Chap 007 Investmetnt

CHAPTER 7
Optimal Risky Portfolios
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
The Investment Decision

• Top-down process with 3 steps:
1. Capital allocation between the risky portfolio
and risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within
each asset class

7-3
The Investment Decision

• Portfolio?
• Diversification?

7-4
Diversification and Portfolio Risk
What would be the sources of risk to

your portfolio?

7-5
• Market risk
– Systematic or nondiversifiable
• Firm-specific risk
– Diversifiable or nonsystematic
– Idiosyncratic
– Unique

7-6

1. Short-term interest rates increase unexpectedly.
2. The interest rate a company pays on its short-term
debt borrowing is increased by its bank.
3. Oil prices unexpectedly decline.
4. An oil tanker ruptures, creating a large oil spill.
5. A manufacturer loses a multimillion-dollar product
liability suit.
6. A Supreme Court decision substantially broadens
producer liability for injuries suffered by product users.

7-7
Figure 7.1 Portfolio Risk as a Function of the

Number of Stocks in the Portfolio

7-8
Figure 7.2 Portfolio Diversification

7-9
Covariance and Correlation

• Portfolio risk depends on the
correlation between the returns of the
assets in the portfolio
• Covariance and the correlation

coefficient provide a measure of the
way returns of two assets vary

7-10
Backward-looking scenario analysis

7-11

7-12
Two-Security Portfolio: Return
rp = wr
D D
+ wEr E
rP = Portfolio Return
wD = Bond Weight
rD = Bond Return
wE = Equity Weight
rE = Equity Return
E ( r p ) = w D E ( rD ) + w E E ( rE )

7-13
Two-Security Portfolio: Risk
 = w  + w  + 2wD wE Cov (rD , rE )

2
p
2
D
2
D
2
E
2
E
 = Variance of Security D
2
D
 2
E = Variance of Security E
Cov (rD , rE ) = Covariance of returns for

Security D and Security E

7-14
Two-Security Portfolio: Risk
• Another way to express variance of the

portfolio:
 P2 = wD wD Cov ( rD , rD ) + w E w E Cov ( rE , rE ) + 2 w D w E Cov ( rD , rE )

7-15
Covariance
Cov(rD,rE) = DEDE
D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D
E = Standard deviation of
returns for Security E
7-16
Correlation Coefficients: Possible Values
Range of values for 1,2

+ 1.0 >  > -1.0
If  = 1.0, the securities are perfectly
positively correlated
If  = - 1.0, the securities are perfectly
negatively correlated

7-17
Correlation Coefficients
• When ρDE = 1, there is no diversification
 P = wE E + wD D
• When ρDE = -1, a perfect hedge is possible
 P = wE E − wD D = 0
D
wE = = 1 − wD
 D + E

7-18
Table 7.2 Computation of Portfolio

Variance From the Covariance Matrix

7-19
Table 7.2 Computation of Portfolio

Variance From the Covariance Matrix

7-20
Three-Asset Portfolio
E ( r p ) = w 1 E ( r1 ) + w 2 E ( r 2 ) + w 3 E ( r 3 )
 p2 = w12 12 + w22 22 + w32 32

+ 2w1w2 1, 2 + 2w1w3 1,3 + 2w2 w3 2,3

7-21
Figure 7.3 Portfolio Expected Return as a

Function of Investment Proportions

7-22
Figure 7.4 Portfolio Standard Deviation as

a Function of Investment Proportions

7-23
The Minimum Variance Portfolio

• The minimum variance • When correlation is
portfolio is the portfolio less than +1, the
composed of the risky portfolio standard
assets that has the deviation may be
smaller than that of
smallest standard either of the individual
deviation, the portfolio component assets.
with least risk.
• When correlation is -
1, the standard
deviation of the
minimum variance
portfolio is zero.

7-24

What are the investment proportions of minimum-
variance portfolio?

