2020/21 BMAN20072 Investment Analysis

Dr. Yoichi Otsubo, Alliance Manchester Business School

Week 2-2: Markowitz Portfolio Optimisation

0. Contents

1. Example spread sheet [P.1]

2. Data preparation: Expected Excess Returns and Covariance matrix [P.2]

3. Find the Optimal Portfolio [P.6]

4. Efficient Frontier and Optimal CAL [P.9]

1. Example spread sheet

a. There are 4 sheets:
i. monthly_data: Monthly data of price series for the five stocks, BWY,
SDRY, SAFE, BVIC, SMIN and 1month LIBOR (risk free rate; 1m LIBOR is
already in rate). 61 months.
ii. returns: monthly returns of the five stocks and 1m LIBOR. 60 months.
iii. Excess returns: monthly excess returns of five stocks. 60 months.
iv. efficient frontier: there are six blocks
1. Expected Excess Returns: Expectation of one month excess
returns of five companies.
2. Covariance Matrix: Covariance matrix of the five stocks
3. Adjusted Covariance Matrix: Covariance matrix adjusted for
degree of freedom
4. Efficient frontier: One global minimum portfolio, minimum
variance portfolios for given risk premium, and one optimal
portfolio.
5. Graph: Plots the efficient frontier and optimum Capital
Allocation Line (CAL).
6. Solver parameters: Parameters to define optimisation problem
and restrictions on Solver. There are three settings:
a. Find Min. Variance Portfolio
b. Efficient Frontier
c. Find Optimal Portfolio

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2. Data preparation: Expected Excess Returns and Covariance matrix
a. Load the Solver Add-in and open a new excel file.
b. In the first sheet of your excel file, copy and paste the monthly price series of
five stocks and 1month LIBOR (1m LIBOR is already in rate). 61 months. Name
the sheet [monthly_data].
c. In the second sheet, calculate the monthly returns as in the example file.
Name the sheet [returns].
d. In the third sheet, calculate the monthly excess returns as in the example file.
Name the sheet [excess returns].
e. Open a fourth sheet; name it [efficient frontier]. Give Expected excess
returns. In this example I randomly give them.

f. Use Covariance function to calculate the covariance matrix. Data > Data
analysis > Covariance. (If you don’t see Data Analysis, please load it.)

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Input Range: ‘excess returns’!$B$1:$F$61

Output Range: $B$9:$G$14

The function only provides the lower triangle of the matrix. Fill in the upper
triangle. Covariance matrix is a “symmetric” matrix, i.e., elements in the 1st
row = elements in the 1st column, 2nd row = 2nd column,… etc.

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g. As the Excel’s Covariance function does not adjust for degree of freedom, you
need to do it by yourself. Multiply all the elements of the Covariance Matrix
by 60/59. (Note: 60 is number of returns you have in your data (61 months of
price. Hence degree of freedom = 60 -1 = 59. In general, N/N-1 must be
mutiplied, where N is number of returns.)

Give equal weights of 0.2 to each stock (does not have to be equal weight;
they are used as initial values of optimization procedure).

Formula in cell C18: = A20, … , Formula in cell G18: = A24.

Complete the block:

1. Formula in cell A25: =SUM(A20:A24).
2. The last row of bordered covariance matrix, Cell C25:G25. Formula in
cell C25: =C18*SUMPRODUCT($A$20:$A$24,C20:C24)
…
Formula in cell G25: =G18*SUMPRODUCT($A$20:$A$24,G20:G24)

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 3. Mean (Risk premium) of portfolio with given weights, Cell A26.
Formula in cell A26: =SUMPRODUCT($A$20:$A$24,$B$2:$B$6)
4. Standard deviation (Risk) of portfolio with given weights, Cell A27.
Formula in A27: =SUM(C25:G25)^0.5
5. Slope (Sharpe ratio) of portfolio with given weights, Cell A28. Formula
in cell A28: =A26/A27

h. Copy and paste the block [6. Solver parameters] from the example spread
sheet to your spread sheet. You will use these to give restrictions and
objective function to Excel Solver function in the next step.

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3. Find the Optimal Portfolio
a. Find the optimum portfolio that maximizes the slope (Sharpe ratio) of CAL.
Data > Solver

Click Load/Save button. (screen shot below is the one already with the loaded
setup. Should be empty or show previously used setup).

Load setting for [c. Find Optimal Portfolio] from the block [6. Solver
parameters].

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You should see the below setting:
It maximizes the number in cell A25, i.e. slope of the portfolio, by changing
the weights, subject to the constraints of 1. sum of the weights equals to one;
2.each weight should not be smaller than 0.05 (this constraint is not
necessary but will use for our coursework). Click Solve.

Click OK.

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You will see the results in the Block 3.

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4. Efficient Frontier and Optimal CAL

a. Find the Global Minimum Variance Portfolio, G. Open Solver and load
optimization setting to find global minimum variance portfolio. Select the
setup for [a. Find Min Variance Portfolio] in the block [6. Solver Parameters].

You should then see the below setting:

It minimize the number in cell A27, i.e. standard deviation of the portfolio, by
changing the weights, subject to the constraints of 1. sum of the weights
equals to one; 2.each weight should not be smaller than 0.05 (this constraint
is not necessary).

You will see the results in block 3. Adjusted Covariance Matrix

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 Save it in the block 4. Efficient Frontier.

Note that the results for Optimum portfolio are saved here as well.

b. Use the expected excess return of the global minimum variance portfolio,
0.0490, as the starting point to draw the efficient frontier. For given expected
excess return, find a portfolio that minimize its variance (standard deviation).
Here the given risk premiums are 0.0502, 0.0513, 0.0524, 0.0535, 0.0547,
0.0558 (optimum), 0.0569, 0.0580.

Give the value of expected excess return in cell L2. Formula in cell L2: =L5

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Open solver. Load the setting for [b. Efficient frontier].

You should see the below setting: It minimizes the number in cell A27, i.e.
standard deviation of the portfolio, by changing the weights, subject to the
constraints of 1. sum of the weights equals to one; 2.each weight should not
be smaller than 0.05 (constraint for our assignment); 3. Expected excess
return is fixed to the value given in the cell L2.

You will see the result in Block 3.

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Save the result in Block 4.

Repeat it for other risk premiums to complete the block.

Calculate risk premium for optimal CAL. Its slope is the slope of the optimal
portfolio, 1.5424. Give a starting point of standard deviation, 0.0320, in this
case. Then for each standard deviation, calculate the risk premium of optimal
CAL in cells J13:S13. The formula in J13: =$Q$7*J6, …, formula in S13: =
=$Q$7*S6.

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c. Prepare the inputs needed to draw efficient frontier and optimal CAL from
Block 4.

Select I17:K27, then Insert > Scatter > Scatter with smooth lines and markers

With a bit of editing and formatting, you can draw a plot like the one below.

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