Mean-Variance Portfolio Theory

Math Review I
• Asset j’s return in State s:
Rjs = (Ws – W0) / W0
• Expected return on asset j:
E(Rj) = ∑sProb(State=s)xRjs
• Asset j’s variance:
σ2j = ∑sProb(State=s)x[Rjs- E(Rj)]2
• Asset j’s standard deviation:
σj = √σ2j
• Thus, Rj ~ N(E(Rj), σ2j)
 Math Review I
• Covariance of asset i’s return & j’s return:
Cov(Ri, Rj)= E[(Ris- E(Ri))x(Rjs- E(Rj))]
=∑sProb(State=s)x[Ris- E(Ri)]x[Rjs- E(Rj)]
• Correlation of asset i’s return & j’s return:
ρij = Cov(Ri, Rj) / (σiσj)
-1 ≤ ρij ≤ 1
When ρij = 1 => i and j are perfectly positively
correlated. They move together all the time.
When ρij = -1 => i and j are perfectly negatively
correlated. They move opposite to each other all
the time.
 Math Review II
• 4 properties concerning Mean and Var

Let ũ be random variable, a be a constant

1) E(ũ+a) = a + E(ũ)
2) E(aũ) = aE(ũ)
3) Var(ũ+a) = Var(ũ)
4) Var(aũ) = a2Var(ũ)
 Quick Activity - 1
Suppose the current price {P0) of Bayside Smoke is $25 per share and you tell
your friend that after a careful analysis the best estimate of the price per share
at the end of the time period is given in Table 5.1.

For Bayside Smoke compute the expected return and the standard deviation
 Quick Activity - 2
Consider the following set of returns for assets X and Y:

Compute the expected return and the standard deviation for assets X and Y.
Also find covariance between assets X and Y
Illustration: A case of 2 risky assets
• Assume you have 2 risky assets (x & y) to
invest, both are normally distributed.
Rx ~ N(E[Rx], σ2x) & Ry ~ N(E[Ry], σ2y)
In your investment portfolio, you put a in x, b in y.
• a + b = 1 (a and b in %)

Compute Portfolio Expected Return and Portfolio

Variance and interpret your answer.
 Illustration: A case of 2 risky assets
Your Portfolio’s Expected Return E(Rp) is:
E(Rp) = E[aRx + bRy]
=aE(Rx)+ bE(Ry)

To calculate your Portfolio Variance:

σ2p = E[Rp - E(Rp)]2
= E[(aRx + bRy)-E[aRx + bRy]]2
= E[(aRx - aE[Rx])+(bRy - bE[bRy])]2
= E[a2(Rx - E[Rx])2 + b2(Ry - E[Ry])2 + 2ab(Rx- E[Rx])(Ry -E[Ry])]
= a2 σ2x + b2 σ2y + 2abCov(Rx, Ry)
= a2 σ2x + b2 σ2y + 2abCov(Rx, Ry)
Var σ2p = a2 σ2x + b2 σ2y + 2abσxσyρxy
s.d. σp = √(a2 σ2x + b2 σ2y + 2abσxσyρxy)

• Thus, the portfolio’s return is normally distributed too

Rp ~ N(E[Rp], σ2p)
Illustration: A case of 2 risky assets
σp = √(a2 σ2x + b2 σ2y + 2abσxσyρxy)
σp increases as ρxy increase.

Implication: given a (and thus b, because they add up to 1),

if ρxy is smaller, the portfolio’s variance is smaller (i.e.,
the risk is lower)

Diversification: you want to maintain the expected return at

a definite level but lower your risk exposure. Ideally, you
hedge by including another asset of similar expected
return but is highly negatively correlated with your
original asset.
 Quick Activity – 2 (revisited)
Consider the following set of returns for assets X and Y: Suppose we invest half
our assets in X and half in Y.

(a) Compute portfolio return and risk.

(b) Plot the relationship between the expected return on the portfolio and the
percentage of the portfolio, a, that is invested in risky asset X.
(c) Compute the minimum variance portfolio and plot the same in portfolio
mean and standard deviation space.
(d) Suppose security returns are related in such a way that X = 1.037Y + 1.703.
How will your results change?
(e) Suppose the returns on X and Y are perfectly inversely correlated. Then
find the relationship between portfolio mean and standard deviation.
Min-Variance opportunity set with
the 2 risky assets
Suppose:
E(Rp) rx ~ N(10%, (8.72%)2) & ry ~ N(8%, (8.41%)2)
σp = √(a2 σ2x + b2 σ2y + 2abσxσyρxy)

10%

 = -0.33

%8

σp
8.41% 8.72%
Min-Variance opportunity set with
the 2 risky assets
Suppose:
E(Rp) rx ~ N(10%, (8.72%)2) & ry ~ N(8%, (8.41%)2)
σp = √(a2 σ2x + b2 σ2y + 2abσxσyρxy)

10% The green line represents the

risk and return provided for all
combinations of X and Y when
they are perfectly correlated.
This trade-off is a straight line,
in the mean-variance
argument plane because no
matter what percentage of
wealth, a, we choose to invest
%8 =1 in X, the trade-off between
expected value and standard
deviation is constant.

