S09 Portfolio Theory

PORTFOLIO THEORY
SELECTION OF SECURITIES IN RISKY ASSET

PORTFOLIO THEORY
• Portfolio theory essentially is a three step process – Capital
Allocation, Asset Allocation and Security Selection.
Capital Allocation:
– Under the top-down approach we first allocated the capital in single risky asset
and single risk-free asset. Risky asset is optimal i.e. has maximum increase in
return for a given change in risk i.e. maximum Sharpe ratio.
Asset Allocation:
– Risky asset may comprise several asset classes with varying risk such as stocks,
commodities, international stocks etc.
Security Selection:
– Once capital allocation is done, assets with different risk return trade-off are
decided, the final phase is identification of individual securities in each class of
asset.
Portfolio Theory RAJIV SRIVASTAVA 2
OBJECTIVES OF A PORTFOLIO
• Portfolio consists of diverse types of asset classes. Each asset class
serves a different purpose.
• Most people do have savings canalised in various other assets like
insurance policies, provident funds, fixed deposits etc. each of the
which serves a different purpose.
• Portfolios to have offsetting effect on the return of one asset on
another.
• Idea of a portfolio comes from different needs that individuals
need to fulfil.

PORTFOLIO RETURN AND RISK
• Different asset classes in the portfolio provide an offsetting effect.
• Due to offsetting effects in a portfolio the return and risk
characteristics – the two most important dimensions of investment
management, are substantially different than those of individual
security and asset classes comprising it.
• They need to be studied separately.

PORTFOLIO RETURN
• When portfolio consists of several assets the return on the portfolio
is given by weighted average of the returns of individual The
expected return for each share can be found by using the
probability-weighted average returns under three different
scenarios
n
Rp= w1R1+w2R2+w3R3……=  w i Ri
1
• Expected returns of five shares 1, 2, 3, 4, and 5 are respectively
18%, 24%,10%, 23%, 30% then the expected return of the portfolio
comprising shares 1 to 5 in the ratio of 1:2:3:4:5
1 2 3 4 5
Rp = x18 + x24 + x10 + x23 + x 30 = 22.53%
15 15 15 15 15

PORTFOLIO RISK
• The risk of the portfolio is measured by the variance of its return –
the same measure as used for single asset.
• The variance of the portfolio is calculated in the same manner as
that of a single asset.
• The variance of the portfolio, σp2 is defined as sum of the squared
deviations from the expected value multiplied by the probability
of occurrence. If Rp is the expected return of the portfolio then the
portfolio variance is
2 n
Var,σ p =  pi (Rp - Rp ) 2

COVARIANCE
• How do returns co-vary with one other is defined as covariance.
For variance we multiply the deviation from its mean.
• Covariance of two securities is determined by product of
deviation of one security and deviation of another security i.e.
n
Cov(R1 ,R2 ) = ∑ pi (R1 - R1 )(R2 - R2 )
1

MEANING OF COVARIANCE
• Covariance between two securities indicates the direction and
extent of linkage of behaviour of variations of returns of two
securities.
– Positive covariance implies that the deviations of returns from
the expected values of the two securities move in same
direction.
– Negative covariance means that the deviations are in opposite
directions.
– The extent of relationship is reflected in the magnitude of the
covariance.

COMPUTING COVARIANCE – 2 RISKY ASSETS
• The covariance of Bollywood and Tollywood is computed as
below:
Scenario
Expected
Conditions A B C
Return
Returns (%)
Bollywood 20.00 15.00 10.00 15.50
Tollywood 12.00 15.00 18.00 14.70
Covariance
Probability, p 30% 50% 20%
Deviation – Bollywood 4.50 -0.50 -5.50
Deviation – Tollywood -2.70 0.30 3.30
p x Product of
deviations -3.65 -0.08 -3.63
Covariance -7.35

COEFFICIENT OF CORRELATION
• Covariance provides the extent of relationship of two securities in
absolute terms.
• To facilitate comparison in relative terms, another measure called
coefficient of correlation is used.
• Coefficient of correlation, denoted as ρ (rho) is defined as
covariance divided by product of the standard deviations.
Cov(R1 ,R2 )
Coefficient of Correlation, ρ =
σ1σ 2

INTERPRETING
COEFFICIENT OF CORRELATION
• Coefficient of correlation can range from –1.00 to +1.00.
• Negative sign indicates an inverse relationship between the two
securities i.e. the returns of the two securities would move in
opposite directions. If returns of one security increases, the return of
the other security decreases.
• A positive value signifies movement in the same directions.
• The magnitude of coefficient of correlation indicates how strong
the relationship is. The values of coefficient of correlation of +1.00
and –1.00 denote perfect positive and perfect negative correlation
implying complete offsetting of positive and negative values.

TWO – ASSET PORTFOLIO
• A factor to be chosen by investor in devising a portfolio is the
proportion of wealth to be invested in each asset.
• The proportion of wealth in each asset can alter the risk-return
characteristics of the portfolio substantially.
• Consider two assets be Bollywood and Tollywood, which have
following characteristics:
Bollywood Tollywood
Expected Return, % 15.50 14.70
Standard Deviation, % 3.50 2.10
Covariance - 7.35
Coefficient of correlation - 1.00

PORTFOLIO RETURN AND RISK
• By changing the proportion of wealth in Bollywood and Tollywood we
can form numerous portfolios.
• The returns of the portfolio would be given as weighted average of
returns of securities in the portfolio.
• However the variance of the portfolio is not a weighted average.
• When two assets with variances of σ12 and σ22 are combined to form
a portfolio, the variance of the portfolio is given by
2 2 2 2 2
Variance of the portfolio, σ p = w1 σ1 + w 2 σ 2 + 2w1w 2Cov(R1 ,R2 )

PROFILE - PORTFOLIO RISK AND RETURN
• Portfolio risk can indeed be less than the least of the risk of the
constituents of the portfolio.
• It is possible because of the negative or low covariance between
the returns of the two assets.
• Portfolio characteristics are dependent on
a. selection of assets in the portfolio, their returns and variances
b. the relative weights of each, and
c. degree of correlation among the securities.

