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7-2 Zaheer
7-2 Zaheer
tests
Wei-Peng Chen
*
Department of Finance, Hsih-Shin University, Taiwan
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H&imin Ch&ng
'ra(&ate )nstit&te of Finance, *ationa+ Chiao T&ng University, Taiwan
,eng--& Ho
Department of Finance, *ationa+ Centra+ University, Taiwan
.engy&ho$cc%nc&%e(&%tw
Ts&i-/ing Hs&
'ra(&ate )nstit&te of Finance, *ationa+ Chiao T&ng University, Taiwan
tracy%sh&$msa%hinet%net
Prepared for Handbook of Quantitative Finance and Risk Management
*
Wei-Peng Chen is at the Department of Finance at Shih-Hsin University0 H&imin Ch&ng an( Ts&i-/ing Hs& are at the
'ra(&ate )nstit&te of Finance at the *ationa+ Chiao T&ng University% ,eng--& Ho is at Department of Finance, *ationa+ Centra+
University% 1((ress correspon(ence to H&imin Ch&ng, 'ra(&ate )nstit&te of Finance, *ationa+ Chiao T&ng University, 22
Ta-Hs&eh 3oa(, Hsinch& 422"2, Taiwan0 Te+5 688#-4-"788 e9t%"727"0 Fa95 688#-4-"7448#20% :-mai+5
ch&ngh&i$mai+%nct&%e(&%tw%
)n this chapter we intro(&ce the theory an( the app+ication of comp&ter program of mo(ern
portfo+io theory% The notion of (iversification is age-o+( ;(on<t p&t yo&r eggs in one =as.et>,
o=vio&s+y pre(ates economic theory% However a forma+ mo(e+ showing how to ma.e the most of
the power of (iversification was not (evise( &nti+ ?"8, a feat for which Harry @ar.owitA
event&a++y won *o=e+ PriAe in economics%
@ar.owitA portfo+io shows that as yo& a(( assets to an investment portfo+io the tota+ ris. of that
portfo+io - as meas&re( =y the variance Bor stan(ar( (eviationC of tota+ ret&rn - (ec+ines
contin&o&s+y, =&t the e9pecte( ret&rn of the portfo+io is a weighte( average of the e9pecte( ret&rns
of the in(ivi(&a+ assets% )n other wor(s, =y investing in portfo+ios rather than in in(ivi(&a+ assets,
investors co&+( +ower the tota+ ris. of investing witho&t sacrificing ret&rn%
)n the secon( part we intro(&ce the mean-variance spanning test which fo++ows (irect+y from the
portfo+io optimiAation pro=+em%
INTRODUCTION OF MARKOWITZ PORTFOLIO-SELECTION MODEL
Harry @ar.owitA B?"8, ?"?C (eve+ope( his portfo+io-se+ection techniD&e, which came to =e
ca++e( mo(ern portfo+io theory B@PTC% Prior to @ar.owitA<s wor., sec&rity-se+ection mo(e+s
foc&se( primari+y on the ret&rns generate( =y investment opport&nities% Stan(ar( investment a(vice
was to i(entify those sec&rities that offere( the =est opport&nities for gain with the +east ris. an(
then constr&ct a portfo+io from these% Fo++owing this a(vice, an investor might conc+&(e that
rai+roa( stoc.s a++ offere( goo( ris.-rewar( characteristics an( compi+e a portfo+io entire+y from
these% The @ar.owitA theory retaine( the emphasis on ret&rn0 =&t it e+evate( ris. to a coeD&a+ +eve+
of importance, an( the concept of portfo+io ris. was =orn% Whereas ris. has =een consi(ere( an
important factor an( variance an accepte( way of meas&ring ris., @ar.owitA was the first to c+ear+y
an( rigoro&s+y show how the variance of a portfo+io can =e re(&ce( thro&gh the impact of
(iversification, he propose( that investors foc&s on se+ecting portfo+ios =ase( on their overa++ ris.-
rewar( characteristics instea( of mere+y compi+ing portfo+ios from sec&rities that each in(ivi(&a++y
have attractive ris.-rewar( characteristics%
1 @ar.owitA portfo+io mo(e+ is one where no a((e( (iversification can +ower the portfo+io<s
ris. for a given ret&rn e9pectation Ba+ternate+y, no a((itiona+ e9pecte( ret&rn can =e gaine( witho&t
increasing the ris. of the portfo+ioC% The @ar.owitA :fficient Frontier is the set of a++ portfo+ios of
8
which e9pecte( ret&rns reach the ma9im&m given a certain +eve+ of ris.%
The Markowitz model is =ase( on severa+ ass&mptions concerning the =ehavior of investors
an( financia+ mar.ets5
% 1 pro=a=i+ity (istri=&tion of possi=+e ret&rns over some ho+(ing perio( can =e estimate(
=y investors%
