Chapter 2

Asset Management

2.1 Introduction
Boradly speaking, asset management refers to the study of managing assets
in finance. For our purupose, we understand asset management mostly in
terms of portfolio selection. How to select an optimal portfolio has been
one of the main missions for financial managers. We clearly want to select
a portfolio that generates a maximum return over a fixed horizon. The
question is how can we achieve this goal. To understand this procedure, we
study a few key concepts about portfolio selection, which ultimatley leads
to the introduction of the celebrated Capital Asset Pricing Model (CAPM)
or the Arbitrage Pricing Theory (APT). We begin with the notion of the
returns of an underlying asset.

2.2 Returns
Let Pt be the closing price of an asset (stock or bond) at period t (day, say).
Then the returns of the asset at the end of period t, rt is defined as

rt = (Pt + Dt − Pt−1 )/Pt−1 ,

where Dt denotes the dividend or coupon income for bond delivered at the
end of day t. Without loss of generality, we may assume Dt = 0. Note that
under normal circumstances, we expect rt to be small. In practice, we usually
work with a different definition of rt which is defined as rt = log Pt −log Pt−1 .
To see the equivalence of these two definitions, note that when Dt = 0, we
can rewrite 1 + rt = Pt /Pt−1 . By taking log on both sides of this expression
and making use of the fact that log(1 + x) ∼ x for small values of x, we see
that
log(Pt /Pt−1 ) = log(1 + rt ) ∼ rt .

9
 Table 2.1:

% of Chance of Less than this Level

Level of Terminal Wealth Portfolio A Portfolio B
0.7 0 2
0.8 0 5
0.9 4 14
1.0 ∗ ∗
1.1 57 46
1.2 ∗ ∗
1.3 99 82

Hence, we can work with the definition that rt = log Pt − log Pt−1 .
Since we expect rt to be small, it may not be too unrealistic to imagine
that rt ∼ N(µ, σ 2 ) for some specified parameters µ and σ 2 (i.e., the returns
series rt are i.i.d. normally distributed random variables with mean µ and
variance σ 2 ). Now the question becomes how do we compare different returns
series for different parameter values. Consider the following example:

Example 2.2.1 Suppose that we have two stocks, A and B, with annual
returns rA ∼ N(0.08, 0.01) and rB ∼ N(0.12, 0.04). In other words, if we
invest one dollar into stock A, on the average, we have $1.08 after one year.
For stock B, we expect to have $1.12 in one year. From this perspective, it
seems that stock B offers a better return than stock A and we should go for
B. Do we pay a premium by buying stock B? Consider Table 2.1. From this
table, we see that although stock B offers a higher return, we have a bigger
chance of losing our investment in one year for stock B than stock A. In
other words, B is more risky than A.

This example leads to the following definition.

Definition 2.2.1 The standard deviation (volatility) of the returns of an

asset (stock) is usually known as the risk.

2.3 Indifference Curves, Feasible Sets and Efficient

Sets
2.3.1 Indifference Curves
Each investor determines her portfolio by means of her preference to risk
exposure. This type of preference is usually known as her indifference curve.

10
Roughly speaking, an indifference curve plays the role of a level curve in
finding an extreme point for a function of two variables. Clearly, there exist
an infinite number of indifference curves for an investor. Each investor has
a map of indifference curves that is unique to her and this map represents
her attitude to risk. There are several intuitive features of an indifference
curve.

• All portfolios that lie on a given indifference curve are equally desirable
to an investor.

• An investor will find any portfolio lying on an indifference curve that

is further “northwest” to be more desirable than any portfolio lying on
an indifference curve that is not as far “northwest”.

• A more risk-averse investor has more steeply sloped indifference curves.

2.3.2 The Feasible Set

How does an investor choose her portfolio? There can be infinitely many
possible portfolios from which an investor can choose. This is known as the
feasible set. In general, this set will have an umbrella-type shape similar
to the figure shown. Reasons for this shape will be given later. Does that
mean that the investor need to evaluate all the portfolios lying on or within
the boundary of the feasible set? The answer is no as discussed in the next
subsection.