PROFILE - PORTFOLIO RISK AND RETURN
• We choose Security 1 and Security 2 with expected returns of R1
and R2 respectively at 15% and 30% respectively, and standard
deviation of σ1 and σ2 of 10% and 20% respectively.
• The relationship of Security 1 and Security 2 is defined as
covariance between the two.
• The relative measure of relationship is defined by coefficient of
correlation ρ which can take any value from -1.00 to + 1.00.
• We examine two extreme cases of perfect negative and perfect
positive correlation i.e. ρ = -1.00 and ρ = +1.00.

CASE 1: PERFECT POSITIVE CORRELATION
• When there exists perfect positive correlation among the securities of
Firm 1 and Firm 2 the portfolio return and risk are given as below:
Portfolio Return, Rp = w1R1 + w 2 R2
2 2 2 2 2
Portfolio Risk, σ p = w1 σ1 + w 2 σ 2 + w1w 2 ρσ1σ 2
2 2 2 2 2
σp = w1 σ1 + w 2 σ 2 + w1w 2 σ1σ 2 ,with ρ = 1
= (w1σ1 + w 2 σ 2 ) 2
or σp = (w1σ1 + w 2 σ 2 )
• Both returns and risks are weighted average when correlation is
positive and perfect.
CASE 2: PERFECT NEGATIVE CORRELATION
• When there exists perfect negative correlation among the securities of
2 2 2 2 2
Portfolio Risk, σ p = w1 σ1 + w 2 σ 2 + w1w 2 ρσ1σ 2
2 2 2 2 2
σ p = w1 σ1 + w 2 σ 2 - w1w 2 σ1σ 2 ,( with ρ = - 1)
2
= (w1σ1 - w 2 σ 2 )
or σ p = (w1σ1 - w 2 σ 2 )

CASE 3: NON PERFECT CORRELATION
• When there exists perfect negative correlation among the securities of
Portfolio Return = w1R1+w2R2

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑖𝑠𝑘, 𝜎p 2 = 𝑤1 2 σ1 2 + 𝑤2 2 σ2 2 + 𝑤1 w2 𝜌𝜎1 σ2

PORTFOLIO RETURN AND RISK PROFILE
• With different proportions of wealth in Firm 1 and Firm 2 the locus of portfolio return
and risk is depicted in Figure
Portfolio Return and Risk and Coefficent of Correlation
Return, %
30 x Security 2
ρ = +1.00
ρ = -1.00
-1.00 < ρ < 1.00
15 x Security 1
10 20
Standard Deviation, %

MARKOWITZ’S DIVERSIFICATION
SELECTION OF SECURITIES IN RISKY PORTFOLIO
EFFICIENT AND INEFFICIENT PORTFOLIOS
• Figure earlier depicts the locus of return and risk of portfolios with
various coefficients of correlation.
• There are two segments for ρ = -1.00. As we move from Security 1
increasing proportions of Security 2 in the portfolio, we observe
a. the portfolio risk decreases and
b. portfolio return increases.
c. after a certain point though the return continues to increase with
increased proportions of Security 2 but the risk too increases.

• The locus gives rise to multiple portfolios for same risk but with different
returns, and with same return but different risks.
• We define an efficient portfolio as one for which there is no portfolio
that
a. offers greater return for the same risk, or
b. offers lower risk for the same return.

• Graphically efficient and inefficient portfolios are depicted in Figure 5-2

EFFICIENT FRONTIER
• All feasible portfolios are not efficient i.e. there exist a
portfolio that either offers higher return for the same risk
or offers lesser risk for the same return.
• Locus of efficient portfolios is called efficient frontier.
• Efficient frontier implies the superiority of the portfolios
falling on it in terms of
a. either maximum return for given risk
b. or least risk for given return.
• Portfolio chosen by the rationale investor must
necessarily lie on the efficient frontier.
EFFICIENT FRONTIER
SEVERAL RISKY ASSETS
• For several risky assets the feasible
portfolios are represented by a
space (rather than a straight line)
bound by individual securities,
and
• Efficient frontier converts to an
arc, rather than a straight line.
• All investors would necessarily
choose portfolios that lie on the
efficient frontier, and ignoring
those not on it.
CAPITAL ALLOCATION TO RISKY AND
RISK-FREE ASSETS
PORTFOLIO – ALLOCATION TO ASSETS
• At the broadest and first level, the portfolio theory
attempts to answer:
• How much proportion of wealth must be allocated
to risky assets, and
• How much proportion of wealth must be allocated
to risk free assets.
• It is the first step towards portfolio construction.
• The detailed composition of risky and risk free assets in
terms of individual securities is secondary to the problem
of capital allocation.
PORTFOLIO – ALLOCATION TO ASSETS
• Investors do not see return and risk in isolation, but take a
combined view of the both.
• Investors demand a risk premium (excess return over risk
free propositions) for investing in risky assets.
• A game or investment that does not offer risk premium to
risky assets is referred as fair game.
• Most investors tend to reject fair game.
• Investors would invest in risk free assets, and in risky assets
provided that risky assets offer some risk premiums.
RISK AVERSION
• All investors are risk averse, and do not have same risk-return profile.
• We know that risk and return go hand in hand. If one wants more
returns he would have to take more risk.
• Investors value different investment opportunities and have a trade-off
between risk and return i.e. extra returns desired by investor for
increasing the risk are different for different investors.
• For the same amount of increase in risk if investor desire larger extra
return he is classified as risk averse investor.
• Different investors desire different risk premiums for the same amount of
increase in risk.
• For the same amount of increase in risk if an investor desires a
– larger risk premium then he is more risk averse, and
– smaller risk premium then he is less risk averse.

