AIN3220

Investment and Risk Analysis

Chapter 3
Chapter 3: Mean-Variance Analysis I - Two-
Asset Portfolio

Question:
• How should you construct the portfolios of two assets?
• Which portfolio do you choose?

Topics in this Chapter:

3.1 Basic Concepts
3.2 Combination Lines

References: EGBG Chapters 4–5.

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3.1 Basic Concepts
3.1.1 A Motivating Example
Example 3.1. Given two assets with mean

µ1 = E[r1] = 0.1, µ2 = E[r2] = 0.3

and standard deviations and correlation

σ1 = 0.2, σ2 = 0.3, ρ1,2 = 0.

Consider a portfolio P consists of two assets. Suppose you invest $300 in asset
1 and $700 in asset 2.
1. What are your portfolio weights in the two assets?
2. What is the expected return of your portfolio?
3. What is the variance of your portfolio?

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 Answer:

1. The wealth you invested in the assets: W1 = 300, W2 = 700. The total
wealth of your investment W = W1 + W2 = $1, 000. Therefore the wealth
proportions of your investment are:
W1 $300 W2 $700
x1 = = = 0.3 x2 = = = 0.7.
W $1000 W $1000
Hence your portfolio weights are (x1, x2) = (0.3, 0.7). Note that x1 +x2 = 1.
2. The return of your portfolio is

rP = x1r1 + x2r2.

Hence your expected return

µP = E[rP ] = x1E[r1] + x2E[r2] = x1µ1 + x2µ2

= 0.3 × 0.1 + 0.7 × 0.3 = 0.24.

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3. Note that the covariance of the two assets σ1,2 = ρ1,2σ1σ2 = 0. The variance
of your portfolio is

σP2 = Var(rP ) = Var(x1r1 + x2r2)

= x21σ12 + x22σ22 + 2x1x2σ1,2
= 0.32 × 0.22 + 0.72 × 0.32 = 0.0477.

Hence σP = 0.2184.

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3.1.2 Terminology
• A portfolio is a collection of assets held by an investor.
• Portfolio weights define the fractional amount of money invested in
each of the assets in the portfolio. We will denote portfolio weights with xi.

Matrix definitions
• For a portfolio consisting of assets 1 and 2, we define the following matrices:
         2 
x1 r µ1 1 σ1 σ1,2
x= , r= 1 , µ= = E[r], 1 = , Ω= ,
x2 r2 µ2 1 σ2,1 σ22
where
- x is the vector of portfolio weights,
- r is the vector of returns,
- µ is the vector of expected returns,
- 1 is the vector of ones, and
- Ω is the variance-covariance matrix.

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Budget constraint
• Because portfolio weights define the fractional amount invested in each asset,
they must sum to 1. This condition is known as the budget constraint,
x1 + x2 = 1, or in matrix form:

x>1 = 1.

Short selling
• When xi > 0, the portfolio contains a long position in the i-th asset.
When xi < 0, the portfolio contains a short position in the i-th asset.
• A portfolio without short selling satisfies the inequalities 0 ≤ xi ≤ 1,
for all i.

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Example 3.2 Suppose you have $1000. You short sell $800 worth of asset
1 so that you now have $1800. You invest the $1800 in asset 2. What are the
portfolio weights x1 and x2?
Answer: Denote x1 and x2 as the portfolio weights on assets 1 and 2, respec-
tively. Total value of your portfolio is

−$800 + $1800 = $1000. (3.1)

Hence,
−$800 $1800
x1 = = −0.8, x2 = = 1.8. (3.2)
$1000 $1000
In other words,
Asset Dollar amount Portfolio weight
1 –$800 –0.8
2 $1800 1.8
Total $1000 1

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3.1.3 Risk and return of a portfolio
• The return of a two-asset portfolio, rP , is rP = x1r1 + x2r2. The expected
or mean return of a two-asset portfolio, µP = E(rP ), is µP = x1µ1 + x2µ2.
In matrix form:

rP = x>r and µP = x>µ.