σp
8.41% 8.72%
Min-Variance opportunity set with
the 2 risky assets
Suppose:
E(Rp) rx ~ N(10%, (8.72%)2) & ry ~ N(8%, (8.41%)2)
σp = √(a2 σ2x + b2 σ2y + 2abσxσyρxy)

10% If the assets have

 = -1 perfect inverse
correlation, it would be
8.92% possible to construct a
perfect hedge. That is,
the appropriate choice
%8  = -1 of a will result in a
portfolio with zero
variance.

σp
8.41% 8.72%
 Min-Variance Opportunity Set

Line AB in Fig. 5.7 shows the risk-return trade-offs available to the

investor if the two assets are perfectly positively correlated, and line
segments AC and CB represent the trade-offs if the assets are perfectly
inversely correlated. However, these are the two extreme cases. Usually,
assets are less than perfectly correlated (i.e., -1 < rxy < 1). The general
slope of the mean-variance opportunity set is the solid line in Fig. 5.7.
Min-Variance opportunity set
Min-Variance Opportunity set – the locus of risk & return
combinations offered by portfolios of risky assets that yields
E(Rp) the minimum variance for a given rate of return

In general, the minimum variance opportunity

set will be convex (as represented by the solid
line in Fig. 5.7). This property is rather obvious
because the opportunity set is bounded by the
triangle ACB. Intuitively, any set of portfolio
combinations formed by two risky assets that
are less than perfectly correlated must lie inside
the triangle ACB and will be convex

σp
 Efficient set
Efficient set – the set of mean-variance choices from the
investment opportunity set where for a given variance (or
E(Rp) standard deviation) no other investment opportunity offers a
higher mean return.

σp
 Investors’ choices with many risky
assets, no risk-free asset
E(Rp)
U’’’ U’’ U’

Efficient set
S As long as there is no
riskless asset, a risk
P averse investor would
maximize his or her
Q expected utility by
Less
finding the point of
risk-averse tangency between
More investor the efficient set and
the highest
risk-averse indifference curve.
investor
σp
 Introducing risk-free assets
• Introduce one risk-free asset. Its variance and covariance with the risky
asset are zero. So, portfolio variance is simply the variance of the risky
asset.
• Assume borrowing rate = lending rate
• Then the investment opportunity set will involve any straight line from
the point of risk-free assets to any risky portfolio on the min-variance
opportunity set.
• Points along the line represent portfolios consisting of combinations of
risk-free and risky assets.
• Several possibilities are graphed. However, only one line will be
chosen because it dominates all the other possible lines.
• The dominating line = linear efficient set
• This line has come to be known as the Capital Market Line (CML). It
represents the relationship between risk and return for efficient portfolio
of assets.
• This line through risk-free asset point is tangent to the min-variance
opportunity set.
• The tangency point = portfolio M (the market)
 Capital market line = the linear efficient set

E(Rp)

M
E(RM)
The investor could attain the
minimum variance portfolio at point
B, but he will not choose this
B alternative because he will do
better with some combination of
risk-free asset and portfolio M
5%=Rf

σp
σM
Investors’ choices with many
risky assets, 1 risk-free asset
E(Rp) CML

B
Q
M

rf

σp
Investors’ choices with many
risky assets, 1 risk-free asset
E(Rp) CML
Investor 1
B
Q Investor I who is least risk-averse will
borrow (at risk-free rate) to invest
Investor 2 M more than 100 percent of his portfolio
in the risky market portfolio M. For
e.g., his investment portfolio consist of
around - 50% on the risk-free asset,
A 150% on the market portfolio.

Investor II is relatively more risk-averse

and will choose to invest a large part of
rf his portfolio in the risk-free asset. For
e.g., his investment portfolio consist of
around 50% on the risk-free asset, 50%
on the market portfolio.
σp
 The Epilogue

• All an investor needs to know is the combination of

risky assets that makes up the portfolio M as well
as the risk-free asset. This is true for any investor,
regardless of his degree of risk aversion.
• Each investor will have his own utility-maximizing
portfolio that is a combination of the risk-free asset
and a portfolio (or fund) of risky assets that is
determined by the line drawn from the risk-free
rate of return tangent to the investor’s efficient set
of risky assets.