UTILITY OF MONEY
• Investors see risk and return not in isolation but see in combined
form. Increasing returns are viewed positively but increasing risk is
perceived negatively.
• An investment is measured in terms of utility of money, U with
– Increasing return (R) increasing the utility of money, and
– Increasing risk (σ)decreasing the utility of money.
• With U representing utility of money, with degree of risk aversion

measured as A we have
U = R – 0.005Aσ2 (R and σ are in % form)
• Rather than minimising risk or maximising return, investors tend to
maximise utility of money.
UTILITY OF MONEY UTILITY AND WEALTH
Utility Change in Utility

• Utility is not linearly proportional to
wealth. U0
• As wealth increases the utility too

increases, but at a decreasing rate.
This is called decreasing marginal
utility i.e. for same increase in wealth Changein Wealth
increase in wealth becomes smaller
and smaller.
• Decrease in wealth is more painful
than pleasure of increase in wealth by
the same amount. This is risk aversion.
• Typical utility functions that exhibit risk
aversion are log normal or square root
functions i.e. U = lnW or √ W W0 Wealth
Portfolio Theory 31
RAJIV SRIVASTAVA
ISO-UTILITY CURVE
• Iso-utility means that two of more investments despite different risks
and returns can provide identical utility.
• The locus of all those investments with different returns and risks that
provide same utility is called iso-utility curve.
– For example consider an investor with risk aversion coefficient, A = 1.00 the utility
of an investment with 20% return and 20% risk is U = R1 – 0.005σ12= 20 – 0.005 x 202
= 18.
– If another investment offers 25% return then the same investor would be
indifferent if the risk associated with this investment is 37.42% as this would provide
the same utility of 18.00.
U = R1 – 0.005σ12= R2 – 0.005σ22=25 – 0.005 x 20 x 20
= 25 – 0.005 σ22 or σ22 = 1400 equivalent to σ2 = 37.42%

OPTIMUM PORTFOLIO
• With the maximisation of utility the investor must choose a
portfolio that lies on efficient frontier.
• Therefore, optimum portfolio must satisfy the following
conditions:
• It must lie on the efficient frontier, and
• Must maximise risk-return trade-of, (steepest CAL), and
• Must maximise utility for the investor.

OPTIMUM PORTFOLIO –
GRAPHICAL VIEW
Finding Optimum Portfolio
Return, %
Increasing utility
U=5
U=4 B
O Efficient
R0 U=3 Frontier
U=2
A
U=1
σ0 Standard Deviation, %

CERTAINTY EQUIVALENT RATE
• Certainty equivalent rate is the rate that a risk free investment must
offer to provide same utility as the risky investment.
• It helps in comparing desirability of different investments.
U = R – 0.005Aσ2 (R and σ are in % form)
U = R – 0.5Aσ2 (R and σ are in decimal form)
EXAMPLE: A risky investment has 20% return and 30% risk. T-bills offer 7%.
Would an investor with risk aversion of 4 invest in risky asset?
Investor A = 4: U = R – 0.005Aσ2 = 20 – 0.005 x 4 x 30 x 30 = 2
( < 7%; Not invest in risky asset)
Investor A = 2: U = R – 0.005Aσ2 = 20 – 0.005 x 2 x 30 x 30 = 11
( > 7%; invest in risky asset)
DEGREE OF RISK AVERSION
UTILITY
• Degree of risk aversion is measured
by A
– larger A implies that investor is more risk A > 0 (Risk Averse)
averse and he desires larger risk
premium for same increase in risk, and
– smaller A implies that investor is less risk RF A = 0 (Risk Neutral)
averse and he desires smaller risk RISK
premium for same increase in risk.
• Risk neutral investor (A = 0)
considers investment based on A< 0 (Risk Lover)
expected return ignoring risk.

• Risk lover (A < 0) engages in
gambling, considers risk as fun.
RAJIV
Portfolio Theory 36
SRIVASTAVA
ISO-UTILITY CURVE - EXAMPLE
• Iso-utility means that two or more investments despite having
different risks and returns can still provide identical utility.
• The locus of all those investments with different returns and risks that
provide same utility is called iso-utility (indifference) curve.
– For example consider an investor with risk aversion coefficient, A = 1.00 the utility
of an investment with 20% return and 20% risk is U = R1 – 0.005σ12= 20 – 0.005 x 202
= 18.
– If another investment offers 25% return then the same investor would be
indifferent if the risk associated with this investment is 37.42% as this would provide
the same utility of 18.00.
U = R1 – 0.005σ12= R2 – 0.005σ22=25 – 0.005 x 20 x 20
= 25 – 0.005 σ22 or σ22 = 1400 equivalent to σ2 = 37.42%

RISK AVERSION AND UTILITY CURVES
ISO-UTILITY CURVES: Iso Utility and Risk Aversion
• Locus of portfolios in the risk

Return, %
Increasing A Increasing risk aversion;
return space that exhibit same More extra return desired for
same increase in risk
utility. Also referred as
indifference curve
RISK AVERSION, A:
• High degree of risk aversion
(larger A) would have steeper
iso-utility curve.
• A flatter iso-utility curve
represent lesser risk aversion. Standard Deviation, %
Portfolio Theory 38
RAJIV SRIVASTAVA
PROPERTIES OF UTILITY CURVE AND RISK
AVERSION
Properties of utility curve and its relationship with risk aversion are:
– Higher the coefficient of risk aversion more risk averse the investor
is. More risk averse investor would require greater increase in return
for the same increase in risk.
– Greater the risk aversion higher is the value of coefficient, A
– Higher the coefficient of risk aversion steeper is the utility curve.
– For the same investment i.e. asset with same return and risk an
investor with higher coefficient of aversion would have lesser utility
value than the investor with lower coefficient of aversion.