2.3.3 Efficient Set Theorem

Harry Markowitz pointed out that the optimal portfolio selection problem
can be reduced to an optimization (maximizing expected returns) problem
under constriant (fixed risk). An investor should choose her portfolio from
the set of portfolios which satifies the efficient set theorem. That is, the
set of portfolio which

1. Offers maximum level of expected return for varyling levels of risk,

known as nonsatiation.

2. Offers minimum risk level for varying levels of expected return, known
as risk aversion.

Definition 2.3.1 The set of portfolios meeting these two conditions is known
as the efficient set or the efficient frontier.

In particular, an investor needs only to look at the efficient set from which
to choose an optimal one. In general, the set of all possible outcomes, the

11
feasible set, will be much bigger than the efficient set. An investor identifies
the efficient set from the feasible set by means of the efficient set theorem as
follows:

Figure 2.1: Feasible and Efficient Sets

Example 2.3.1 Applying rule 1, the set of portfolios that offers maximum
µ for varying σ should be lying on the “northern” boundary of the feasible
set between points E and H.
Applying rule 2, the set of portfolios that offer minimum risk for varying
levels of µ should be lying on the “western” boundary of the feasible set
between points G and S.
Since both of these two conditions have to be met, the only efficient set
are the portfolios lying on the “northwest” boundary of the feasible set be-
tween points E and S. Accordingly, an investor is going to look for an
optimal portfolio from this set of efficient portfolios, all other portfolios
are inefficient and can therefore be ignored.

How does an investor choose her optimal portfolio among the efficient
set? The answer is an investor chooses her optimal portfolio on her in-
difference curve that is “furthest northwest” among the efficient set. This
point corresponds to the point where the indifference curve is tangent to the
efficient set, indicated by O∗ in the Figure 2.2
How do we find O∗ ? That depends on the concavity (or convexity if the
figure is plotted as σ versus µ) of the efficient set. This fact can be proved
mathematically.

12
 Figure 2.2: Selecting an Optimal Portfolio

Figure 2.3: Highly Risk-Averse Investor

2.4 A Two-Stock Example

Suppose that we have two stocks A and B with returns rA and rG . Construct
a portfolio as a convex combination of these two returns as follows.
p(α) = αrA + (1 − α)rG ,
where α is a number lying between [0, 1]. Note that when α = 1, pA = p(1) =
rA corresponds to investing in stock A only while pG = p(0) corresponds to
investing in stock B only. Let rA have mean µA and variance σA 2 and r
G
2
have mean µG and variance σG . It is easily seen that the mean and variance
of the portfolio p(α) are given by
µ(α) = αµA + (1 − α)µG ,
σ 2 (α) = α2 σA
2
+ (1 − α)2 σG
2
+ 2α(1 − α)ρσA σG ,
where ρ denotes the correlation between the returns rA and rG . To compute
the risk of the portfolio, we need to know the value ρ. From this expression,

13
 Figure 2.4: Slightly Risk-Averse Investor

we see that σ 2 (α) is largest when ρ = 1 and smallest when ρ = −1. That is,

[ασA − (1 − α)σG ]2 ≤ σ 2 (α) ≤ [ασA + (1 − α)σG ]2 . (2.1)

In particular, if ρ = 1, it can be shown that the point (σ(α), µ(α)) lies on

the line segment connecting the points (σA , µA ) and (σG , µG ). On the other
hand, when ρ = −1,

σ 2 (α) = [ασA − (1 − α)σG ]2 ,

which equals to zero when

σG
α= .
σA + σG
In other words, we see that the risk of the portfolio is highest when there is
perfect correlation and lowest (zero) when there is perfect negative correla-
tion.
Now assume that rA ∼ N(0.05, 0.04) and rG ∼ N(0.15, 0.16), denoted by
points A and G in Figure 2.5 respectively. To calculate µ(α) and σ(α), pick
specific values of α and ρ. For example, when ρ = −1, we get σ( α) = 0
by taking α = 4/6 = 0.67. With this α, σ(0.67) = 0 and µ(0.67) = 0.083,
denoted by O. For other values of α, we can only find out the bounds for
σ(α). Construct seven portfolios with different values of α in Table 2.2.
Now calculate the bounds for σi for i ∈ {A, . . . , G} according to (2.1).
For example, consider portfolio D where α = 0.5. In this case, it can be
calculated that
10% ≤ σD ≤ 30%,
and µD = 10%. Similar bounds can be established for other portfolios given
in Table 2.3.

