Memorandum

To: Mr. I
From: Jonathan Taylor Clayton
Date: November 16, 2019
Subject: Suggestion of two optimal risky portfolios.

I am writing to inform you that I have created two optimal risky portfolios, one with short

sale and the other without short sale option using combination of nine risky assets. Graphs of two

efficient frontiers, one having shorting and one without having shorting are also included for

your convenience. I have also described how I obtained the optimal risky portfolios under both

options and explained the related technical terms.

The optimal risky portfolio with short sale is expected to give an annual return of 8.78%

with a stand deviation of 2.10%. The proportion of investment required in each of the assets: the

S&P500, short-maturity corporate bonds, long-maturity corporate bonds, international equity: the

MSCI index, real estate, high yield securities, leveraged loans, hedge funds, and 30-year bond

are 0.2738, 0.8147, - 0.2145, -0.3547, 0.1132, 0.0209, 0.0184, 0.2740, 0.0542 respectively.

Figure 1: Efficient frontier with short sale together with optimal risky portfolio

Efficient frontier with short sale

14
Expected return (%)

12
10
8
6 Investment Opportunity Set
4
Optimal risky portfolio
2
0
0.0000 0.5000 1.0000 1.5000 2.0000 2.5000 3.0000 3.5000
Standard deviation (%)
 The optimal risky portfolio without the short sale option does not include all the assets; it

includes only four assets: short-maturity corporate bonds, real estate, leveraged loans, and hedge

funds with proportion of 0.7830, 0.0901, 0.0472, and 0.0798 respectively. Expected return from

this optimal risky portfolio is 7.69% with a standard deviation of 2.21%.

Figure 2: Efficient frontier without short sale together with optimal risky portfolio

Efficient frontier without short sale

14
12
Expected return (%)

10
8
6 Investment Opportunity Set
4 Optimal risky portfolio
2
0
0.0000 2.0000 4.0000 6.0000 8.0000 10.0000
Standard deviation (%)

An efficient frontier is the graphical representation of the set of optimal portfolios that

provides the highest possible return for a given level of risk. An efficient frontier with short sale

is different from that of without short sale because of advantage provided by the short sale. Short

sale is not mandatory, but is an added advantage in the form of flexibility. As a result, often short

sale increases attractiveness of a portfolio by increasing expected return or by decreasing risk or

both. The optimal risky portfolio lies on the efficient frontier. Optimum risky portfolio is the

portfolio having the greatest Sharpe ratio. Sharpe ratio is the ratio of excess return to risk.

One advantage of having a portfolio of assets is that risk is diversified, not necessarily by

decreasing return. Diversification is the act of adding verities in the portfolio primarily to reduce

risk of the portfolio. Correlation is the strength and direction of a relationship between returns of
two securities. Covariance is a similar concept. Correlation is a standardized value whereas

covariance is not. Only portfolios of assets with perfectly positive correlation of returns is not

subject to reduction of risks. In all other situation, risk is diversified and diversification is highest

with assets having perfectly negative correlation of returns. So, variance of the portfolio can be

less than one or more assets in the portfolio. Return of the portfolio is the weighted average of

the return of the assets in the portfolio, and so, still remains high even though risk is reduced.

Understanding portfolio theory help us to do this as portfolio theory deal with risk and return.

I had to start with calculating average of monthly returns and standard deviation of

returns for each of the nine risky assets and had to annualize both the returns and standard

deviations. I had to find correlation of returns of each pair of all the nine assets. Covariance of

returns is obtained by multiplying correlation by each of the standard deviation of the pairs of

returns. Then, I found the bordered covariance by multiplying corresponding two weights. I had

to assign initial weight for all the nine assets to make an initial portfolio. Sum of all the elements

of 9×9 bordered covariance matrix is the variance of the portfolio. Standard deviation is obtained

by taking the square root of variance. Return of the portfolio is obtained by calculating weighted

average of returns of all the nine assets. Sharpe ratio of the portfolio is calculated dividing excess

return by standard deviation. Using excel solver, for a given level of return ranging from 1 to 12

percent, I found minimum standard deviation. Plotting return against standard deviation, I drew

two efficient frontiers. Optimal portfolios were obtained by maximizing Sharpe ratio by varying

weights. Negative weights were allowed for portfolio with short sale, but were not allowed for

portfolio without short sale.

Attachment: Excel file showing calculations