PROPERTIES OF ISO-UTILITY CURVE
• With increasing utility the iso- Iso Utility Curves
utility curves would move Return, %
upwards. Increasing utility
• Each curve represents the same U=5

level of utility of money for U=4
different combinations of risk
and return of investments to U=3
which the investor is indifferent. U=2
U=1
• No two utility curves would ever
intersect each other. They Standard Deviation, %
remain parallel to one another.

CAPITAL ALLOCATION LINE (CAL)
• The simplest case to allocate funds to different asset classes is to
consider only two asset classes – one risk free and other risk bearing, F
and S respectively.
• Assume risk free asset, F has a return, RF of 5% and risky asset S has
return, RS of 15%. The standard deviation for F is zero, while risk of S is
20%. The correlation between the two is zero.
• Let the proportion of money invested in S is y and the remaining
amount (1 - y) is invested F.
Portfolio Return, Rp = yRs + ( 1 - y )RF = R f + y(Rs - RF )
= y 2 σ s + (1 - y) 2 σF + y(1 - y)Cov(RF ,Rs ) = y 2 σ s ,
2 2 2 2
Portfolio Risk, σ p
or σ p = yσ s Since Cov(RF ,Rs ) = 0, and  F = 0

The slope of the CAL is dependent Capital Allocation Line (CAL) - Risk Free and Risk Assets
the excess return and the additional Return, %

risk attached with S. The slope of the Sharpe Ratio
CAL, called Sharpe Ratio is
Slope of CAL = 10/20 = 0.5
Excess Return y > 1.00

Slope of the CAL = 20% S, y = 1 BORROWING
Additional Risk RS = 15%
Rs - R f 15 - 5
= = = 0.50 LENDING 15 - 5 = 10%
σs 20 y<1
F
Portfolio Return Rp = R f + Slope x σ p RF = 5%
Rs - R f σp
= Rf + x σ p = R f + (Rs - R f )
σs σs
σS = 20% Standard Deviation, %
and Portfolio Risk σP = y x σ S

CAPITAL ALLOCATION LINE (CAL) - EXAMPLES
Assume risk free asset, F has a
return, RF of 5% and risky asset S has a) 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 12 = 𝑅𝐹 + 𝑦 𝑅𝑆 − 𝑅𝐹
return, RS of 15% and risk of 20%.
= 5 + 𝑦 𝑥 10; 𝑔𝑖𝑣𝑒𝑠 𝑦 = 70%
a) What proportion must be
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘 = 𝑦 𝑥 𝜎𝑆 = 20 𝑥 0.7 = 14%
invested in risky asset to have
portfolio returns of 12%. What b) For required return of 20%:
risk investor would assume? 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 20 = 𝑅𝐹 + 𝑦 𝑅𝑆 − 𝑅𝐹
b) Can investor obtain a return of = 5 + 𝑦 𝑥 10; 𝑔𝑖𝑣𝑒𝑠 𝑦 = 150%;
20%. If so what risk he bears? 𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝑚𝑢𝑠𝑡 𝑏𝑜𝑟𝑟𝑜𝑤 50% 𝑜𝑓 𝑡ℎ𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
c) If investor wants to confine risk 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘 = 1.5 𝑥 20 = 30%
to 25% then what portfolio c) For maximum risk of 25%
should he make? 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑖𝑠𝑘 = 𝑦 𝑥 𝜎𝑆 = 25%, gives y = 1.25
Let the proportion of money 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑅𝐹 + 𝑦 𝑅𝑆 − 𝑅𝐹
invested in S is y. = 5 + 1.25 𝑥 10; 𝑔𝑖𝑣𝑒𝑠 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 17.5%
• Borrowing rate is higher than lending rate.
This creates a kink in the CAL at y = 1, as
shown in Segment SB.
Capital Allocation Line (CAL) - Different Lending and Borrowing Rate
Return, %
• The slope of the CAL is dependent the

excess return and the additional risk
B
y>1
attached with S. The slope of the CAL,

20% S
RS = 15%
called Sharpe Ratio is

y=1
15 - 5 = 10%
y<1
Excess Return RF = 5%
F
Slope of the CAL=

Additional Risk
R s −R F 15−5 σS = 20% Standard Deviation, %
= = =0.50
σs 20

• CAL is the locus of feasible portfolios with changing proportions of allocation to
risky asset (y) and remaining (1 – y) to risk free asset.
• The slope of the CAL is depends on the excess return and the additional risk
attached with S. The slope of the CAL, also referred as Sharpe Ratio, is the
reward to risk ratio.
• Slope of the CAL is independent of y. Investors can choose any portfolio along
CAL, They would have same Sharpe ratio and would only differ in the
proportions of investment in risky assets.
– The segment FS: lending segment (investors would allocate some funds to risk
free asset),
– at S y = 1: implying that 100% allocation would be made to risky asset, and
– segment beyond FS: indicates that investor would borrow ( y > 1) and owned
and borrowed funds would be invested in risky asset, S
OPTIMAL PORTFOLIO –
ONE RISKY AND ONE RISK FREE ASSET
• An investor must choose a portfolio that lies on Finding Optimum Portfolio
CAL, as well as that maximises utility.
Return, %
• Expressing utility in terms of CAL given by
substituting the values of Rp and σp in utility Increasing utility
CAL
function we get, B
U=5
𝑈=R F + (R s −R F )y−0.005Aσs 2 y 2 U=4 S
• Utility would be maximised for y* as given by R0 U=3
O
(Refer Point O)
U=2
Rs− RF
y∗=
0.01 x A x σs 2 RF
F
U=1
• At Point O the CAL and Utility Curve would be σ0 Standard Deviation, %
tangential to one another.