• The variance of returns for a two-asset portfolio, σP2 , is σP2 = x21σ12 + x22σ22 +
2x1x2σ1,2, or in matrix form:

σ12
  
σ1,2 x1
σP2 = x1 x2 = x>Ωx.


2
σ2,1 σ2 x2

• Why use matrices? These matrix equations are the exact same for
portfolios with more than two assets (see Chapters 4 and 5).

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Example 3.3 In matrix form, compute µP and σP in Example 3.1.

Answer: The vector of portfolio weights, the vector of expected returns, and
the variance-covariance matrix are:
     
0.3 0.10 0.04 0
x= , µ= , and Ω = .
0.7 0.30 0 0.09
Note that ρ1,2 = 0, hence σ1,2 = ρ1,2σ1σ2 = 0. The expected return and
variance of returns for your portfolio are:
 
0.10
µP = x>µ = 0.3 0.7


= 0.24,
0.30
  
0.04 0 0.3
σP2 = x>Ωx = 0.3 0.7


= 0.0477.
0 0.09 0.7
√
Therefore σP = 0.0477 = 0.2184.

Exercise: Verify that if we change x1 = x2 = 1/2 in Example 3.1, µA =

0.20 and σA = 0.1803.
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3.2 Combination Lines
3.2.1 Two-asset portfolios in mean-standard deviation space
Combination lines
• A combination line is the set of points in mean-standard deviation (µ, σ)
space that are acheivable by combining together two assets into one portfolio.
• Financial Interpretation: The combination line displays the trade-
off between risk (measured by standard deviation) and return
(measured by mean) of any combination of a two-asset portfolio.
• In Example 3.1, we calculated one point on the combination line for
assets 1 and 2. We can generate the entire combination line by cycling
through all possible portfolios of assets 1 and 2 and plotting these portfolios
in mean-standard deviation space. The result is shown in Fig. 3.1.
• The shape and position of the combination line depends on the cor-
relation, ρ1,2, between the two assets (in Example 3.1 we assumed
ρ1,2 = 0).

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 0.6

0.5

0.4

Combination with short sell

mu

0.3 Combination without short sell

Portfolio A
Asset 1
Asset 2
0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6
sigma

Figure 3.1: Combination line for assets 1 and 2 from Example 3.1 when
ρ1,2 = 0. The region where short selling occurs is dark blue. The portfolio
A with 1/2 invested in each asset is shown. The global MVP, G, is also shown
(see below).
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 0.35

0.3

0.25

0.2
Combo Line (rho=-1)
mu_P

Combo Line (rho=-0.5)

Combo Line (rho=0)
0.15
Combo Line (rho=0.5)
Combo Line (rho=1)

0.1

0.05

0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
sigma_P

Figure 3.2: Combination line for assets 1 and 2 from Example 3.1 but varying
ρ1,2 = −1, −0.5, 0, 0.5, 1.

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• In general, the combination line is a hyperbola in mean-standard deviation
space (see Fig. 3.2).
• For several special cases (see Sections 3.2.3, 3.2.4, and 3.2.5), the
combination line is a series of straight lines in mean-standard deviation
space (see Fig. 3.4 and 3.5 below).

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3.2.2 Combination lines: General Case
• Consider an arbitrary portfolio, P , with a fraction x1 invested in asset 1,
and therefore a fraction (1 − x1) invested in asset 2. The expected return
and variance of returns for the portfolio are:
µP = x>µ = x1µ1 + (1 − x1)µ2, (3.3)
σP2 = x>Ωx = x21σ12 + (1 − x1)2σ22 + 2x1(1 − x1)ρ1,2σ1σ2. (3.4)

• The equation of the combination line can be derived by rearranging Eq. (3.3)
in terms of x1, and substituting this into Eq. (3.4).
• In other words, the portfolio x1 that achieves the expected return µP is
given by the following formula

µP − µ2
x1 = ,
µ1 − µ2

with the variance of returns for the portfolio σP2 given as in Eq. (3.4).
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• Except in certain special cases, the resulting equation is a hyperbola in
mean-standard deviation space (see Fig 3.1 and 3.2).
• In Excel demonstration, we show that there is a much easier way to
graph the combination line for the general case.