8% )nvestors have sing+e-perio( &ti+ity f&nctions in which they ma9imiAe &ti+ity within the
framewor. of (iminishing margina+ &ti+ity of wea+th%
4% Earia=i+ity a=o&t the possi=+e va+&es of ret&rn is &se( =y investors to meas&re ris.%
!% )nvestors care on+y a=o&t the means an( variance of the ret&rns of their portfo+ios over a
partic&+ar perio(%
"% :9pecte( ret&rn an( ris. as &se( =y investors are meas&re( =y the first two moments of
the pro=a=i+ity (istri=&tion of ret&rns-e9pecte( va+&e an( variance%
#% 3et&rn is (esira=+e0 ris. is to =e avoi(e(
%
7% Financia+ mar.ets are friction+ess%
MEASURMENT OF RETURN AND RISK
Thro&gho&t this chapter, investors are ass&me( to meas&re the +eve+ of ret&rn =y comp&ting the
e9pecte( va+&e of the (istri=&tion, &sing the pro=a=i+ity (istri=&tion of e9pecte( ret&rns for a
portfo+io% 3is. is ass&me( to =e meas&ra=+e =y the varia=i+ity aro&n( the e9pecte( va+&e of the
pro=a=i+ity (istri=&tion of ret&rns% The most accepte( meas&res of this varia=i+ity are the variance
an( stan(ar( (eviation%
Return
'iven any set of ris.y assets an( a set of weights that (escri=e how the portfo+io investment is
@ar.owitA mo(e+ ass&mes that investors are ris. averse% This means that given two assets that offer the same e9pecte(
ret&rn, investors wi++ prefer the +ess ris.y one% Th&s, an investor wi++ ta.e on increase( ris. on+y if compensate( =y
higher e9pecte( ret&rns% Converse+y, an investor who wants higher ret&rns m&st accept more ris.% The e9act tra(e-off
wi++ (iffer =y investor =ase( on in(ivi(&a+ ris. aversion characteristics% The imp+ication is that a rationa+ investor wi++
not invest in a portfo+io if a secon( portfo+io e9ists with a more favora=+e ris.-ret&rn profi+e - i%e%, if for that +eve+ of ris.
an a+ternative portfo+io e9ists which has =etter e9pecte( ret&rns%
Using ris. to+erance, we can simp+e c+assify investors into three types5 ris.-ne&tra+, ris.-averse, an( ris.-+over% 3is.-
ne&tra+ investorFs (o not reD&ire the ris. premi&m for ris. investments0 they G&(ge ris.y prospects so+e+y =y their
e9pecte( rates of ret&rn% 3is.-averse investors are wi++ing to consi(er on+y ris.-free or spec&+ative prospects with
positive premi&m0 they ma.e investment accor(ing the ris.-ret&rn tra(e-off% 1 ris.-+over is wi++ing to engage in fair
games an( gam=+es0 this investor a(G&sts the e9pecte( ret&rn &pwar( to ta.e into acco&nt the Ff&nF of confronting the
prospectFs ris.%
4
sp+it, the genera+ form&+as of e9pecte( ret&rn for n assets is5
( )
B C
n
P i i
i
E r wE r
(X.1)
where5
n
i
i
w
H %20
n H the n&m=er of sec&rities0
i
w
H the proportion of the f&n(s investe( in sec&rity i0
,
i P
r r
H the ret&rn on ith sec&rity an( portfo+io p0 an(
( ) E
H the e9pectation of the varia=+e in the parentheses%
The ret&rn comp&tation is nothing more than fin(ing the weighte( average ret&rn of the
sec&rities inc+&(e( in the portfo+io%
Risk
The variance of a sing+e sec&rity is the e9pecte( va+&e of the s&m of the sD&are( (eviations
from the mean, an( the stan(ar( (eviation is the sD&are root of the variance% The variance of a
portfo+io com=ination of sec&rities is eD&a+ to the weighte( average covariance
2
of the ret&rns on
its in(ivi(&a+ sec&rities5
( ) ( )
8
Ear Cov ,
n n
p p i j i j
i j
r ww r r
BI%8C
Covariance can a+so =e e9presse( in terms of the corre+ation coefficient as fo++ows5
( )
Cov ,
i j ij i j ij
r r
BI%4C
where
ij
, an(
j
BI%!C
Jvera++, the estimate of the mean ret&rn for each sec&rity is its average va+&e in the samp+e
perio(0 the estimate of variance is the average va+&e of the sD&are( (eviations aro&n( the samp+e
8
High covariance in(icates that an increase in one stoc.<s ret&rn is +i.e+y to correspon( to an increase in the other% 1
+ow covariance means the ret&rn rates are re+ative+y in(epen(ent an( a negative covariance means that an increase in
one stoc.<s ret&rn is +i.e+y to correspon( to a (ecrease in the other%
!