PORTFOLIO CONSTRUCTION
• An approach to portfolio selection would be to first categorise
investments into different classes so as to club the investment of
similar kind in terms of broad parameters.
• One such classification asset classification can be bonds, real
assets and stocks. While bonds would comprise government
securities like T-Bills, Treasury Bonds, and other government
securities offering nominal returns with minimal risk.
• Once this is done the funds may be allocated to different asset
classes depending upon the desired levels of return and risk. In the
subsequent stage funds allocated in one asset class can be
further distributed in chosen assets in the same asset class. This
process of portfolio optimisation is known as top-down approach.
EFFICIENT, INEFFICIENT AND FEASIBLE
PORTFOLIOS
Find a) non-feasible, b) feasible and efficient, and c) feasible and inefficient portfolios

COMPREHENSIVE PROBLEM
A risky asset has an expected return of 18% and standard deviation of 28%.
Investment in T-bills provide a return of 8%.
• If an investor allocates 70% to the risky asset, what expected return and
risk would he face?
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑒𝑡𝑢𝑟𝑛, 𝑅 = 𝑅𝐹 + 𝑦 𝑅𝑠 − 𝑅𝐹 = 8 + 0.7 18 − 8 = 15%
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑖𝑠𝑘, 𝜎 = 𝑦𝜎𝑆 = 0.7 𝑥 28 = 19.6%
• What is the risk reward relationship of the portfolio of the investor?
𝑅 − 𝑅𝐹 15 − 8
𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐶𝐴𝐿 = 𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = = = 0.3571
𝜎 19.6
For 1% change in risk, the return changes by about 0.36%
• If an investor requires a return of 16% what portfolio he must constitute? What
would be the risk of such a portfolio?
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑒𝑡𝑢𝑟𝑛, 𝑅 = 16 = 𝑅𝐹 + 𝑦 𝑅𝑠 − 𝑅𝐹 = 8 + 𝑦 𝑥 10 𝑔𝑖𝑣𝑒𝑠 𝑦 = 0.80 ≡ 80%
Investor must allocate 80% to the risky asset and 20% to risk free asset.
• If the investor wants to limit the risk to 18% what portfolio he would form and
what return could be expected?
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑖𝑠𝑘, 𝜎 = 𝑦𝜎𝑆 = 𝑦 𝑥 28 = 18; 𝑔𝑖𝑣𝑒𝑠 𝑦 = 0.6429
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑒𝑡𝑢𝑟𝑛, 𝑅 = 𝑅𝐹 + 𝑦 𝑅𝑠 − 𝑅𝐹 = 8 + 0.6429 𝑦 𝑥 10 = 14.429%
• If an investor has risk aversion coefficient, A = 3.5 what portfolio he must form to
maximise utility? What would be the return and risk of such a portfolio?
𝑅 −𝑅 10
• 𝑇ℎ𝑒 𝑜𝑝𝑡𝑖𝑚𝑢𝑚 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛 𝑡𝑜 𝑟𝑖𝑠𝑘𝑦 𝑎𝑠𝑠𝑒𝑡, 𝑦 ∗= 𝑆 𝐹 2 = = 0.3644
0.01 𝐴 𝜎𝑆 0.01𝑥3.5𝑥28𝑥28
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑅𝑒𝑡𝑢𝑟𝑛, 𝑅 = 𝑅𝐹 + 𝑦 𝑅𝑠 − 𝑅𝐹 = 8 + 0.3644 𝑥 10 = 11.644%
• If the investor faces a borrowing rate 0f 10%, what type of investors would
neither borrow nor lend?
𝑅 −𝑅 10
• 𝐹𝑜𝑟 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 𝑦 ∗≤ 1 = 𝑆 𝐹 2 = ; 𝑔𝑖𝑣𝑒𝑠 𝐴 ≥ 1.2755
0.01 𝐴 𝜎𝑆 0.01𝑥𝐴𝑥28𝑥28
𝑅𝑆 −𝑅𝐹 8
• 𝐹𝑜𝑟 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑦 ∗≥ 1= = ; 𝑔𝑖𝑣𝑒𝑠 𝐴 ≤ 1.0205
0.01 𝐴 𝜎𝑆2 0.01𝑥𝐴𝑥28𝑥28
𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟𝑠 𝑤𝑖𝑡ℎ 𝑟𝑖𝑠𝑘 𝑎𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡, 𝐴 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡ℎ𝑒 𝑡𝑤𝑜 𝑣𝑎𝑙𝑢𝑒𝑠 1.0205 𝑎𝑛𝑑 1.2755
𝑤𝑜𝑢𝑙𝑑 𝑛𝑒𝑖𝑡ℎ𝑒𝑟 𝑏𝑜𝑟𝑟𝑜𝑤 𝑛𝑜𝑟 𝑙𝑒𝑛𝑑.
CAPITAL ALLOCATION Capital Allocation to Two Risky Assets
TO RISKY ASSETS Return, %

30 x Security 2
• With different proportions of wealth
in Sec 1 and Sec 2 the locus of Portfolio A
portfolio return and risk is depicted
by Blue line.
CALs
• These portfolios may be combined Feasible Portfolios
with risk free asset, in such a manner Portfolio B
that maximises the risk-return trade
off.
15 x Security 1
• CAL with risk free asset and Portfolio
A has higher slope (Sharpe ratio)
than the CAL with Portfolio B. RF=7
• Therefore CAL with portfolio A is
preferred over CAL with portfolio B. 10 20