14
 Table 2.2: Seven Portfolios

A B C D E F G
α 1 0.83 0.67 0.5 0.33 0.17 0
1−α 0 0.17 0.33 0.5 0.67 0.83 1

Table 2.3: Standard Deviation of Portfolio

Portfolio Lower Bound Upper Bound

A 20 % 20 %
B 10 23.33
C 0 26.67
D 10 30
E 20 33.33
F 30 36.67
G 40 40

In particular, we note that all of the upper bounds for σ lie on the
straight line connecting A and G. Consequently, any portfolio consisting of
these two stocks cannot have a standard deviation that plots to the right
of this straight line. It must lie on or to the left of this line. Therefore,
diversification generally leads to risk reduction as the upper bound straight
line is obtained when ρ = 1.

Figure 2.5: Upper and Lower Bounds to Different Combinations of Two

Stocks

Also, we can see from the figure that the lower bounds are lying on the
straight lines from A to a point on the vertical axis with µ = 8.3%, call

15
it O and from this point O to G. Together, this means that any portfolio
must have a standard deviation lying on or inside the triangle formed by
A − O − G − A.
What about the actual locations of the portfolios? As pointed out pre-
viously, we need the value of ρ to determine their positions in the figure.
To illustrate, let us consider the case ρ = 0. Simple calculations show that
σA = 20%, σB = 17.94%, σC = 18.81%, σD = 22.36%, σE = 27.6%, σF =
33.37%, and σG = 40%. As a general pattern, for |ρ| < 1, we have a curved
segment as depicted in the figure and it is always curved to the left, the
“northwest” portion (i.e., the efficient set is always concave).
Therefore, the risk σp = σp (α, ρ) is a function of the weight α and the
correlation ρ. For any given ρ, the point (σp (α), µp ) traces out a curve lying
within the triangle. The feasible set for a given ρ for two assets is then this
curved segment, see Figure 2.6.
For three assets, it consists of curved segments of the different combina-
tions of two out of the three assets. Suppose a new portfolio, 4, is formed
by combining assets 2 and 3. Then it can be used to combine with asset
1 to form the curve connecting 1 and 4. When portfolio 4 moves up and
down the curve connecting assets 2 and 3, this line traces out the region in
Figure 2.7. For n assets, it will be in general like an umbrella-like shape as
illustrated in Figure 2.8.

Figure 2.6: Two assets Feasible Region

2.5 Markowitz Model

Suppose that we have n assets with means µ1 , . . . , µn and covariances σij , i, j =
1, . . . , n. A portfolio is constructed with weights wi , i = 1, . . . , n that sum to
1 (we allow negative weights for short selling). To find the minimum variance
portfolio, first fix the mean value at a level, µ, say. Then the mathematical

16
 Figure 2.7: Three assets Feasible Region

Figure 2.8: n assets Feasible Region

problem becomes

1
n
minimize 2 i,j=1 wi wj σij

n
subject to i=1 wi µi =µ

n
i=1 wi = 1.

This model provides the foundation for single-period investment theory.

