Finding a Minimum-Risk Portfolio

The example on the next page illustrates the calculations which underlie the
Capital Asset Pricing Model (CAPM).

There are three investment alternatives, and our goal is to find, for any
"target" expected rate of return, the portfolio for which the standard deviation
of the rate of return on the portfolio (i.e., the value in cell B12) is minimal.

I've set up "Solver" to solve the minimization problem, To set the target rate
of return, select the equality constraint in the Solver menu-box, and click on
"Change".

I've also tabulated (by invoking Solver 11 separate times) the optimal
portfolios, and graphed the standard deviation of the rate-of-return of the
optimal portfolio below the table.

Note: Don't let the final tab of this workbook frighten you. I built it in order to
show that the same approach, with a bit more work, can also deal with
investment opportunities for which the rates of return are not independent.
Not surprisingly, for any target rate of return, there's somewhat more risk in
the optimal portfolio than there was in the independent case: The risk can't
be as fully "diversified away" when the covariances in rates of return are all
positive.
 Independent Rates of Return

budget $100.00

Investment A Investment B Investment C

E[ROR] 10.00% 12.50% 15.00%
Stdev[ROR] 3.00% 4.00% 5.00%

$ invested $32.65 $34.69 $32.65

E[portfolio ROR] 12.50%

Stdev[portfolio ROR] 2.36%

minimum-risk portfolio that achieves minimum

E[ROR]
the target expected rate of return stdev(ROR)
10.00% $100.00 $0.00 $0.00 3.00%
10.50% $80.00 $20.00 $0.00 2.53%
11.00% $67.55 $24.90 $7.55 2.29%
11.50% $55.92 $28.16 $15.92 2.17%
12.00% $44.29 $31.43 $24.29 2.20%
12.50% $32.65 $34.69 $32.65 2.36%
13.00% $21.02 $37.96 $41.02 2.63%
13.50% $9.39 $41.22 $49.39 2.98%
14.00% $0.00 $40.00 $60.00 3.40%
14.50% $0.00 $20.00 $80.00 4.08%
15.00% $0.00 $0.00 $100.00 5.00%
E[ROR]

Risk vs. Rate of Return

15.00%

12.50%

10.00%

7.50%

5.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
Stdev(ROR)
 risk-free ROR
7.00%

1.000
1.383
1.747
2.072
2.277
2.334 market portfolio
2.283
2.179
2.059
1.839
1.600

Data for tangent line

7.00% 0.00%
12.50% 2.36%
18.67% 5.00%
 Correlated Rates of Return
correlation matrix
budget $100.00 3.00%
3.00% 1.00
Investment A Investment B Investment C 4.00% 0.20
E[ROR] 10.00% 12.50% 15.00% 5.00% 0.30
Stdev[ROR] 3.00% 4.00% 5.00%
covariance matrix
$ invested $33.55 $32.90 $33.55 A
A 0.00090
E[portfolio ROR] 12.50% B 0.00024
Stdev[portfolio ROR] 3.01% C 0.00045

minimum-risk portfolio that achieves minimum

E[ROR]
the target expected rate of return stdev(ROR)
10.00% $100.00 $0.00 $0.00 3.00%
10.50% $80.00 $20.00 $0.00 2.68%
11.00% $64.92 $30.16 $4.92 2.61%
11.50% $54.46 $31.07 $14.46 2.66%
12.00% $44.01 $31.99 $24.01 2.80%
12.50% $33.55 $32.90 $33.55 3.01%
13.00% $23.09 $33.81 $43.09 3.29%
13.50% $12.64 $34.72 $52.64 3.62%
14.00% $2.18 $35.64 $62.18 3.98%
14.50% $0.00 $20.00 $80.00 4.42%
15.00% $0.00 $0.00 $100.00 5.00%
E[ROR]

Risk vs. Rate of Return

15.00%

12.50%

10.00%

7.50%

5.00%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
Stdev(ROR)
correlation matrix
4.00% 5.00%
0.20 0.30
1.00 0.45
0.45 1.00

covariance matrix
B C
0.00024 0.00045
0.00160 0.00090
0.00090 0.00250

risk-free ROR
7.00%

1.000
1.307
1.534
1.693
1.787
1.824 market portfolio
1.822
1.796
1.758
1.698
1.600

Data for tangent line

7.00% 0.00%
12.50% 3.01%
16.12% 5.00%