Portfolio Management and Performance Evaluation: 4321

University of Minnesota November 15, 2019

Professor Erik Loualiche (eloualic@umn.edu) Problem Set 2

Portfolio Management and Performance Evaluation

Homework 2-answers.

Question (1) (Minimum Variance Frontier with one risk-free asset and one risky asset) (10
points)

(a) Zero. Because the correlation of any random-variable with a constant (note that the risk-free rate
is constant, that’s what it means to be riskfree) is always zero (there is no co-movement between a
constant and a risky asset)

(b) As I showed in class, Rule #1 of portfolio algebra states that the expected return on any portfolio is
equal to the weighted average of the expected return of the individual securities. Thus here we have:

E [Rp ] = Xs × E [Rs ] + (1 − Xs ) × Rf = Xs × 15 + (1 − Xs ) × 10 = 10 + 5 × Xs

For the standard deviation, Rule #3 of portfolio algebra states that the variance of any portfolio with
two assets is
σ 2 (Rp ) = Xs2 × σs2 + Xf2 × σf2 + 2 × Xs × Xf × σs × σf × ρs,f
now since asset F is risk-free it means that σf2 = 0 (because there is no uncertainty about its returns)
and, as we saw in part (a), ρs,f = 0. Then the previous formula simplifies to

σ 2 (Rp ) = Xs2 × σs2

√
Now to get the standard deviation, just take the square root of the variance (recall standard deviation= Variance)
to get p
σ(Rp ) = Xs2 × σs2 = |Xs | σs
Note: the reason why I take the absolute value of |Xs | is because in general we allow for short-selling
of the stock (i.e. Xs < 0). Thus if we didn’t put the absolute value, the standard deviation would be
negative when we short-sale the stock (i.e. Xs σs < 0) which does not make any sense.

(c) Look at the definition in the lecture notes. The Sharpe Ratio of the stock measures the reward per
unit of risk of the stock (naturally, a high Sharpe ratio is a good thing). It is given by:

Reward E[Rs ] − Rf 15 − 5
Sharpe Ratio= = = =1
Risk σ(Rs ) 10

(d) As we saw in class (and you have in the formula sheet (formula #6)), the CAL is given by:

E[Ri ] − Rf
E[R] = Rf + ×σ
σi
E[Rs ]−Rf
Thus, since in our case we have SRs = σs = 1 and Rf = 5, then the CAL is given by

E[R] = 5 + 1 × σ

Here is the (pretty!) picture:

2 Handout 2: Portfolio Management and Performance Evaluation

Figure 1:

(e) In class (and lecture slides), I showed you the formula for the optimal portfolio when the portfolio was
composed of two assets and one asset is risk-free. The formula is

E[Rs ] − Rf
Xsoptimal =
A × σ 2 (Rs )

and thus given the information provided, we have

(15 − 5)% 0.1

Xsoptimal = = = 20
0.5 × (10%)2 0.5 × 0.12

which is a HUGE number (in real life you would never see something like this, except perhaps LTCM...).
This portfolio means that you invest 2000% on the stock and −1900% on the Rf asset. Yes, the numbers
are right. Basically, the stock looks very attractive for this investor, and thus she would like to borrow
a lot to invest in the stock (note that she also has a low risk aversion A = 0.5). Optimal means that
this particular portfolio is the portfolio that gives this investor the highest level of utility among all
the possible portfolios that you can create with these two assets.

(f ) In this case we have:

(15 − 5)% 0.10

Xsoptimal = = = 10
1 × (10%)2 1 × (0.1)2

which is still a HUGE number. This means that this investor wants to invest 1000% on the stock and
the remaining 1 − 10 = −9 or −900% on the risk free rate. Comparing to the previous case, this result
makes sense: this investor is more risk averse (A = 1 > A = 0.5) and thus her optimal portfolio invests
relatively less on the stock.
Handout 2: Portfolio Management and Performance Evaluation 3

Question (2) (Minimum Variance Frontier with two risky asset) (5 points)

(a) As in question 1 part b, Rule #1 of portfolio algebra states that the expected return on any portfolio
is equal to the weighted average of the expected return of the individual securities. Thus here we have:

E [Rp ] = XD × E [RD ] + (1 − XD ) × RI = XD × 16 + (1 − XD ) × 10 = 10 + 6 × XD

For the standard deviation, Rule #3 of portfolio algebra states that the variance of any portfolio with
two assets is

σ 2 (Rp ) = XD
2 2
× σD + XI2 × σI2 + 2 × XD × XI × σD × σI × ρD,I

Plugging numbers we have (and using the fact that XI = 1 − XD ) (remember, sum of weights is always
one)

σ 2 (Rp ) = 2
XD × 202 + (1 − XD )2 × 152 + 2 × XD × (1 − XD ) × 20 × 15 × 0.6
2
= XD × 400 + (1 − XD )2 × 225 + 360 × XD × (1 − XD )

Now
√ to get the standard deviation, just take the square root of the variance (recall standard deviation=
Variance) to get

q
σ(Rp ) = 2 × 400 + (1 − X )2 × 225 + 360 × X × (1 − X )
XD D D D

(b) Plugging the values for XD in the formulas from the previous question yields:

XD E(Rp ) % σ(Rp ) %
−0.5 7 18.34
0 10 15
0.5 13 15.69
1 16 20
1.5 19 26.2

(c) Here is the picture. I did it in Excel (you can see how by looking at the Excel file Homework #2
answers.xls on the course webpage):
4 Handout 2: Portfolio Management and Performance Evaluation

Figure 2:

By definition, an efficient portfolio is a portfolio that has the maximum possible return for a given
level of risk. Thus any efficient portfolio will be on the minimum variance frontier, but only on the
part of the frontier that is ”above” the minimum variance portfolio (see picture).

(d) In class, I showed you the formula for the minimum variance portfolio with two risky assets which is
given by
MVP σ 2 − σAB
XA = 2 B 2
σA + σB − 2σAB
now note that (always remember the formula for covariance and correlation!) σAB = σA σB ρAB and
thus given the information provided, we have

MVP σI2 − σD σI ρDI 152 − 15 × 20 × 0.6

XD = 2 + σ 2 − 2σ σ ρ = = 0.1698
σD I D I DI 202 + 152 − 2 × 15 × 20 × 0.6

Question (3) (Minimum Variance Frontier with many risky assets) (5 points)

(a) Yes: according to the two fund separation theorem, the whole minimum variance frontier can be found
by combining any two portfolios that ARE ALSO on the minimum variance frontier. Of course, in the
real world you don’t know if a given portfolio is on the minimum variance frontier or not, so you will
always have to find them. But since this is computationally a very hard problem to do, we will not do
it. Thus I will always tell you if two portfolios are on the minimum variance frontier or not.

(b) To sketch the minimum variance frontier, we repeat exactly the same steps as in question 2. Here is
my picture (see next page). Again, the part that is efficient is the region above the minimum variance
portfolio (not shown in the picture, but by now you already know that the minimum variance portfolio
is the risky portfolio further to the left):

(c) I didn’t graded this question, I just wanted to make you think about how mean variance analysis is
done in practice. The answer to the question is a definite no! Here’s what you would need to do in a
real optimal portfolio allocation problem. You would need to estimate the expected returns, variances
and covariance of ALL securities in the market. Trust me, this is a big number (with 3000 securities in
the NYSE this means that you need to compute approximately 4.5 million values (expected returns +
variances + covariances!) and these estimates are in general hard to obtain. But don’t get discouraged,
Handout 2: Portfolio Management and Performance Evaluation 5

Figure 3:

we’ll study ways to simplify this problem and be able to make this problem manageable when we cover
the topic ”factor models”.
Now, once we have all these inputs for our portfolio selection problem (i.e. expected returns, variances
and covariances) we will need a sophisticated software to be able to generate the whole minimum
variance frontier (I say a sophisticated software because we need to find the combination of ALL assets
in the economy that maximizes the return for each level of risk). Excel can do this for simple cases
of up to 7 or 8 assets. But with more assets (imagine 3000!), if you try to do this in Excel, you will
probably get an error message...