SAPM Module – 3 – Theories of Capital Market

Optimal Risky Portfolio

By, Ashok Bantwa

 Optimum Portfolio

Ω Portfolio Optimization can be conducted at two

levels
ő Asset allocation level
ő Security selection level
 Diversification and Portfolio Risk

Ω Market risk
¤ Systematic or non diversifiable
¤ Can not be diversified by forming a portfolio of
assets

Ω Firm-specific risk
¤ Unsystematic or diversifiable (Unique Risk)
¤ Can be diversified by forming a portfolio of assets
Figure 7.1 Portfolio Risk as a Function of the Number of
Stocks in the Portfolio

Panel A : Only unsystematic risk

Panel B : Systematic + Unsystematic Risk
Portfolio of Two Risky Assets
 Covariance and Correlation
Ω Portfolio risk depends on the relationship
between the returns of the assets in the portfolio
Ω Covariance and the correlation coefficient
provide a measure of the way returns on two
assets vary
Two-Security Portfolio: Return

E (rp ) wb E (rb )  ws E (rs )

Two-Security Portfolio: Risk

 w   w   2 wb ws pbs b s
2
P
2
b
2
b
2
s
2
s
 Minimum Variance Portfolio of
two risky assets
Ω Portfolio of two risky assets are relatively easy to
analyze and they illustrate the principles and
considerations that apply to portfolio of many assets
Ω Weights of assets that drives portfolio variance to
zero when two assets have perfect negative
correlation
When PAB  1

B A
WA  WB 
 A  B  A  B
 Example – 1
Ω Following information is available about two risky
assets A and B
A B
Expected Return 12% 20%
Standard Deviation 20% 40
Correlation Coefficient -1

Ω Find out weight of A and B that drives risk of

portfolio of two assets to zero
 Example

B 40
WA  WA  0.6666
 A  B 20  40

WB 1  WA
1  0.6666 0.3333
 Minimum Variance Portfolio
Ω Such proportion of two assets that minimizes the
portfolio variance
Ω For example for two securities Bonds and Share weight
of investment in bonds is
Ω When correlation coefficient is not perfect negative

   b S pbs
2
WB (min)  2 S
 b   s2  2 b S pbs

OR
 s2  Covbs
Wb (min)  2
 b   s  2Covbs
2
 Example – 2
Ω Consider the following information
Bond Stock
Expected Return 8% 15%
Standard Deviation 10% 20%

Ω For three different levels of correlations (p= -1, p =0

and p=0.5) between the returns of bond and stocks
find out minimum variance portfolios, expected
return and standard deviation of portfolio at each
level.
 Example
Ω When p = -1
ő Minimum variance portfolio
S 20
WB  WB  0.6666
 B  S 10  20
WS 1  WB WS 1  0.6666 0.3333
ő Expected return
E (rp ) wb E (rb )  ws E (rs )
E (rp ) 0.6666 8   0.3333 15  10.33%
ő Standard deviation

 P2 wb2 b2  ws2 s2  2wb ws pbs b  s

 P2 0.6662 102   0.3332 202   2 0.666 0.3333  110 20  0
 Example
Ω When p = 0
ő Minimum variance portfolio

 S2   b S pbs
WB (min)  2
 b   s2  2 b S pbs

202  10 20 0
WB (min)  2 2
0.8
10  20  2 10 20 0

WS 1  WB WS 1  0.8 0.2
 Example
ő Expected return
E (rp ) wb E (rb )  ws E (rs )

E (rp ) 0.8 8   0.2 15  9.4%

ő Standard deviation

 w   w   2wb ws pbs b s
2
P
2
b
2
b
2
s
2
s

 P2 0.82 102   0.22 202   2 0.8 0.2 0 10 20  80

 P  80 8.94%
 Example
Ω When p = 0.5
ő Minimum variance portfolio

 S2   b S pbs
WB (min)  2
 b   s2  2 b S pbs

202  10 20 0.5

WB (min)  2 2
1
10  20  2 10 20 0.5

WS 1  WB WS 1  1 0
 Example
ő Expected return
E (rp ) wb E (rb )  ws E (rs )

E (rp ) 18   0 15  8%

ő Standard deviation

 w   w   2wb ws pbs b s
2
P
2
b
2
b
2
s
2
s

 P2 12 102   02 202   2 10 0.5 10 20  100

 P  100 10%
 The optimal portfolio with two risky and a risk
free security
Ω Weight of two risky securities in risky portfolio
(rD  rf ) E2  (rE  rf )CovrD rE
WD 
 
(rD  rf ) E2  (rE  rf ) D2  (rD  rf )  (rE  rf ) CovrD rE
WE 1  WD
Ω Return on portfolio of risky securities
E (rp ) wD E (rD )  wE E (rE )
Ω Standard deviation of portfolio of risky securities

 P  w   w   2wD wE pDE D E
2
D
2
D
2
E
2
E
 The optimal portfolio with two risky and a risk
free security
Ω Weight of risky security in portfolio

E rP   rF
y
0.01A 2
P
 Example – 3
Particulars Debentures Equity T – Bills
Stocks
Expected Return 8% 13% 5%

Standard Deviation 12% 20% 0

Co-variance between 72
debentures equity
Correlation Coefficient 0.30

How much will an investor with A = 4 will invest in Debt, Equity

Stock and Treasury bills?
 Example
Ω Weight of Debentures and Equity stocks in optimal
risky portfolio

