Economics 435

Chapter 8

In Chapter 7, we took the risky portfolio as given. In this chapter, we step back and think
about how to construct the optimal risky portfolio.
Its worth remembering that were taking the random variables that describe
returns as given.

Diversification

Risky assets provide a hedge for other risky assets if their returns are negatively
correlated.
Most extreme example of a hedge is an asset whose returns are perfectly
negatively correlated (correlation coefficient of 1)
o When one assets return is 5% above its mean, the others is 5% below
its mean, so that a portfolio that invests in the two in equal proportions
has no risk.
It turns out that the risk of a portfolio can also be reduced by adding an asset that
is positively correlated, but not perfectly so.

Diversification is the idea that the riskiness of a portfolio can be reduced by adding many
assets whose returns are imperfectly correlated.

Two classes of risk
Systematic risk (a.k.a. market risk, or nondiversifiable risk, or aggregate risk):
Risk which is attributable to a source that is common to all assets, and affects all
assets similarly.
o Business cycle, wars, changes in tax policy, etc.
Nonsystematic risk (a.k.a. unique risk, firm-specific risk, diversifiable risk,
idiosyncratic risk): Risk which can be diversified away

Economics 435

#assets

Market risk
Unique risk


Efficient Diversification

We can probably do a better job of diversifying than by simply throwing together a whole
bunch of assets in equal proportions.
So the goal is to find the correct proportions, so as to reduce the standard
deviation by as much as possible for a given rate of return.

Well start by thinking of portfolios with just two risky assets. Following the example of
the book well look at a bond mutual fund and an equity mutual fund (both of which
actually consist of lots of assets)

Bond Mutual Fund Equity Mutual Fund
Expected return: E(r) 0.08 0.13
Standard deviation: 0.12 0.20
Covariance: ) , (
E D
r r Cov 0.0072
Correlation coef:
E D,
0.0072/(0.12*0.20)=0.30

Recalling Rule 3 from Chapter 6:
) ( ) ( ) (
E E D D p
r E w r E w r E + =

And Rule 5:
) , ( 2
2 2 2 2 2
E D E D E E D D p
r r Cov w w w w + + =

The covariance of one random variable with itself is just the variance of that random
variable. Recognizing this allows us to rewrite the previous formula as:
) , ( 2 ) , ( ) , (
2
E D E D E E E E D D D D p
r r Cov w w r r Cov w w r r Cov w w + + =

Economics 435
Viewing the formula in this way suggests an easy way of calculating the portfolio
variance:


D
w
E
w
D
w ) , (
D D
r r Cov ) , (
E D
r r Cov
E
w ) , (
D E
r r Cov ) , (
E E
r r Cov

Multiply each covariance by the weights in its row and in its column, and then sum them
all up.
This way of viewing the problem is useful because it generalizes to more than two
assets.
The portfolio variance is reduced if the covariance between the two assets is less
than one (it doesn't have to be negative to reduce the overall covariance).

To see this, use the relationship between the covariance and the correlation coefficient,
E D E D E D
r r Cov
,
) , ( =
to rewrite the portfolio variance formula as:
E D E D E D E E D D p
w w w w
,
2 2 2 2 2
2 + + =
If the two assets are perfectly correlated ( 1
,
=
E D
), then
E E D D p
E E D D
E D E D E E D D p
w w
w w
w w w w



+ =
+ =
+ + =
2
2 2 2 2 2
) (
2

and the portfolio standard deviation is just the weighted average of the two assets
standard deviations. Clearly, any value of
E D,
less than one leads to a portfolio standard
deviation that is less than the weighted average of the two assets standard deviations.
So the combined portfolio offers better risk-return opportunities that just taking
the assets by themselves.

We can graphically represent the risk-return opportunities that result from different
portfolio weights
Economics 435

E
w
E(r)
0
) (
D
r E
1
) (
E
r E



E
w
p

0 1
1
0
1
=
=
=

From these two diagrams, it is apparent that the relationship between standard deviation
and expected return is the following:
Economics 435

P

) (
P
r E
D

E

) (
D
r E
) (
E
r E
1 =
0 =
1 =

These curves are known as the portfolio opportunity set
Notice that the minimum-variance portfolio has a standard deviation that is less
than either asset taken alone.
o This reflects the benefits of diversification.

We can determine the portfolio proportions that lead to a standard deviation of zero when
two assets are perfectly negatively correlated:
D E
E
D
E D D D
E E D D
E E D D p
E E D D
E D E D E E D D p
w
w w
w w
w w
w w
w w w w







+
=
=
=
=
=
+ =
) 1 (
0
) (
2
2
2 2 2 2 2


What is the optimal mix of the two "risky" assets?
Create a CAL that passes through the riskless rate and is tangent to the portfolio
opportunity set


Economics 435

E(r)
CAL(P)
f
r
) (
p
r E
p

P

So an investor can achieve any risk-return combination along the CAL(P)
Mix the risk-free asset with the P portfolio. As you increase the amount in the
risky portfolio P, you don't alter the weights, you just increase all of the risky
assets proportionally.
The slope of this CAL is known as the reward-to-variability ratio.
o
p
f p
r r E

) (

o Clearly the CAL that is tangent to the portfolio opportunity set is the one
that is used because it offers the highest reward-to-variability ratio.

Optimal Complete Portfolio
The optimal complete portfolio is determined by the tangency of an indifference
curve with the CAL from the optimal risky portfolio.
[insert figure]

An Example

Markowitz Portfolio Selection Model
Generalizes the approach described above to the case of many (the whole
universe) risky assets.

Four main steps
1. Conduct research to determine each assets' expected return, standard deviation,
and covariance with returns of all other assets
J ust use historical data to extrapolate forward?
2. Construct minimum variance frontier
Use a computer algorithm to determine the portfolio weights that
minimize the variance for a given expected return.
That part which lies above the global minimum variance portfolio is
known as the efficient frontier.
Economics 435
3. Construct the CAL associated with the efficient frontier.
4. Find the mix of the risk-free asset and the optimal risky portfolio that maximizes
utility (tangency of indifference curve with CAL).

Separation Property

Mention some restrictions (short sales, different borrowing rate)

Time diversification
Economics 435