average0 the estimate of the covariance is the average va+&e of the cross-pro(&ct of (eviations%
EFFICIENT PORTFOLIO
Efficient portfolios may contain any n&m=er of asset com=inations% We e9amine efficient
asset a++ocation =y &sing two ris.y assets for e9amp+e% 1fter we &n(erstan( the properties of
portfo+ios forme( =y mi9ing two ris.y assets, it wi++ =e easy to see how portfo+io of many ris.y
assets might =est =e constr&cte(%
Two-risky-ssets !ort"o#io
Keca&se we now envision forming a -portfo+io from two ris.y assets, we nee( to &n(erstan( how
the &ncertainties of asset ret&rns interact% )t t&rns o&t that the .ey (eterminant of portfo+io ris. i( the
e9tent to which the ret&rns on the two assets ten( to vary rather in tan(em or in opposition% The
(egree to which a two-ris.y-assets portfo+io re(&ces variance of ret&rns (epen(s on the (egree of
corre+ation =etween the ret&rns of the sec&rities%
S&ppose a proportion (enote( =y
A
w
is investe( in asset 1, an( the remain(er
A
w
, (enote( =y
B
w
, is investe( in asset K% The e9pecte( rate of ret&rn on the portfo+io is a weighte( average of the
e9pecte( ret&rns on the component assets, with the same portfo+io proportions as weights%
B C B C B C
P A A B B
E r w E r w E r +
BI%"C
The variance of the rate of ret&rn on the two-asset portfo+io is
8 8 8 8 8 8
B C 8
P A A B B A A B B A B AB A B
w w w w w w + + + BI%#C
where
AB
is the corre+ation coefficient =etween the ret&rns on asset 1 an( asset K% )f the
corre+ation =etween the component assets is sma++ or negative, this wi++ re(&ce portfo+io ris.%
First, ass&me that
%2
AB
, which wo&+( mean that 1sset 1 an( K are perfect+y positive+y
corre+ate(, the right-han( si(e of eqation X.! is a perfect sD&are an( simp+ifies to
8 8 8 8 8
8
8
B C
p A A B B A B A B
A A B B
w w w w
w w
+ +
+
or
"
p A A B B
w w +
Therefore, the portfo+io stan(ar( (eviation is a weighte( average of the component sec&rity
stan(ar( (eviations on+y in the specia+ case of perfect positive corre+ation% )n this circ&mstance,
there are no gains to =e ha( form (iversification% Whatever the proportions of asset 1 an( asset K,
=oth the portfo+io mean an( the stan(ar( (eviation are simp+e weighte( averages% Fig&re I% shows
the opport&nity set with perfect positive corre+ation - a straight +ine thro&gh the component assets%
*o portfo+io can =e (iscar(e( as inefficient in this case, an( the choice among portfo+ios (epen(s
on+y on ris. preference% Diversification in the case of perfect positive corre+ation is not effective%
"igre X.1 #nvestment opportnit$ sets for asset % and asset & wit' varios correlation coefficients
(
Perfect positive corre+ation is the on+y case in which there is no =enefit from (iversification%
With any corre+ation coefficient +ess than %2B
<
C, there wi++ =e a (iversification effect, the
portfo+io stan(ar( (eviation is +ess than the weighte( average of the stan(ar( (eviations of the
component sec&rities% Therefore, there are =enefits to (iversification whenever asset ret&rns are +ess
than perfect+y corre+ate(%
J&r ana+ysis has range( from very attractive (iversification =enefits B
2
AB
<
C to no =enefits at
a++
%2
AB
% For
AB
r
n
asset K
asset 1
2
2 < <
#
perfect negative corre+ation, we s&=stit&te
%2
AB
in eD&ation I%# an( simp+ify it in the same
way as with positive perfect corre+ation% Here, too, we can comp+ete the sD&are, this time, however,
with (ifferent res&+ts%
8 8
B C
P A A B B
w w
1n(, therefore,
L M
P A A B B
ABS w w BI%7C
With perfect negative corre+ation, the =enefits from (iversification stretch to the +imit%
:D&ation I%7 points to the proportions that wi++ re(&ce the portfo+io stan(ar( (eviation a++ the way
to Aero%
1n investor can re(&ce portfo+io ris. simp+y =y ho+(ing instr&ments which are not perfect+y
corre+ate(% )n other wor(s, investors can re(&ce their e9pos&re to in(ivi(&a+ asset ris. =y ho+(ing a
(iversifie( portfo+io of assets% Diversification wi++ a++ow for the same portfo+io ret&rn with re(&ce(
ris.%
T$e %on%e!t o" Mrkowit& e""i%ient "rontier
:very possi=+e asset com=ination can =e p+otte( in ris.-ret&rn space, an( the co++ection of a++
s&ch possi=+e portfo+ios (efines a region in this space% The +ine a+ong the &pper e(ge of this region
is .nown as the efficient frontier% Com=inations a+ong this +ine represent portfo+ios Be9p+icit+y
e9c+&(ing the ris.-free a+ternativeC for which there is +owest ris. for a given +eve+ of ret&rn%
Converse+y, for a given amo&nt of ris., the portfo+io +ying on the efficient frontier represents the
com=ination offering the =est possi=+e ret&rn% @athematica++y the efficient frontier is the
intersection of the set of portfo+ios with minim&m variance an( the set of portfo+ios with ma9im&m
ret&rn%
Fig&re I%8 shows investors the entire investment opport&nity set, which is the set of a++
attaina=+e com=inations of ris. an( ret&rn offere( =y portfo+ios forme( =y asset 1 an( asset K in
(iffering proportions% The c&rve passing thro&gh 1 an( K shows the ris.-ret&rn com=inations of a++
the portfo+ios that can =e forme( =y com=ining those two assets% )nvestors (esire portfo+ios that +ie
to the northwest in Fig&re I%8% These are portfo+ios with high e9pecte( ret&rns Btowar( the north of
the fig&reC an( +ow vo+ati+ity Bto the westC%
7
"igre X.2 #nvestment opportnit$ set for asset % and asset &
The area within c&rve '(AZ is the feasi=+e opport&nity set representing a++ possi=+e portfo+io
com=inations% Portfo+ios that +ie =e+ow the minim&m-variance portfo+io Bpoint EC on the fig&re can
therefore =e reGecte( o&t of han( as inefficient% The portfo+ios that +ie on the frontier (A in Fig&re
I%8wo&+( not =e +i.e+y can(i(ates for investors to ho+(% Keca&se they (o not meet the criteria of
ma9imiAing e9pecte( ret&rn for a given +eve+ of ris. or minimiAing ris. for a given +eve+ of ret&rn%
This is easi+y seen =y comparing the portfo+io represente( =y points K an( KF% Since investors
a+ways prefer more e9pecte( ret&rn than +ess for a given +eve+ of ris., KF is a+ways =etter than K%
Using simi+ar reasoning, investors wo&+( a+ways prefer K to E =eca&se it has =oth a higher ret&rn
an( a +ower +eve+ of ris.% )n fact, the portfo+io at point E is i(entifie( as the minimm-variance
portfolio0 since no other portfo+io e9ists that has a +ower stan(ar( (eviation% The c&rve (A
represents a++ possi=+e efficient portfo+ios an( is the efficient frontier
!