(rD  rf ) E2  (rE  rf )CovrD rE

WD 
 
(rD  rf ) E2  (rE  rf ) D2  (rD  rf )  (rE  rf ) CovrD rE

WD 
 8  5 400  13  5 72
0.40
8  5 400  13  5144  8  5 13  5 72

WE 1  WD

WE 1  0.40 0.60
 Example
Ω Risk and return of optimal risky portfolio
E (rp ) wD E (rD )  wE E (rE )

E (rp ) 0.4 8   0.6 13 11%

 P  wD2  D2  wE2 E2  2wD wE pDE D E

 P  0.4 144   0.6 400   2 0.4 0.6 72

2 2

 P 14.2%
 Example
Ω Weight of risky securities in portfolio

E rP   rF
y
0.01A 2
P
11  5
y 2
74.39%
0.014 14.2
Ω Weight of treasury bills in portfolio

1  y 1  0.7439 25.61%
 Example
Ω Complete Portfolio
Securities Weights

Debentures (74.39×0.4) 29.76%

Equity Stocks (74.39×0.6) 44.63%

Treasury Bills 25.61%

 Example – 4
Ω A pension fund manager is considering three mutual
funds. The first is a stock fund, the second is a bond fund
and third is T-bill money market funds that yields a rate
of 8%. The probability distribution of risky portfolio is as
follow
Expected Standard
Return Deviation
Stock fund (S) 20% 30%

Bond Fund (B) 12 15

Ω The correlation between the fund returns is 0.1

Ω What are the investment proportion in minimum
variance portfolio of the two risky funds, and what is the
expected value and standard deviation of its return?
ő For a portfolio of two risky assets

 b2   b s pbs
Ws  2
 b   s2  2 b s pbs

152  15 30 0.1

Ws  2 2
15  30  2 15 30 0.1
Ws 0.1739
w b 1  ws
w b 1  0.1739 0.8261
For a portfolio of two risky assets
•Return of risky portfolio
rp ws rs  wb rb
rp (0.1739 20)  (0.8216 12)
rp 13.19%
•Risk (Standard deviation)of risky portfolio

 w   w   2ws wb rsb s b
2
p
2
s
2
s
2
b
2
b
 p2 0.1739 2 30 2  0.82612 152  2 0.1739 0.82610.130 15

 p2 187.23
 p  187.23 13.68%
Ω Tabulate and draw investment opportunity set of the
two risky funds. Use investment proportions for the
stock funds of zero to 100% in increments of 20%
Proportion Proportion Expected Standard
in stock fund in bond fund return Deviation

0.00% 100.00% 12.00% 15.00%

17.39% 82.61% 13.39% 13.92% minimum variance
20.00% 80.00% 13.60% 13.94%
40.00% 60.00% 15.20% 15.70%
60.00% 40.00% 16.80% 19.53%
80.00% 20.00% 18.40% 24.48%
100.00% 0.00% 20.00% 30.00%
 35.00%

30.00%

25.00%

20.00%
Return

15.00%

10.00%

5.00%

0.00%
11.00% 12.00% 13.00% 14.00% 15.00% 16.00% 17.00% 18.00% 19.00% 20.00% 21.00%
Risk
Ω Solve numerically for the proportion of each of the risky
asset in three asset portfolio and the expected return and
standard deviation of the optimal risky portfolio
Weight of stock fund (S) in risky portfolio
(rs  rf ) b2  (rb  rf )Covrs rb
Ws 
 
(rs  rf ) b2  (rb  rf ) s2  (rs  rf )  (rb  rf ) Covrs rb
Covrs rb  s b psb Covrs rb 30 15 0.1 45
[(20  8) 225]  [(12  8) 45]
Ws  0.4516
[(20  8) 225]  [(12  8) 900]  [(20  8  12  8) 45]

Weight of bond fund (B) in risky portfolio

wb 1  0.45616 0.5484
Ω Return from optimal risky portfolio

rp ws rs  wb rb

(0.4516 20) + (0.5484 12) = 15.61%

Ω Risk of optimal risky portfolio

 w   w   2ws wb rsb s b
2
p
2
s
2
s
2
b
2
b

 p2 0.4516 2 30 2  0.5484 2 152  2 0.4516 0.5484 0.130 15

 p2 262.35  p  262.35 16.20%

 Example – 5
Ω Suppose that there are many stocks in the security
market and the characteristics of stock A and Stock B
are given as follows
Stocks Expected Standard
Return Deviation
A 10% 5%

B 15 10

Correlation -1

Ω Suppose that it is possible to borrow at risk free rate

(rf). What must be the value of risk free rate?
Ω Since Stock A and Stock B are perfectly negatively
correlated, a risk-free portfolio can be created and the
rate of return for this portfolio, in equilibrium, will be the
risk-free rate.
Ω Weight of A and B that drives portfolio standard
deviation to zero

B 10
wA  wA  0.67
 A  B 15  10
Ω Return from portfolio
wB 1  0.67 0.33

Ω Therefore risk free rate is 11.67%

rp wA rA  wB rB rp 0.67 10  (0.33 15) 11.67%
 Example – 6
Ω Suppose that you have a project that has 0.7 chance of
doubling your investment in a year and 0.3 chance of halving
your investment in a year. What is standard deviation of rate of
return on this investment?

Probability Rate of Return

0.7 100%
0.3 -50%
Ω Mean expected return

r )  piri
E (return
Ω Standard deviation of
E (r ) (0.7 100)  (0.3  50) 55%

   pi ri  E (ri )2

  [0.7 (100 - 55) 2 ] + [0.3 (- 50 - 55) 2 ] 68.74%