OPTIMAL CAPITAL
ALLOCATION LINE Capital Allocation to Two Risky Assets
Return, % OPTIMAL CAL

• With different proportions of wealth 30 x Security 2
Portfolio O
in Sec 1 and Sec 2 the locus of
portfolio return and risk is depicted
Blue line.
Portfolio A
• These portfolios may be combined CALs
with risk free asset, in such a manner Feasible Portfolios
that maximises the risk return trade Portfolio B
off.
• CAL with risk free asset and Portfolio 15 x Security 1
A has higher slope (Sharpe ratio)
than the CAL with Portfolio B. RF=7
• Therefore CAL with portfolio A is 10 20
preferred over CAL with portfolio B.

OPTIMAL CAPITAL ALLOCATION LINE
Excess Return 𝑅𝑜 −R𝑓
Maximise Slope of the CAL= =
Additional Risk 𝜎𝑜
𝑅𝑜 = 𝑤1 𝑅1 + 𝑤2 𝑅2
𝜎𝑜 2 =w1 2 𝜎1 2 +w2 2 𝜎2 2 +2w1 𝑤2 ρσ1 𝜎2 ; where w1 +w2 =1
For maximum slope of the capital allocation line we differentiate the CAL equation
with respect to w1 and equate it to zero for the value of w1 The proportion of fund
in Portfolio 1, w1* that yields the maximum slope capital allocation line is given by:
(𝑅 −R )𝜎 2 − (𝑅 −R )𝜌𝜎 𝜎
∗ 1 𝑓 2 2 𝑓 1 2
𝑤1 =
(𝑅1 −R𝑓 )𝜎2 2 + (𝑅2 −R𝑓 )𝜎1 2 − (𝑅1 + 𝑅2 −2R𝑓 )𝜌𝜎1 𝜎2
and 𝑤2∗ =1−𝑤1∗
OPTIMISING PORTFOLIO - EXAMPLE
Given two securities 1 and 2 with expected returns of 16% and 24% respectively,
and standard deviations of 20% and 30% respectively. T-bill serving as proxy for risk
free asset offer a return of 8%. The coefficient of correlation between Sec 1 and Sec
2 is 0.5.
What would be the return and risk of the optimum portfolio, and the Sharpe ratio?
SOLUTION
Given R1 = 16, R2 = 24 RF = 8, σ1 = 20, σ2 = 30, and ρ = 0.50
(𝑅1 − 𝑅𝑓 )𝜎2 2 −(𝑅2 − 𝑅𝑓 )𝜌𝜎1 𝜎2
𝑤1∗ =
(𝑅1 − 𝑅𝑓 )𝜎2 2 +(𝑅2 − 𝑅𝑓 )𝜎1 2 −(𝑅1 +𝑅2 −2 𝑅𝑓 )𝜌𝜎1 𝜎2
8 𝑥 900 −16 𝑥 300 3 3 5

= = and 𝑤2∗ =1− =
8 𝑥 900+16 𝑥 400 −24 𝑥 300 8 8 8
The optimal portfolio of risky assets, O would have return, and risk and Sharpe Ratio
of the CAL emanating from F and passing through Optimal portfolio O as:
3 5
𝑅𝑜 = 𝑤1 𝑅1 + 𝑤2 𝑅2 = 𝑥 16 + 𝑥 24 = 21%
8 8
2 2 2 2 2
𝜎𝑜 = w1 𝜎1 +w2 𝜎2 +2w1 𝑤2 ρσ1 𝜎2 ;
9 25 35
= 𝑥 400 + 𝑥 900 + 2 𝑥 𝑥 300 = 548.44 𝑜𝑟 𝜎0
64 64 88
= 23.42%
Excess Return 𝑅𝑜 −R𝑓 21 − 8

Maximise Slope of the CAL, Sharpe Ratio = = = = 0.56
Additional Risk 𝜎𝑜 23.42

• Optimal portfolio O would be common to all investors.
• Along with Portfolio O the investor would invest in risk free asset
according to degree of risk aversion, A and would maximise utility.
This is where different investors would differ from one another.
• Assume investor has risk aversion coefficient of 4.00
• This would be the portfolio where optimal CAL would be tangential
to Utility curve. With Portfolio O and risk free asset F the optimum
allocation to risky asset is:
𝑅0 −𝑅𝐹 21 − 8
y∗= 2
= = 59.25%
0.01 x A x σ𝑜 0.01 𝑥 4 𝑥 548.44

OPTIMAL PORTFOLIO FOR INDIVIDUALS
OPTIMAL PORTFOLIO FOR INDIVIDUAL INVESTOR
Return, % OPTIMAL CAL

R2 x Security 2
Portfolio O
R0
Utility Curves
Portfolio C Feasible Portfolios
Portfolio B
RC
R1 x Security 1
RF =7
σC σ1 σ0 σ1

• The complete portfolio, Portfolio C comprising of F, Sec 1 and Sec 2 with
allocations as follows:
ASSET Allocation
Risk Free Asset 1 – 0.5925 = 0.6075 ≡ 60.75%
Security 1 0.5925 x 3/8 =0.2222 ≡ 22.22%
Security 2 0.5925 x 5/8 =0.3703 ≡ 37.03%