Once the problem is formulated, it can be solved by numerical methods
to obtain specific solutions. Specifically, we can use the Lagrange multipli-
ers methods to achieve this goal. Let λ1 and λ2 be two constants and form
the Lagrangian

n n n
1   
L= wi wj σij − λ1 ( wi µi − µ) − λ2 ( wi − 1).
2 i,j=1 i=1 i=1

17
Now differentiate the Lagrangian with respect to each variable wi and set
them to zero. To illustrate the idea, consider the two variable case. We have
1
L = (w12 σ12 + w22 σ22 + 2w1 w2 σ12 ) − λ1 (w1 µ1 + w2 µ2 − µ) − λ2 (w1 + w2 − 1).
2
Hence,

∂L 1
= (2w1 σ12 + 2w2 σ12 ) − λ1 µ1 − λ2
∂w1 2
∂L 1
= (2w2 σ22 + 2w1 σ12 ) − λ1 µ2 − λ2 .
∂w2 2
Setting these derivatives to zero yeilds

w1 σ12 + w2 σ12 ) − λ1 µ1 − λ2 = 0
w2 σ22 + w1 σ12 ) − λ1 µ2 − λ2 = 0.

These two equations plus the additional two equations of the constriants
gives a total of four equations for the four unknowns w1 , w2 , λ1 , and λ2 . In
general, there are (n+2) equations for the (n+2) unknowns; w1 , . . . , wn , λ1 , λ2
as follows:
n

wj σij − λ1 µi − λ2 = 0 for i = 1, . . . , n (2.2)
j=1
n

wi µi = µ (2.3)
i=1
n

wi = 1. (2.4)
i=1

These equations can be solved by linear algebra. As an illustration, consider

the following example.

Example 2.5.1 Suppose that there are three assets that are uncorrelated,
each has variance 1 and the mean values are 1, 2, and 3. That is, σij = 0
for i = j and σii = σi2 = 1 for i = 1, 2, 3 and µ1 = 1, µ2 = 2, µ3 = 3.
Substituting these values into equations (2.2)–(2.4), we get

w1 − λ1 − λ2 = 0
w2 − 2λ1 − λ2 = 0
w3 − 3λ1 − λ2 = 0
w1 + 2w2 + 3w3 = µ
w1 + w2 + w3 = 1.

18
Solving for wi s in terms of λ1 and λ2 from the first three equations and
substituting into the last two equations, we get
14λ1 + 6λ2 = µ
6λ1 + 3λ2 = 1.
Solving for λi s in terms of µ from these two equations, we get
7
λ1 = (µ/2) − 1 and λ2 = − µ.
3
Then
4 µ
w1 = −
3 2
1
w2 =
3
µ 2
w3 = − .
2 3
The variance of the portfolio is w12 + w22 + w32 . By direct substitution,

7 µ2
σ= − 2µ + .
3 2
For different values of µ, this equation gives rise to different values of σ.
However,
√ its minimum occurs at the point µ = 2 and at this value of µ,
σ = 3/3 = 0.58. Therefore, the minimum-variance portfolio occurs at
µ = 2, σ = 0.58, w1 = 1/3, w2 = 1/3, and w3 = 1/3.
As can be seen, there is a symmetry in this example and the feasible region
is given by the bullet-shaped curve. When short selling is not allowed, the
analysis will be different. Please take a look at Example 6.10 in the text.

2.6 Two-Fund Theorem

The minimum-variance set has a very desirable property. Let w1 = (w11 , . . . ,
wn1 ), λ11 , λ12 and w2 = (w12 , . . . , wn2 ), λ21 , λ22 be two different portfolios in the
minimum variance set, that is, they both satisfy equations (2.2)–(2.4), then
αw 1 + (1 − α)w 2 is also a solution lying on the minimum variance set for
any −∞ < α < ∞. In other words, once we have determined two solutions,
the portfolios defined by a convex combination of these two will sweep out
the entire minimum-variance set, i.e., the left-most boundary of the feasible
region. Of course, we can in particular choose the two efficient portfolios
w1 and w 2 from the efficient frontier, i.e., the upper part of the minimum-
variance set. When this is done, the result is often stated in the following
form:

19
Theorem 2.6.1 (Two-fund Theorem) Two efficient funds (portfolios)
can be established so that any efficient portfolio can be duplicated, in terms
of mean and variance, as a combination of these two. In other words, all in-
vestors seeking efficient portfolios need only invest in combinations of these
two funds.