, which represents the set of
portfo+ios that offers the highest possi=+e e9pecte( rate of ret&rn for each +eve+ of portfo+io stan(ar(
(eviation%
!
The efficient frontier wi++ =e conve9 N this is =eca&se the ris.-ret&rn characteristics of a portfo+io change in a non-
+inear fashion as its component weightings are change(% B1s (escri=e( a=ove, portfo+io ris. is a f&nction of the
corre+ation of the component assets, an( th&s changes in a non-+inear fashion as the weighting of component assets
changes%C The efficient frontier is a para=o+a Bhyper=o+aC when e9pecte( ret&rn is p+otte( against variance Bstan(ar(
(eviationC%
1
@inim&m
Eariance
Portfo+io
B@EPC
2
K
KF
)nvestment
Jpport&nity
Set
E
)tandard *eviation
E
+
p
e
c
t
e
d
,
e
t
r
n
O
8
"igre X.( -'e efficient frontier of risk$ assets and individal assets
1ny portfo+io on the (own war( s+oping potion of the frontier c&rve is (ominate( =y the
portfo+io that +ies (irect+y a=ove it on the &pwar( s+oping portion of the frontier c&rve since that
portfo+io has higher e9pecte( ret&rn an( eD&a+ stan(ar( (eviation% The =est choice among the
portfo+ios on the &pwar( s+oping portion of the frontier c&rve is not as o=vio&s, =eca&se in this
region higher e9pecte( ret&rn is accompanie( =y higher ris.% The =est choice wi++ (epen( on the
investorFs wi++ingness to tra(e off ris. against e9pecte( ret&rn%
S$ort se##in)
Eario&s constraints may prec+&(e a partic&+ar investor from choosing portfo+ios on the efficient
frontier, however% Short sa+e restrictions are on+y one possi=+e constraint% Short sa+e is a &s&a+
reg&+ate( type of mar.et transaction% )t invo+ves se++ing assets that are =orrowe( in e9pectation of a
fa++ in the assetsF price% When an( if the price (ec+ines, the investor =&ys an eD&iva+ent n&m=er of
assets at the new +ower price an( ret&rns to the +en(er the assets that was =orrowe(%
*ow, re+a9ing the ass&mption of no short se++ing, investors co&+( se++ the +owest-ret&rn asset K
Bhere, we ass&me that
B C B C an(
A B A B
E r E r
C% )f the n&m=er of short sa+es is &nrestricte(,
then =y a contin&o&s short se++ing of K an( reinvesting in 1 the investor co&+( generate an infinite
e9pecte( ret&rn% The efficient frontier of &nconstraint portfo+io is shown in Fig&re I%!% The &pper
=o&n( of the highest-ret&rn portfo+io wo&+( no +onger =e 1 =&t infinity Bshown =y the arrow on the
top of the efficient frontierC% /i.ewise the investor co&+( short se++ the highest-ret&rn sec&rity 1 an(
2
:fficient frontier
of ris.y assets
)tandard *eviation
E
+
p
e
c
t
e
d
,
e
t
r
n
)n(ivi(&a+ assets
@inim&m
variance
portfo+io
?