PORTFOLIO CONSTRUCTION
• An approach to portfolio selection would be to first categorise
investments into different classes so as to club the investment of
similar kind in terms of broad parameters.
• One such classification asset classification can be bonds, real
assets and stocks. While bonds would comprise government
securities like T-Bills, Treasury Bonds, and other government
securities offering nominal returns with minimal risk.
• Once this is done the funds may be allocated to different asset
classes depending upon the desired levels of return and risk. In the
subsequent stage funds allocated in one asset class can be
further distributed in chosen assets in the same asset class. This
process of portfolio optimisation is known as top down approach.
• The simplest case to allocate funds to different asset classes is to
consider only two asset classes – one risk free and other risk
bearing, F and S respectively.
• Assume risk free asset, F has a return, RF of 5% and risky asset S has
return, RS of 15%. The standard deviation for F is zero, while risk of S
is 20%. The correlation between the two is zero.
• Let the proportion of money invested in S is y and the remaining
amount (1 - y) is invested F.
Portfolio Return, Rp = yRs + ( 1 - y )RF = R f + y(Rs - RF )
= y 2 σ s + (1 - y) 2 σF + y(1 - y)Cov(RF ,Rs ) = y 2 σ s ,
2 2 2 2
Portfolio Risk, σ p
or σ p = yσ s Since Cov(RF ,Rs ) = 0, and  F = 0
Portfolio Theory 61
RAJIV SRIVASTAVA
The slope of the CAL is dependent
the excess return and the
additional risk attached with S. The
slope of the CAL is
Excess Return
Slope of the CAL =
Additional Risk
Rs - R f 15 - 5
= = = 0.50
σs 20
Portfolio Return Rp = R f + Slope x σ p
Rs - R f σp
= Rf + x σ p = R f + (Rs - R f )
σs σs
and Portfolio Risk σP = y x σ S
RAJIV
Portfolio Theory 62
SRIVASTAVA
CAL AND ISO-UTILITY CURVE
• Capital Allocation Line is the locus of feasible alternatives for
investment.
• The risk and return combinations not satisfying CAL are not feasible
portfolios.
• All desired portfolios necessarily must lie on CAL. Simultaneously
portfolios must maximise utility for each investor.
• Neither return nor risk can be viewed in isolation. A combination of
risk and return forms a composite asset that provides some utility.
• Combining two would give feasible investment that maximises
utility.

CAL AND ISO-UTILITY CURVE
• Expressing utility in terms of CAL gives by substituting the values of
Rp and σp in utility function we get,
2 2
U = R f + (Rs - R f )y - 0.005Aσ s y
• Utility would be maximised for y* as given by
Rs - R f
y* = 2
0.01 x A x σ s

• There can be many capital allocation lines joining the risk free asset
with a portfolio on efficient frontier.
• The maximum slope of CAL would be provided by the that is
tangential to the efficient frontier.
• This tangential too would provide certain utility. Refer Figure 5-9 on
next slide.

CALs AND ISO-UTILITY CURVE
Figure 5-9: Finding Optimal Capital Allocation Line (CAL)
Return, % Feasible CALs
U=5 Y
U=4 B Z
O
R0 U=3
Efficient
U=2 A
Frontier
F U=1
σ0 Standard Deviation, %

EFFICIENT FRONTIER, CAPITAL ALLOCATION
LINE AND ISO-UTILITY CURVE
• Optimal portfolio is derived as below:
– Identify the optimum portfolio for an investor that is tangential to
efficient frontier as well as Iso-utility curve.
– With the risk free asset the capital allocation line is derived joining
any portfolio on efficient frontier and risk free asset.
– The CAL joining risk free asset and optimal portfolio would be
steepest and give highest reward per unit of risk taken and
therefore would be chosen by all investors.
– Optimal portfolio would be common to all investors.
– Along this CAL any portfolio could be obtained simply by
changing the proportions of investment in the risky asset.
EFFICIENT FRONTIER, CAPITAL ALLOCATION
LINE AND ISO-UTILITY CURVE

FINDING EFFICIENT FRONTIER
• The return and risk of the portfolio on n assets are dependent upon
– returns of the individual assets denoted as R1, R2, R3 etc.,
– the risk of each asset measured by variance or standard
deviation denoted as σ1, σ2, σ3 etc.,
– the linkage of various assets among themselves specified by
coefficients of correlation of each asset with rest of the assets
denoted as ρ12, ρ13, ρ23, ρ24, ρ34, ρ35 etc., and finally
– the proportion of each asset in the portfolio denoted as w1, w2, w3
etc.

FINDING EFFICIENT FRONTIER
• Mathematical representation of portfolio return and risk is,
n n n
R p =  w i Ri  p = ∑ ∑ wi w jCov( Ri ,R j )
2
1 j =1 i =1
• Optimisation process is subject to constraints

n
∑ w i = 1, and wi ≥ 0
1
• With the objective function of maximisation of return or

minimisation of risk and the constraints as above, the optimal
portfolio can be arrived using the tool of SOLVER in EXCEL.

UNDERSTANDING DIVERSIFICATION AND RISK
• General expression of portfolio risk of n securities is
n n
 p 2 = ∑∑ w i w j Cov( R i , R j )
j =1 i =1
• Assume that the portfolio a) has n securities b) is equal weighted i.e. wi = 1/n,
c) each of the security has same variance of σ, and d) each of the
correlation coefficient is same and equals ρ giving average covariance as
AvCov(Ri,Rj).
• Segregating the variance term (variance of security i with itself, Cov(Ri,Ri)= σi2
from rest of the securities (i ≠ j) the variance of the portfolio is
n n n
1 1 2 1
p 2
=
n
∑ n
i + ∑∑ n 2
Cov( Ri , R j )
1 j =1 i =1
j ≠i