According to this result, two mutual funds can provide a complete invest-
ment service for everyone. There would be no need for anyone to purchase
other stocks separately. This result relies on some severe assumptions:

• Everyone investor cares only about mean and variance.

• Everyone investor has the same assessment of mean, variance and co-
variances.

• Only a single period investment framework.

Of course, these assumptions can be examined and questioned. However, if

you are a busy investor who cannot afford the time and effort to examine
these, you might choose two funds managed by people whose assessments
you trust, and invest in them.

2.7 Risk-Free Lending and Borrowing

What is a risk-free asset? An obvious answer would be those assets with σf =
0. What are typical examples of risk-free assets? One would tend to think
fixed income instruments such as the U.S. Treasury are risk-free. However,
even for U.S. Treasury, one needs to notice the duration to maturity.
Consider an investor with a 3-month horizon holding period who pur-
chases a treasury security maturing in 20 years. Because of the presence
of an interest rate risk, this asset cannot be considered as risk-free. The
uncertainties comes from the fluctuations of the interest rate. Because inter-
est rate will very likely be changed in an unpredictable manner during the
next 3 months, the market price of the security will likewise be changed and
consequently, the investor does not know what this secuirty will be worth
at the end of the holding period. As a result, any security with a maturity
date greater than the holding period cannot be qulaified as risk-free. The
risk in this case comes from the interest rate.
On the other hand, consider another situation where the investor pur-
chases a 30-day U.S. Treasury Bill. This security matures before the end
of the holding period. Again, due to the uncertainty in interest rate, the
investor does not know the interest rate at which the proceeds from the
maturing Treasury Bill can be reinvested for the remainder of the holding

20
period. The presence of such re-investment risk means that this security
cannot be considered as risk-free.
The only type of securities that can be qualifed as risk-free are those
when the maturity date matches the holding period. Investing in risk-free
instrument is sometimes known as risk-free lending. In practice, one usually
asssumes a nominal rate as the risk-free rate µf . By the same token, one
can also borrow money from the bank and has a risk-free interest rate, −µf .
Let us consider an example which illustrates the effect of risk-free lending
and borrowing on the efficient set. Suppose there are three stocks A, B, and
C with mean returns and variance covariance matrix in percentage as follows.
⎛ ⎞ ⎛ ⎞
16.2 146 187 145
⎜ ⎟ ⎜ ⎟
µ = ⎝ 24.6 ⎠ and Γ = ⎝ 187 854 104 ⎠ .
22.9 145 104 289

Let µf = 4% and suppose there is a portfolio P AC = 0.8A + 0.2C. Then

it can be easily calculated that rP AC = 17.52% and σP AC = 12.3%. Now
consider adding a risk-free asset X4 to P AC and form a new portfolio

P = 0.25P AC + 0.75X4 .
√
Then rP = 0.25·17.52+0.75·4 = 7.38% and σP = 0.252 × 12.32 + 0.752 × 0 =
3.08%. If we look at Figure 2.9, we find that the portfolio P corresponds
to the point P lying on the straight line between the risk-free asset and the
portfolio P AC. In general, any combination of a risky portfolio and the
riskless asset lies on the straight line connecting the riskless asset and that
portfolio.
Now let us consider what would be the effect of the riskless asset on
the efficient set. Suppose the efficient set is shown as the curved part on
Figure 2.10 with a minimum risk portfolio V . There are two straight lines
emanating from the risk-free asset. The bottom line connects the risk-free
asset and stock B. It represents portfolios formed by combining B and the
risk-free asset.
The other straight line emanating from the risk-free asset to a particular
point T that is tangent to the efficient set. Any portfolio lies on this line
is formed by a linear combination of T and the risk-free asset. Note that
T deserves special attention in the sense that there is no other portfolio
consisting purely of risky assets that, when connected to the risk-free asset
by a straight line, lies northwest of it.
In other words, part of the original efficient set is now dominated by
this line. In particular, the original efficient set going from the minimum
risk portfolio V to T is no longer efficient when a risk-free asset is made
available. Instead, the efficient set now consists of a straight line segment,
from the risk-free asset to T and a curved segment from T to B. The straight