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Example 3.4 Consider two assets with the expected returns µ1 = 0.10
and µ2 = 0.30 and the variances σ1 = 0.2 and σ2 = 0.3 with correlation
ρ1,2 = −0.5.
What is the portfolio x1 such that the expected return of the portfolio is
0.24? What are the variance and the standard deviation of returns for the
corresponding portfolio?
Answer: Note first that the vector of expected returns, and the variance-
covariance matrix are:  
0.10
µ= ,
0.30
 
0.04 −0.03
Ω= .
−0.03 0.09
Hence, given the expected return of the portfolio µP = 0.24, the portfolio x1
is calculated as follows:
0.24 − 0.30
x1 = = 0.3.
0.10 − 0.30

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In addition, the variance of returns for the corresponding portfolio is:
  
0.04 −0.03 0.3
σP2 = x>Ωx = 0.3 0.7


= 0.0351.
−0.03 0.09 0.7
√
and hence σP = 0.0351 = 0.1873.
Remark: What is the main difference between the portfolios in Example
3.3 and Example 3.4? What is the financial interpretation behind this
difference?

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Global MVP for two-asset portfolio
• The portfolio with the least possible variance of returns is known as the
global minimum variance portfolio, G. For a two-asset portfolio,
the weight in asset 1 for G, denoted as xG, can be derived by setting the
derivative of Eq. (3.4) with respect to x1 equal to zero:
dσP2
= 0,
dxG
implying
2xGσ12 − 2(1 − xG)σ22 + 2(1 − xG)ρ1,2σ1σ2 − 2xGρ1,2σ1σ2 = 0. (3.5)
Solving for x1 we have:

σ22 − σ1,2
xG = 2 2 .
σ1 + σ2 − 2ρ1,2σ1σ2

Financial Interpretation: The global minimum variance portfolio G

separates the combination line into the efficient and inefficient frontiers
(see Fig. 3.3 below).
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Example 3.5 Consider assets 1 and 2 from Example 3.1. What is the
expected return of the minimum variance portfolio, µG? What is the standard
deviation of returns for the minimum variance portfolio, σG?

Answer: The weight in asset 1 for G is

0.302 − 0
xG = 2 2
= 0.6923.
0.10 + 0.30 − 2 × 0
Plugging into Eqs. (3.3)–(3.4):

µG = 0.6923 × 0.10 + 0.3077 × 0.30 = 0.1615,

2
σG = 0.69232 × 0.202 + 0.30772 × 0.302 + 0 = 0.0277.
√
σG is therefore 0.0277 = 0.1664. Notice that these values correspond to the
position of G in Fig. 3.3.

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 0.6

0.5

0.4

Portfolio A
Asset 1
mu

0.3
Asset 2
G
Efficient Frontier
0.2
InEfficient Frontier

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6
sigma

Figure 3.3: Combination line for assets 1 and 2 from Example 3.5. The
Efficient Frontier is marked in green, whereas the Inefficient Frontier
is marked in blue.

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3.2.3 Special Case 1: Combination line for the case of perfect
positive correlation (ρ1,2 = +1)
In this case, we plug this into Eq. (3.4) we find that σP = ±[x1σ1+(1 − x1)σ2].
Rearranging for x1, we have

σ2±σP
x1 = .
σ2 − σ1

Substituting the above expression of x1 into Eq. (3.3) gives us the equation of
the combination line for ρ1,2 = +1:

µ1 − µ2
µP = µ2 + (σ2±σP ).
σ 2 − σ1

Notice that the combination line in this case is linear.