UNDERSTANDING DIVERSIFICATION AND RISK
• There would be n terms of variances and n(n-1) terms of
covariance's. The average variance and average covariance are
1 n 1 n n
 = ∑  i2
2
Av Cov = ∑∑ Cov(Ri ,R j )
n(n - 1) jj=≠1i i=1
n1
• If all securities have equal standard deviation, σ and a common
correlation coefficient, ρ then the variance of the portfolio is
2 1 2 n-1
σp = σ + AvCov(Ri ,R j ),
n n
1 2 n-1 2
=  + 
n n
• With n large the portfolio risk would primarily consist of covariance
terms as 1/n approaches zero and (n - 1)/n approaches 1, and the
portfolio variance would equal ρσ2.
Efficient Frontier and Inefficient Frontier, and Diversification Effect
EFFICIENT FRONTIER, AND
DIVERSIFICATION EFFECT
Return, % Efficient Frontier
30 x Security 2
• With a correlation coefficient ρ ≤1

it is possible to reduce risk of the Risk Reduction
Diversification Effect
portfolio that is lesser than any of
the two asset. The risk reduction Minimum InefficientFrontier
would happen as long as Variance Portfolio
V
ρ ≤ σ1/σ2
• Risk reduction would take place 15 x Security 1
up to a point, V when it starts rising
again. The minimum risk
(Variance) portfolio would be 10 20
𝝈𝟐𝟐 −𝝆𝝈𝟏 𝝈𝟐 Standard Deviation, %
when 𝒘𝟏 =
𝝈𝟐𝟏 +𝝈𝟐𝟐 −𝟐𝝆𝝈𝟏 𝝈𝟐
Efficient Frontier and Inefficient Frontier, and Diversification Effect
EFFICIENT FRONTIER, AND
DIVERSIFICATION EFFECT
Return, % Efficient Frontier
30 x Security 2
• The portfolios in the segment from

Sec 1 to V are inefficient, because Risk Reduction
Diversification Effect
for every portfolio on this segment
we have another portfolio vertically Minimum InefficientFrontier
opposite in the segment from V to Variance Portfolio
Sec 2 that offer greater return for the V
same risk.
15 x Security 1
• A rationale investor therefore would
reject all the portfolios on segment
from Sec 1 to V, since for the same
risk investor has a portfolio in the 10 20
Standard Deviation, %
segment V to Sec 2, directly above it

S09 Portfolio Theory

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

S09 Portfolio Theory

Uploaded by

Copyright:

Available Formats

PORTFOLIO THEORY

SELECTION OF SECURITIES IN RISKY ASSET

Portfolio Theory RAJIV SRIVASTAVA 3

Portfolio Theory RAJIV SRIVASTAVA 4

Portfolio Theory RAJIV SRIVASTAVA 5

Portfolio Theory RAJIV SRIVASTAVA 6

Portfolio Theory RAJIV SRIVASTAVA 7

Portfolio Theory RAJIV SRIVASTAVA 8

Portfolio Theory RAJIV SRIVASTAVA 9

Portfolio Theory RAJIV SRIVASTAVA 10

Portfolio Theory RAJIV SRIVASTAVA 11

Portfolio Theory RAJIV SRIVASTAVA 12

Portfolio Theory RAJIV SRIVASTAVA 13

Portfolio Theory RAJIV SRIVASTAVA 14

Portfolio Theory RAJIV SRIVASTAVA 15

Portfolio Theory RAJIV SRIVASTAVA 17

Portfolio Return = w1R1+w2R2

Portfolio Theory RAJIV SRIVASTAVA 18

Portfolio Theory RAJIV SRIVASTAVA 19

Portfolio Theory RAJIV SRIVASTAVA 21

Portfolio Theory RAJIV SRIVASTAVA 22

Portfolio Theory RAJIV SRIVASTAVA 23

Portfolio Theory RAJIV SRIVASTAVA 29

• With U representing utility of money, with degree of risk aversion

Utility Change in Utility

• As wealth increases the utility too

Portfolio Theory RAJIV SRIVASTAVA 32

Portfolio Theory RAJIV SRIVASTAVA 33

Portfolio Theory RAJIV SRIVASTAVA 34

expected return ignoring risk.

Portfolio Theory RAJIV SRIVASTAVA 37

• Locus of portfolios in the risk

Portfolio Theory RAJIV SRIVASTAVA 39

utility curves would move Return, %

upwards. Increasing utility

• Each curve represents the same U=5

which the investor is indifferent. U=2

Portfolio Theory RAJIV SRIVASTAVA 40

Portfolio Theory RAJIV SRIVASTAVA 41

the excess return and the additional Return, %

Excess Return y > 1.00

Portfolio Theory RAJIV SRIVASTAVA 42

• The slope of the CAL is dependent the

attached with S. The slope of the CAL,

called Sharpe Ratio is

Slope of the CAL=

Portfolio Theory RAJIV SRIVASTAVA 44

• At Point O the CAL and Utility Curve would be σ0 Standard Deviation, %

tangential to one another.

Portfolio Theory RAJIV SRIVASTAVA 48

TO RISKY ASSETS Return, %

Portfolio Theory RAJIV SRIVASTAVA 52

Return, % OPTIMAL CAL

Portfolio Theory RAJIV SRIVASTAVA 53

8 𝑥 900 −16 𝑥 300 3 3 5

Excess Return 𝑅𝑜 −R𝑓 21 − 8

Portfolio Theory RAJIV SRIVASTAVA 56

Portfolio Theory RAJIV SRIVASTAVA 57

Return, % OPTIMAL CAL

Portfolio Theory RAJIV SRIVASTAVA 58

Portfolio Theory RAJIV SRIVASTAVA 59

Portfolio Theory RAJIV SRIVASTAVA 63

Portfolio Theory RAJIV SRIVASTAVA 64