21
 Figure 2.9: Combining Risk-free Lending with a Risky Portfolio.

line represents all portfolios formed by combining the risk-free asset and T
and the curved segment are the original efficient portfolios from T to B
which are to the northeast of T .
Consequently, depending on the shape of the indifference curve, optimal
portfolio O∗ can be located either on the straight line or on the curved
segment.
By a similar argument, we can extend the notion of risk-free lending to
risk-free borrowing by the weight α assigning to X4 to be negative. In this
case, the other weight (1 − α) can be greater than one but the sum of these
two weights is still constrained to be one. Then it can be easily seen that
the efficient set would lie beyond the point T in Figure 2.10. In this case,
the original efficient set has been changed to the line from the risk-free asset
passing through T and onward (the solid and the dotted line). Any portfolio
on the original efficient set is now dominated by a portfolio on this line which
involves either risk-free lending (before T ) or risk-free borrowing (after T ),
see Figure 2.11.

2.8 One-Fund Theorem

A risk-free asset has a return that is deteministic (i.e., σ = 0). In other
words, a risk-free asset is a pure interest-bearing instrument. Its inclusion in
a portfolio corresponds to lending or borrowing at the risk-free rate. Lending
corrsponds to a positive weight while borrowing corresponds to a negative

22
Figure 2.10: Feasible and Efficient Sets when Risk-free Lending is Intro-
duced.

weight. When we include a risk-free asset into the portfolio, the analysis can
further be simplified and the efficient set becomes much simpler. Suppose
that we have two assets: a risky asset rf with mean return µ and risk σ
and a risk-free asset r with mean return µf and risk σf = 0. Suppose these
two assets are combined to form a portfolio p = αrf + (1 − α)r. Then this
portfolio has mean

µp = αµf + (1 − α)µ
σp2 = α2 σf2 + (1 − α)2 σ 2
= (1 − α)2 σ 2 .

These equations show that both the mean and standard deviation of the
portfolio vary linearly with α. As α varies, the point representing this port-
folio traces out a straight line in the µ-σ plane.
Suppose that we have n risky assets with means µi and covariances σij .
Suppose also that there is a risk-free asset with mean µf . If we combine
the risk-free asset with the other n risky assets, how does the feasible region
look like? To see that, first construct the feasible region of the risky assets
as usual, which results in an umbrella-like shape as before. Second, for each
asset in this region, we combine it with the risk-free asset. If we allow both
lending and borrowing of the risk-free asset, these new combinations trace
out an infinite straight line originating at the risk-free point, passing through
the risky asset and continuing indefinitely. There is a line for every asset in

23
Figure 2.11: Feasible and Efficient Sets when Risk-free Lending and Borrow-
ing are Introduced.

the original feasible region. The totality of these lines forms a triangularly
shaped feasible region as given in Figure 2.12. If borrowing is not allowed for
the risk-free asset, then the resulting feasible region is shown in Figure 2.13.
When the risk-free asset is included, the efficient set consists of the single
straight line, which is in the top of the triangular feasible region. This
line will be tangent to the original feasible region of the risky assets. Any
other efficient point can be expressed as a combination of this asset and the
risk-free asset. We obtain different efficient points by changing the weights
between these two assets. Therefore, this tangent point can be considered
as a fund made up of risky assets, which when combined with the risk-free
asset, provides all the necessary information of any efficient portfolio. In
summary, we have just proved the following theorem.

Theorem 2.8.1 (One-Fund Theorem) There is a single fund T of risky

assets such that any efficient portfolio can be constructed as a combination
of this fund T and the risk-free asset.

2.9 Determining T
How can we find the tangent point that represents the efficient portfolio?
We just solve it in terms of an optimization problem. Given a point in the
feasible region, we draw a line between the risk-free asset and that point.