reinvest the procee(s into the +owest-yie+( sec&rity K
"
, there=y generating a ret&rn +ess than the
ret&rn on the +owest-ret&rn assets% 'iven no restriction on the amo&nt of short se++ing, an infinite+y
negative ret&rn can =e achieve(, there=y removing the +ower =o&n( of K on the efficient frontier%
Hence, short se++ing genera++y wi++ increase the range of a+ternative investments from the minim&m-
variance portfo+io to p+&s or min&s infinity
#
%
"igre X.. -'e efficient frontier of nrestricted/restricted portfolio
3e+a9ing the ass&mption of no short se++ing in this (eve+opment of the efficient frontier
invo+ves a mo(ification of the ana+ysis of the efficient frontier of constraint Bnot a++owe( short
sa+esC% *e9t section, we intro(&ce the mathematica+ ana+ysis of the efficient frontier withPwitho&t
short se++ing constraints%
C#%u#tin) t$e Mini*u* +rin%e !ort"o#io
)n @ar.owitA portfo+io mo(e+, we ass&me investors choose portfo+ios =ase( on =oth e9pecte(
ret&rn,
B C
p
E r
, an( the stan(ar( (eviation of ret&rn as a meas&re of its ris.,
p
r
n
)tandard *eviation
K
witho&t short sa+es
with short sa+es
2
@athematica++y, the portfo+io se+ection pro=+em can =e form&+ate( as D&a(ratic program% For
two ris.y assets 1 an( K, the portfo+io consists of
,
A B
w w
, the ret&rn of the portfo+io is then, The
weights sho&+( =e chosen so that Bfor e9amp+eC the ris. is minimiAe(, that is
8 8 8 8 8
@in 8
A
P A A B B A B AB A B
w
w w w w + +
for each chosen ret&rn an( s&=Gect to
, 2, 2
A B A B
w w w w +
% The +ast two constraints
simp+y imp+y that the assets cannot =e in short positions%
The minim&m variance portfo+io weights are shown in Ta=+e I%, the (etai+ proofs are in
1ppen(i9 K%
-a0le X.1 -'e mimimm variance portfolio weig't of two-assets portfolio wit'ot s'ort selling
The corre+ation of two assets Weight of 1sset 1 Weight of 1sset K
QH
B
A
A B
w
8
A B
B
A B
w
QH -
B
A
A B
w
+
A
B
A B
w
+
QH 2
8
8 8
B
A B
A
w
+
8 8
8 8
8
A B
A B
B
w
+
1=ove, we simp+y &se two-ris.y-assets portfo+io to ca+c&+ate the minim&m variance portfo+io
weights% )f we genera+iAation to portfo+ios containing assets, the minim&m portfo+io weights can
then =e o=taine( =y minimiAing the /agrange f&nction ! for portfo+io variance%
8
@in
n n
p i j ij i j
i j
ww
S&=Gect to
8
%%%
w w w + + +
( )
Cov
n n n
i j i j i
i j i
! ww rr "
_
+
,
BI%8C
in which
sec&rities consi(ere( grows% The efficient set that is generate( =y the aforementione( approach
BeD&ation I%8C is sometimes ca++e( the minimm-variance set =eca&se of the minimiAing nat&re of
the /agrangian so+&tion%
C#%u#tin) t$e wei)$ts o" o!ti*# risky !ort"o#io
Jne of the goa+s of portfo+io ana+ysis is minimiAing the ris. or variance of the portfo+io%
Previo&s section intro(&ce the ca+c&+ation of minim&m variance portfo+io, we minim&m the
variance of portfo+io s&=Gect to the portfo+io weightsF s&mming to one% )f we a(( a con(ition into
the eD&ation I%8# whish is =e s&=Gect to the portfo+ioFs attaining some target e9pecte( rate of
ret&rn, we can get the optima+ ris.y portfo+io%
8
@in
n n
p i j ij i j
i j
""
S&=Gect to
( )
*
n
i i
i
" E R E
, where
*
E
is the target e9pecte( ret&rn an(
%2
n
i
i
"
The first constraint simp+y says that the e9pecte( ret&rn on the portfo+io sho&+( eD&a+ the target
ret&rn (etermine( =y the portfo+io manager% The secon( constraint says that the weights of the
sec&rities investe( in the portfo+io m&st s&m to one%
The /agrangian o=Gective f&nction can =e written5
( ) ( )
*
8
Cov
n n n n
i j i j i i i
i j i i
! ww rr E wE r w
1 _
+ +
1
] ,
BI%?C
Ta.ing the partia+ (erivatives of this eD&ation with respect to each of the varia=+es,
8
, ,%%%%,
w w w
8
, , an( setting the res&+ting eD&ations eD&a+ to Aero yie+(s the minimiAation of ris.