In this case, the variance of the global minimum variance portfolio G has zero
variance, i.e. it is riskless.
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3.2.4 Special Case 2: Combination line for the case of perfect
negative correlation (ρ1,2 = −1)
In this case, we plug this into Eq. (3.4) we find that σP = ±[x1σ1−(1 − x1)σ2].
Rearranging for x1, we have

σ2±σP
x1 = .
σ1 + σ2

Substituting the above expression of x1 result into Eq. (3.3) gives us the equa-
tion of the combination line for ρ1,2 = −1:

µ1 − µ2
µP = µ2 + (σ2±σP ).
σ1 + σ2

Notice that the combination line in this case is linear.

In this case, the variance of the global minimum variance portfolio G has zero
variance, i.e. it is riskless.
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Example 3.6 Let us revisit assets 1 and 2 from Example 3.1, except now
that ρ1,2 = ±1. What is the combination lines for the case when ρ1,2 = +1
and ρ1,2 = −1? What is the Global MVP in each case?
Answer: In this case, the vector of expected returns, µ, remains unchanged,
i.e.  
0.10
µ= .
0.30
When ρ1,2 = +1, the variance-covariance matrix now becomes
 
0.04 0.06
Ω= .
0.06 0.09

When ρ1,2 = −1, the variance-covariance matrix now becomes

 
0.04 −0.06
Ω= .
−0.06 0.09

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• For ρ1,2 = +1,
The portfolio weight on asset 1, in terms of σP , becomes
0.30 ± σp
x1 =
0.30 − 0.20
0.30 ± σP
= ,
0.10
and the combination line in this case becomes
0.10 − 0.30
µP = 0.30 + (0.30 ± σP )
0.35 − 0.20
= −0.30 ± 2σP .

In this case, the Global minimum variance portfolio xG is achieved when

σG = 0, which means xG = 0.30
0.10 = 3 with µG = −0.3.

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• For ρ1,2 = −1,
The portfolio weight on asset 1, in terms of σp, becomes
0.30 ± σP
x1 =
0.30 + 0.20
0.30 ± σP
= .
0.50
and the combination line in this case becomes
0.10 − 0.30
µP = 0.30 + (0.30 ± σP )
0.30 + 0.20
= 0.18 ± 0.4σP .

In this case, the Global minimum variance portfolio xG is achieved when σG =

0, which means xG = 0.6 with µG = 0.18.

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 0.4

0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
mu

-0.1

-0.2

-0.3

-0.4

-0.5
sigma

Figure 3.4: Combination line for assets 1 and 2 from Example 3.6 for ρ1,2 =
−1, +1. The red line denotes the combination line for the case ρ1,2 = +1,
whereas the blue line denotes the combination line for the case ρ1,2 = −1.

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3.2.5 Special Case 3: Portfolios of one risk-free asset and one
risky asset
• A risk-free asset provides a deterministic return, rF . Its return therefore
has no risk, σF = 0, and its mean or expected return is just the deterministic
return, µF = rF .
• To derive the combination line, notice that µF = rF , σF = 0, and ρ1,F = 0.
Plugging these into Eq. (3.4) we find that σP = ±x1σ1. Rearranging for x1
gives

σP
x1 = ± .
σ1

and substituting this expression of x1 into Eq. (3.3), we obtain

µ1 − rF
µP = rF ± σP .
σ1

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 • When x1 < 1, you are lending at the risk-free rate.
• When x1 > 1, you are leveraging (borrowing at the risk-free rate and
investing the proceeds in the risky security).

Example 3.7
Let us consider a portfolio with assets 1 from Example 3.1 and a risk-free
asset with rF = 0.05. What is the portfolio weight x1 on asset 1 in terms of
σP ? What is the corresponding equation for the combination line?
Answer:

• Since µ1 = 0.1 and σ1 = 0.2, it follows that the portfolio weight on asset 1,
in terms of σP , is
σP
x1 = ± .
0.2
• The combination line now becomes
0.10 − 0.05
µP = 0.05 ± σP = 0.05 ± 0.25σP .
0.20
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 0.16

0.14

0.12

0.1
mu

0.08

0.06

0.04

0.02

0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4
sigma

Figure 3.5: Combination line for assets 1 and 2 from Example 3.7. The
red lines denote the combination line with leveraging, whereas the blue line
denotes the combination line with lending.

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