24
Figure 2.12: When both borrowing and lending are allowed, there is a unique
fund F that is efficient. All points on the efficient frontier are combinations
of F and the risk-free asset.

Let the angle between the line and the horizontal axis be θ. For any risky
portfolio P , we have
µP − µf
tan θ = .
σP
The tangent portfolio is the one that maximizes θ or equivalently, tan θ.
Such a solution can be found by solving a system of linear equations.
Let w1 , . . . , wn denote the weights for n risky assets and consider a

n
n
portfolio P such that rP = i=1 wi ri . We have µP = i=1 wi µi and
2
n
n
σP = i,j=1 wi wj σij . Since we assume i=1 wi = 1, it follows that µf =

n
i=1 wi µf and
n
wi (µi − µf ) u
tan θ =
ni=1 1/2
= ,
( i,j=1 σij wi wj ) v




where u = ni=1 wi (µi − µf ) and v = ( ni=1 nj=1 σij wi wj )1/2 . We then set
the derivative of tan θ with respect to each wk equal to zero. Using the
quotient rule for derivative, we have
∂ tan θ v du − u dv
= .
∂wk v2
Note that
n 
 n n
∂ 
v du = ( σij wi wj )1/2 ( wi (µi − µf )) = v(µk − µf ).
i=1 j=1
∂wk i=1

25
Figure 2.13: If only lending is allowed, the region will have a triangular front
end, but will curve for larger σ.

On the other hand,

n  n
∂ 
dv = ( σij wi wj )1/2 )
∂wk i=1 j=1
n  n n  n
1  ∂ 
= ( σij wi wj )−1/2 ( σij wi wj )
2 i=1 j=1 ∂wk i=1 j=1
n n
1 −1 ∂
= v (w1 wj σ1j + · · · + wn wj σnj )
2 ∂wk j=1 j=1
n
1 −1 
= v ( wj σkj + w1 σ1k + · · · + wn σnk ) (using prodcut rule)
2 j=1
n n
1 −1  
= v ( wj σkj + wi σik )
2 j=1 i=1
n
1 −1 
= v 2 wj σkj (since σij = σji )
2 j=1
n

= v −1 wj σkj .
j=1

26
Therefore,
n
 n

u dv = wi (µi − µf )v −1 wj σkj .
i=1 j=1

Now set
∂ tan θ
= 0,
∂wk
i.e., v du = u dv. As a result,
n
 n

(µk − µf ) = v −1 wi (µi − µf )( wi σik )
i=1 i=1
n
 n

= λ( wi σik ), where λ = v −1 wi (µi − µf ).
i=1 i=1

This leads to the following system of linear equations:

n

σki λwi = µk − µf , k = 1, . . . , n, (2.5)
i=1


where λ = v −1 ni=1 wi (µi − µf ) defined earlier. Substituting vi = λwi into
these equations, we have
n

σki vi = µk − µf , k = 1, . . . , n.
i=1

Solving for these vi s and normalizing them to get

vi
wi =
n .
j=1 vj

Example 2.9.1 Consider the portfolio consisting of stocks A, B, and C with

⎛ ⎞ ⎛ ⎞
16.2 146 187 145
⎜ ⎟ ⎜ ⎟
µ = ⎝ 24.6 ⎠ and Γ = ⎝ 187 854 104 ⎠ .
22.9 145 104 289

Let µf = 4%. Then the tangency portfolio can be solved by finding the
weights wi . In this case, we may use the Splus function solve(a,b) to solve
for the values of vi from which wi can be determined. In other words, we
want to solve for the following system of equations.
⎛ ⎞⎛ ⎞ ⎛ ⎞
146 187 145 v1 16.2 − 4
1 ⎜ ⎟⎜ ⎟ ⎜ ⎟
⎝ 187 854 104 ⎠ ⎝ v2 ⎠ = ⎝ 24.6 − 4 ⎠ .
100
145 104 289 v3 22.9 − 4

Therefore (v1 , v2 , v3 ) = (0.86, 1.55, 5.55) and hence (w1 , w2 , w3 ) = (0.12, 0.19, 0.69).