s&=Gect to the /agrangian constraints% Then, we can so+ve the weights an( these weights are
represente( optima+ ris.y portfo+io =y &sing of matri9 a+ge=ra%
)f there no short se++ing constraint in the portfo+io ana+ysis, secon( constraint,
%2
n
i
i
w
, sho&+(
8
s&=stit&te to
%2
n
i
i
w
$
an(
8
$
are shown together with the efficient frontier% The
$
c&rve has a higher
s+ope, in(icating a greater +eve+ of ris. aversion% The investor is in(ifferent to any com=ination of
p
r
an(
p
BI%8C
For the portfo+io with two ris.y assets, the e9pecte( ret&rn an( stan(ar( (eviation of portfo+io
S are
B C B C B C
P A A B B
E r w E r w E r +
BI%"C
2
K
1
)tandard *eviation
E
+
p
e
c
t
e
d
,
e
t
r
n
@inim&m
variance
portfo+io :fficient
frontier of
ris.y assets
$
8
$
"
8 8 8 8 P 8
B 8 C
P A A B B A B AB A B
w w w w + + BI%4C
When we ma9imiAe the o=Gection f&nction,
S
!A%
, we have to satisfy the constraint that the
portfo+io weights s&m to % Therefore, we so+ve a mathematica+ pro=+em forma++y written as
B C
i
p f
S
w
p
E r r
!A%
Ma&
S&=Gect to
i
w
%)n this case of two ris.y assets, the so+&tion for the weights of the o!ti*#
risky !ort"o#io S, can =e shown to =e as fo++ows
7
5
8
8 8
L B C M L B C M
L B C M L B C M L B C B C M
A f B B f AB A B
A
A f B B f A A f B f AB A B
B A
E r r E r r
w
E r r E r r E r r E r r
w w
+ +
Then, we form an optima+ comp+ete portfo+io
8
given an optima+ ris.y portfo+io an( the C1/
generate( =y a com=ination of portfo+io S an( ris.-free asset% We have constr&cte( the optima+
portfo+io S, we can &se the in(ivi(&a+ investorFs (egree of ris. aversion, 1, to ca+c&+ate the optima+
proportion of comp+ete portfo+io to invest in the ris.y component%
1ss&ming that a ris.-free rate is
f
r
, an( a ris.y portfo+io with e9pecte( ret&rn
B C
p
E r
an(
stan(ar( (eviation
p
+
7
The so+&tion proce(&re for two ris.y assets is as fo++ows% S&=stit&te for e9pecte( ret&rn from eD&ationI%" an( for
stan(ar( (eviation from eD&ation I%4% S&=stit&te
A
w for
B
w % Differentiate the res&+ting e9pression for Sp with
respect to
A
w , set the (erivative eD&a+ to Aero, an( so+ve for
B
w %
8
The comp+ete portfo+io means that the entire portfo+io inc+&(ing ris.y an( ris.-free assets%
#
Setting the (erivative of this e9pression to Aero, we can so+ve for
'
yie+( the optima+ position
for ris.-averse investors in the ris.y asset,
*
' , as fo++ows5
*
8
B C
2%2
p f
p
E r r
'
A
BI%!C
The so+&tion shows that the optima+ position in the ris.y asset is, as one wo&+( e9pect,
inverse+y proportiona+ to the +eve+ of ris. aversion an( the +eve+ of ris. Bmeas&re( =y the varianceC
an( (irect+y proportiona+ to the ris. premi&m offere( =y the ris.y asset%
Jnce we have reache( this point, genera+iAing to the case of many ris.y assets is
straightforwar(% Kefore we move on, +et &s =rief+y s&mmariAe the steps we fo++owe( to arrive at the
comp+ete portfo+io%
% Specify the ret&rn characteristics of a++ sec&rities Be9pecte( ret&rns, variances,
covariancesC%
8% :sta=+ish the ris.y portfo+io5
a% Ca+c&+ate the optima+ ris.y portfo+io S%
=% Ca+c&+ate the properties of portfo+io S &sing the weights (etermine( in step an(
eD&ations I%" an( I%4%
4% 1++ocation f&n(s =etween the ris.y portfo+io an( the ris.-free asset5
a% Ca+c&+ate the fraction of the comp+ete portfo+io a++ocate( to Portfo+io S Bthe ris.y
portfo+ioC an( to ris.-free asset BeD&ation I%!C%
=% Ca+c&+ate the share of the comp+ete portfo+io investe( in each asset an( in ris.-free
asset%
7
"igre X.3 *etermination of t'e optimal portfolio
)n practice, when we try to constr&ct optima+ ris.y portfo+ios from more than two ris.y assets
we nee( to re+y on @icrosoft :IC:/ or another comp&ter program% We present can =e &se( to
constr&ct efficient portfo+ios of many assets in the ne9t section%
ALTERNATI(E COMPUTER PRO-AME TO CALCULATE EFFICIENT FRONTIER
Severa+ software pac.ages can =e &se( to generate the efficient frontier% )n this section, we wi++
(emonstrate the metho( &sing @icrosoft :9ce+ an( @1T/1K%
A!!#i%tion. Mi%roso"t E/%e#
:9ce+ is far from the =est program for generating the efficient frontier an( is +imite( in the
n&m=er of assets it can han(+e, =&t wor.ing thro&gh a simp+e portfo+io optimiAer in :9ce+ can
i++&strate concrete+y the nat&re of the ca+c&+ations &se( in more sophisticate( T=+ac.-=o9F programs%
-o& wi++ fin( that :9ce+, the comp&tation o the efficient frontier is fair+y easy%
1ss&me an 1merican investor who forms a si9-stoc.-in(e9 portfo+io% The portfo+io consists of
si9 stoc. in(e9es5 Unite( State BSUP"22C, Unite( ,ing(om BFTS:22C, SwitAer+an BSwiss @ar.et
)n(e9, S@)C ,Singapore BStraits Times )n(e9, ST)C, Hong,ong BHang Seng )n(e9, HS)C , an( ,orea
B,orea Composite Stoc. Price )n(e9, ,JSP)C, with month+y price (ata from Van% ??2 to Dec%
822#% HePshe wants to .now hisPher optima+ portfo+io a++ocation%
)n(ifference C&rve
Jpport&nity Set of 3is.y
1ssets
Jptima+
Comp+ete
Portfo+io
C1/
2
Jptima+ 3is.y Portfo+io
)tandard *eviation
E
+
p
e
c
t
e
d
,
e
t
r
n
f
r
8
The @ar.owitA portfo+io se+ection pro=+em can =e (ivi(e( into three parts% First, we nee( to
ca+c&+ate the efficient frontier% Secon(+y, we nee( to choose the optima+ ris.y portfo+io given oneFs
capita+ a++ocation +ine Bfin( the point at the tangent of a C1/ an( the efficient frontierC% Fina++y,
&sing the optima+ comp+ete portfo+io a++ocate f&n(s =etween the ris.y portfo+io an( the ris.-free
asset%
)tep one4 "inding efficient frontier
First, we nee( to ca+c&+ate e9pecte( ret&rn, stan(ar( (eviation, an( covariance matri9% The
e9pecte( ret&rn an( stan(ar( (eviation can =een ca+c&+ate( =y app+ying the :9ce+ STD:E an(
1E:31': f&nctions to the historic month+y percentage ret&rns (ata
?
