights
• Recall portfolio variance as
s p2 = wD2 s D2 + wE2s E2 + 2wD wE Cov ( rD , rE )

• Using calculus, we can identify minimum variance portfolio.

• WD = 1 – WE

• Using this in the equation and differentiating the result with WD

yields the optimal weight that results in a minimum variance
portfolio.
 Optimal Weights

$
∗
σ# − 𝐶𝑜𝑣 (𝑟! , 𝑟# )
𝑊! = $
σ! + σ$# − 2𝐶𝑜𝑣 (𝑟! , 𝑟# )

For our example, estimate the minimum variance portfolio.

What do you observe at the variance of the portfolio?

Graph Expected Return vs Standard Deviation including the

minimum variance portfolio weights using your tabulation.
Portfolio Expected Return as a Function of
Standard Deviation
 The Opportunity Sets
• The resulting graphs for given correlation values provides the opportunity
sets.

• Portfolio opportunity set shows all combinations of portfolio expected

return and standard deviation from the two available assets.

• When correlation is -1, linear opportunity set with perfect hedging.

• Once we have these graphs, we go subjective.

• Best portfolio depends upon your risk aversion
• Portfolios north east of the graph are high risk, high expected return
• Best trade-off is personal preference, if you’re highly risk averse, you’re likely to find
your portfolio south-west.
 Let’s complicate things a bit..
• Your risky portfolio contains debt and equity funds.

• What if you want to further invest in t-bills yielding 5%?

• Therefore, we have two risky assets and a risk-free asset.

• Draw CAL with minimum variance portfolio – Portfolio A

• What if you choose 70% in bonds and 30% in stocks – Portfolio B

• Estimate slope (sharpe ratio) of both portfolios.

The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs
 The Sharpe Ratio

• Maximize the slope of the CAL for any possible portfolio, P

• The objective function is the slope:

E (rp ) - rf
Sp =
sp
• The slope is also the Sharpe ratio
 A different optimization problem
• Unlike previous case, now we optimize the sharpe ratio (maximize SR) subject to
∑ 𝑤! = 1.

• When we have only 2 risky assets,

# $! ×&#" '#($" )×*+,($! ,$" )

• 𝑤" =
# $! ×&#" .# $" ×&#! '[# $! .# $" ]×*+, $! ,$"

• WE = 1 – WD

• Where R represents excess returns.

• Estimate the optimal weights with risky assets.

Debt and Equity Funds with the Optimal
Risky Portfolio
 What about the optimal complete
portfolio?
• Refer back to previous class’s discussion on the optimal
weightage to invest in a risk-free asset and risky asset portfolio.

E(rp) – rf
• y* = &×("
!

• For a A = 4, what is your portfolio weights for complete

portfolio?
Determination of the Optimal Overall Portfolio
The Proportions of the Optimal Complete Portfolio
 Markowitz Portfolio Optimization Model

• Security selection
• The first step is to 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
The Minimum-Variance Frontier of Risky Assets
 Markowitz Portfolio Optimization Model

• Search for the CAL with the highest reward-to-variability ratio

• Everyone invests in P, regardless of their degree of risk aversion
• More risk averse investors put more in the risk-free asset
• Less risk averse investors put more in P
The Efficient Frontier of Risky Assets with the
Optimal CAL
 Markowitz Portfolio Optimization Model

• 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
Capital Allocation Lines with Various Portfolios from the
Efficient Set
 Markowitz Portfolio Optimization Model

• The Power of Diversificationn n

• Remember: s p2 = åå wi w j Cov ( ri , rj )
i =1 j =1

• If we define the average variance and average covariance of the

securities as:

1 n 2
s = ås i
2

n i =1
n n
1
Cov = åå Cov ( ri , rj )
n ( n - 1) j =1 i =1
j ¹i
 Markowitz Portfolio Optimization Model

• The Power of Diversification

• We can then express portfolio variance as
1 2 n -1
s = s +
2
p Cov
n n

• Portfolio variance can be driven to zero if the average

covariance is zero (only firm specific risk)
• The irreducible risk of a diversified portfolio depends on
the covariance of the returns, which is a function of the
systematic factors in the economy
Risk Reduction of Equally Weighted Portfolios
 Markowitz Portfolio Optimization Model

• Optimal Portfolios and Nonnormal Returns

• Fat-tailed distributions can result in extreme values of VaR and ES and
encourage smaller allocations to the risky portfolio
• 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
 Risk Pooling and the Insurance Principle

• Risk pooling
• Merging uncorrelated, risky projects as a means to reduce risk
• It increases the scale of the risky investment by adding additional
uncorrelated assets
• The insurance principle
• Risk increases less than proportionally to the number of policies when
the policies are uncorrelated
• Sharpe ratio increases
 Risk Sharing

• As risky assets are added to the portfolio, a portion of the pool

is sold to maintain a risky portfolio of fixed size
• Risk sharing combined with risk pooling is the key to the
insurance industry
• True diversification means spreading a portfolio of fixed size
across many assets, not merely adding more risky bets to an ever-
growing risky portfolio