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2.10 Market Model

Having seen the notion of an efficient set and the optimal portfolio, we next
introduce the notion of the market model. Let ri denote the return of asset
i, rM denote the return of the Market at the same time, usually S&P500,
βiM denote the relationship between the asset i and the Market, and i an
idiosyncratic error term. The market model or the simplest form of the
Capital Asset Pricing Model (CAPM) states the following.

ri = αi + βiM rM + i ,

where αi denotes the intercept term in this linear relationship. This equa-
tions states that equity i is going to trend with the market according to the
regression coefficient βiM . Whatever cannot be explained by this equation
is put to the error term i . Note that there is no time dimension in this
equation, it relates a specific asset to the market at a single period. We
usually assume i to be i.i.d. random variables with mean zero. In this case,
E(ri ) = αi + βiM rM (i.e., on the average, the return of asset i is related to
the market through βiM ). For example, if rM = 10%, αi = 2%, βiM = 1.2,
then on the average, ri = 2 + 1.2 × 10 = 14%.
Clearly, the slope parameter βiM represents the sensitvity of the secu-
rity’s returns to the market returns. The higher this number is, the more
sensitive is the returns of this security to the market. This slope term is
often known as beta and it is equal to

cov(ri , rm )
βiM = ,
var(rM )

where cov(ri , rM ) denotes the covariance between ri and rM and var(rM )

denotes the volatility of the market. A stock that has a return that mirrors
the returns of the market will have a beta equal to one (and the intercept
term zero, resulting in a market model ri = rM +i ). Hence, stocks with beta
greater than one are more volatile (risky) than the market and are known
as aggresive stocks. Stocks with beta less than one are less risky and are
known as defensive stocks.
Finally, note that to estimate β, we need the values of (rit , rM t ) over
different time horizons t = 1, . . . , T and then use OLS to run a regression of
rit against rM t . For example, if we have monthly returns, we may want to
use T = 60, the pass five years of returns to estimate βiM . Note also that
the values of beta are stock specific, different stocks would have different
values of beta.

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2.11 Diversification
With the market model, we can consider the effect of divsersification. First,
what would be the risk of the market model? From its definition, it can be
easily seen that
σi2 = βiM
2 2
σM 2
+ σ
i ,
where σM2 denotes the market (systematic) risk so that the product β 2 σ 2
iM M
represents the market risk of security i and σ
i 2 denotes the unique (unsys-

tematic or idiosyncratic) risk. Similarly, if a portfolio P is constructed with

return rP = N i=1 Xi ri , then
N

rP = Xi (αi + βiM rM + i )
i=1
N N
 N

= Xi αi + ( Xi βiM )rM + Xi i
i=1 i=1 i=1
= αp + βP M rM + P ,

N

N
where αP = i=1 Xi αi , βP M = N i=1 Xi βiM and P = i=1 Xi i . In this
case, the risk of the portfolio becomes
N
 N

σP2 = ( Xi βiM )2 σM
2
+ Xi2 σ
i
2

i=1 i=1
= βP2 M σM
2
+ 2
σ
P .
Consequently, diversification leads to risk reduction. When we increase N ,
each Xi decreases so that the unique risk to the portfolio σ
P2 decreases but

the value of βP M remains relatively stable as it is a weighted average of

the betas of the individual securities. Unless a deliberate attempt is made,
increasing N would not affect this value significantly.
To see why σP2 decreases with N , consider the simple case where Xi =
1/N and the securities are all uncorrelated with the same variance C, that
2 = C. In this case,
is, i s are uncorrelated with variance σ
i
N

2 2
σ
P = σ
i /N 2
i=1
= C/N.
When we increase N to N + 1, the same calculation shows that
2
σ
P = C/(N + 1),
which is less than C/N . Consequently, diversification leads to the reduction
of the unique risk. As a rule of thumb, when N ≥ 30, the unique risk will
be very close to market risk.

29