% Ta=+e I%81 an( K shows
average ret&rns, stan(ar( (eviations, an( the corre+ation matri9
2
for the rates of ret&rn on the stoc.
in(e9% 1fter we inp&t Ta=+e I%8A into o&r sprea(sheet as shown, we create the covariance matri9 in
Ta=+e I%8B &sing the re+ationship
B , C
i j ij i j
!ov r r
%
-a0le X.2 Performance of si+ stock inde+es
?
The e9pecte( ret&rn an( stan(ar( (eviation of each in(e9 nee( to =e ann&a+iAe(%
2
The corre+ation matri9 is ca+c&+ate( in :9ce+ &sing the (ata ana+ysis f&nction that is fo&n( &n(er the Too+ @en&% *ote
if Data 1na+ysis (oes not appear on the Too+ @en& yo& wi++ nee( to se+ect 1((-in an( a(( to the @en&%
?
-a0le X.2 (2onclded)
82
-a0le X.2 (2onclded)
8
Kefore comp&ting of the efficient frontier, we nee( to prepare the (ata to esta=+ish a
=enchmar. against which to eva+&ate o&r efficient portfo+ios, we can form a =or(er-m&+tip+ie(
covariance matri9% We &se the target mean of "W for e9amp+e% To comp&te the target portfo+ioFs
mean an( variance, these weights are entere( in the =or(er co(umn B)*+B,) an( =or(er row C)-+
H)-% We ca+c&+ate the variance of this portfo+io in ce++ C"# in Ta=+e I%8./ The entry in C"# eD&a+s
the s&m of a++ e+ements in the =or(er-m&+tip+ie( covariance matri9 where each e+ement is first
m&+tip+ie( =y the portfo+io weights given in =oth the row an( co+&mn =or(ers% We a+so inc+&(e two
ce++s to comp&te the stan(ar( (eviation an( e9pecte( ret&rn of the target portfo+io Bform&+as in ce++s
C"7, C"8C
%
To comp&te points a+ong the efficient frontier we &se the :9ce+ So+ver in Ta=+e I%8D Bwhich yo&
can fin( in the Too+s men&C
8
% Jnce yo& =ring &p So+ver, yo& are as.e( to enter the ce++ of the target
Bo=GectiveC f&nction% )n o&r app+ication, the target is the variance of the portfo+io, given in ce++ C"#%
So+ver wi++ minimiAe this target% -o& ne9t m&st inp&t the ce++ range if the (ecision varia=+es B in this
case, the portfo+io weights, containe( in ce++s K!?-K"!C% Fina++y, yo& enter a++ necessary constraints
into the So+ver% For an &nrestricte( efficient frontier that a++ows short sa+es, there are two
constraints5 first, that the s&m of the weights%2 Bce++ K""HC, an( secon(, that the portfo+io
e9pecte( ret&rn eD&a+s target ret&rn "W Bce++ K"8H"C
4
% Jnce yo& have entere( the two
constraints yo& as. the So+ver to fin( the optima+ portfo+io weights%
The So+ver =eeps when it has fo&n( a so+&tion an( a&tomatica++y a+ters the portfo+io weight
ce++s in row !8 an( co+&mn C to show the ma.e&p of the efficient portfo+io% )t a(G&sts the entries in
the =or(er-m&+tip+ie( covariance matri9 to ref+ect the m&+tip+ication =y these new weights, an( it
shows the mean an( variance of this optima+ portfo+io-the minim&m variance portfo+io with mean
ret&rn of "W% These res&+ts are shown in Ta=+e I%8., ce++s C"#-C"8% -o& can fin( that they yie+(
an e9pecte( ret&rn of "W with a stan(ar( (eviation of 7%W Bres&+ts in ce++s C"8 an( C"7C% To
generate the entire efficient frontier, .eep changing the reD&ire( mean in the constraint Bce++ C"8C,
Keca&se the e9pecte( ret&rns an( the portfo+io weights are represente( =y co+&mn vectors B(enote(
e
an(
w
respective+y, with row vector transposes
0
e
an(
0
w
C, an( the variance-covariance terms =y matri9
1
, then the
e9pressions can =e written as simp+e matri9 form&+as% So, the ca+c&+ation of e9pecte( ret&rn an( variance of portfo+io
can &se the :9ce+ array f&nctions%
@atri9 notation :9ce+ form&+a5
Portfo+io ret&rn5
0
w e
HSU@P3JDUCTBw,eC
Portfo+io variance5
0
w 1w
H@@U/TBT31*SPJS:B C,@@U/TB , CC w 1 w
8
)f So+ver (oes not show &p &n(er the Too+s men&, yo& sho&+( se+ect 1((-)ns an( then se+ect 1na+ysis% This sho&+( ass
So+ver to the +ist of options in the Too+s men&%
4
)f yo& (o not set the secon( constraint5 target mean eD&a+ to 82, then yo& can the minim&m variance portfo+io% The
minim&m variance portfo+io has 8%#47W e9pecte( ret&rn an( a stan(ar( (eviation of "%#!4W%
88
+etting the So+ver wor. for yo&% )f yo& recor( a s&fficient n&m=er of points, yo& wi++ =e a=+e to
generate a graph of the D&a+ity of Fig&re I%8%
)f short se++ing is not a++owe(, the So+ver a+so a++ows yo& to a++ ;no short sa+es> an( other
constrains easi+y% We nee( to impose the a((itiona+ constraints that each weight Bthe e+ements in
co+&mn K an( row !?C m&st =e nonnegative% Jnce they are entere(, yo& repeat the variance-
minimiAation e9ercise &nti+ yo& generate the entire restricte( frontier% The o&ter frontier in Figure
2/- is (rawn ass&ming that the investor may maintain negative portfo+io weights, the insi(e frontier
o=taine( a++owing short sa+es% Ta=+e I%8 : an( F present a n&m=er of points on the two frontiers
with an( witho&t short sa+es% -o& can see that the weights in restricte( portfo+ios are never negative%
The minim&m variance portfo+ios in two frontiers are not the same%
Kefore we move on, +et &s s&mmariAe the steps of &sing So+ver to ca+c&+ate the variance-
minimiAation portfo+io%
The steps with So+ver are5
% )nvo.e So+ver =y choosing Too+s then Jptions then So+ver%
8% Specify in the So+ver parameter Dia+og Ko95 the Target ce++ to =e optimiAe( specify ma9
or min
4% Choose 1(( to specify the constrains then J,
!% So+ve an( get the res&+ts in the sprea(sheet%
"igre X.5 Efficient frontier of nrestricted and restricted portfolio
84
Portfolio Efficient "rontier
2
"
2
"
82
8"
42
2 " 2 " 82 8" 42 4"
Portfo+io 3is. BWC
P
o
r
t
f
o
+
i
o
3
e
t
&
r
n
B
W
C
3estricte( Unrestricte( SUP "22 FTS:22 S@) ST) HS) ,JSP)
)tep two4 "inding optimal risk$ portfolio
*ow that we have the efficient frontier, we procee( to step two% )n or(er to get the optima+ ris.y
portfo+io, we sho&+( fin( the portfo+io on the tangency point of capita+ a++ocation an( efficient
frontier% To (o so, we can &se the So+ver to he+p &s% First, yo& enter the of the target f&nction,
;ma9im&m> the rewar(-to-varia=i+ity ratio B
B C
p f
p
E r r
+ +
+ +
+
* *
B A
w w
Case one5 Two assets are perfect+y position corre+ate(
)f short sa+es are a++owe(, then even tho&gh
Se++ing short asset 1 an( go e9tra +ong in asset K
8
)f , +
8 8
8
*
B C B C B C B C
L B C M
L B C M
5 2
B C
, B C B C
B C
B C
B C B C
p A A A B
p A A A B
p A A A B
p
B
A
A A B
p p
A B A B
A A
p
p
A A B
p
p A B
A
E R w E r w E r
w w
w w
M1P w
w
E R
E r E r
w w
E R
E R
w E r E r
w
+
+
+
+
t
+
>
>
+
+ >
+
+
*
*
* *
C
L B C M
B C
B C
B C B C
c%
2%"
2%"
2%"
B C 2%" 2
L B
A B B
A A
p A A A B
p
p p
A A B
A B
p
A p B B
A
A A
B
A A A
A B
B
p A B B B
A B
p A A A
w4en w w
w w
E R
E R
w E r E r
w
w
w w
%et w w w
w w
+
>
+
+
+ +
+ +
<
<
+
+ <
+
*
C M L B C M
L M
B C
B C
B C B C
B C
B A A B B
A A
p A A B A B
p
p p
A A B
A B
p
A p A B
A
w
w4en w w
w w
E R
E R
w E r E r
w
w
+
<
+
+
+
%ppendi+ &
4#
The weights of minim&m variance portfo+io
The weights sho&+( =e chosen so that Bfor e9amp+eC the ris. is minimiAe(, that is
8 8 8 8 8
@in 8
A
P A A B B A B AB A B
w
w w w w + +
for each chosen ret&rn an( s&=Gect to
, 2, 2
A B A B
w w w w +
% The +ast two constraints simp+y
imp+y that the assets cannot =e in short positions%
S&=stit&te
B , C
A B
AB
A B
!ov r r
8
8 8 8
8 8 8 8 !
P
A A B A B AB A B A AB A A
A
w w w
w
+ +
H
8 8 8
8 B 8 C 8 8 2
A A B AB A B B AB B A
w +
8
8 8
8
B AB A B
A
A B AB A B
w
B A
w w
When QH
B
A
A B
w
8
A B
B
A B
w
When QH -
B
A
A B
w
+
A
B
A B
w
+
When QH 2
8
8 8
B
A B
A
w
+
8 8
8 8
8
A B
A B
B
w
+
47