7-25

What are the investment proportions weights of
minimum-variance portfolio?
wMin (E)= 1- wMin(D)

7-26
Figure 7.5 Portfolio Expected Return as a

Function of Standard Deviation

7-27
Correlation Effects
• The amount of possible risk reduction
through diversification depends on the
correlation.
• The risk reduction potential increases as
the correlation approaches -1.
– If  = +1.0, no risk reduction is possible.
– If  = 0, σP may be less than the standard
deviation of either component asset.
– If  = -1.0, a riskless hedge is possible.

7-28
Figure 7.6 The Opportunity Set of the Debt and Equity

Funds and Two Feasible CALs

7-29
The Sharpe Ratio

• Maximize the slope of the CAL for any
possible portfolio, P.
• The objective function is the slope:
E ( rP ) − r f
SP =
P
• The slope is also the Sharpe ratio.

7-30
Figure 7.7 The Opportunity Set of the Debt and Equity Funds
with the Optimal CAL and the Optimal Risky Portfolio

7-31
Figure 7.8 Determination of the Optimal

Overall Portfolio

7-32
Figure 7.9 The Proportions of the Optimal

Overall Portfolio

7-33
Capital Allocation Line

7-34
[ E (rS ) − rf ]   B2 − [ E (rB ) − rf ]  Cov(rS , rB )

wS =
Optimal risky portfolio
[ E (rS ) − rf ]   B2 + [ E (rB ) − rf ]   S2 − [ E (rS ) − rf + E (rB ) − rf ]  Cov(rS , rB )
R: excess return = E(r) – rf

7-35
Steps to arrive at the complete

porfolio
1. Specify the return characteristics of all securities (expected
returns, variances, covariances).
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, P
b. Calculate the properties of portfolio P using the weights
determined in step (a)
3. Allocate funds between the risky portfolio and the risk-free
asset (capital allocation):
a. Calculate the fraction of the complete portfolio allocated to
portfolio P (the risky portfolio) and to T-bills (the risk-free asset)
b. Calculate the share of the complete portfolio invested in each
asset and in T-bills.

7-36
Markowitz Portfolio Selection Model

• Security Selection
– The first step is to determine the risk-
return opportunities available.
– All portfolios that lie on the minimum-
variance frontier from the global
minimum-variance portfolio and upward
provide the best risk-return
combinations

7-37
Figure 7.10 The Minimum-Variance

Frontier of Risky Assets

7-38
• We now search for the CAL with the

highest reward-to-variability ratio

7-39
Figure 7.11 The Efficient Frontier of Risky

Assets with the Optimal CAL

7-40
• Everyone invests in P, regardless of their

degree of risk aversion.
– More risk averse investors put more in the

risk-free asset.
– Less risk averse investors put more in P.

7-41
Capital Allocation and the

Separation Property
• The separation property tells us that the
portfolio choice problem may be
separated into two independent tasks
– Determination of the optimal risky
portfolio is purely technical.
– Allocation of the complete portfolio to T-
bills versus the risky portfolio depends
on personal preference.

7-42
Figure 7.13 Capital Allocation Lines with

Various Portfolios from the Efficient Set

7-43
The Power of Diversification

n n
• Remember:  2 =
P   w w C ov ( r , r )
i =1 j =1
i j i j
• If we define the average variance and average

covariance of the securities as:
1 n 2
 = i
2
n i =1
n n
1
Cov = 
n ( n − 1) j =1
 Cov (r , r )
i =1
i j
j i

7-44
The Power of Diversification

• We can then express portfolio variance as:
1 n −1
 2
P =  2
+ C ov
n n

7-45
Table 7.4 Risk Reduction of Equally Weighted

Portfolios in Correlated and Uncorrelated Universes

7-46
Optimal Portfolios and Nonnormal

Returns At home
• Fat-tailed distributions can result in extreme
values of VaR and ES and encourage smaller
allocations to the risky portfolio.
• If other portfolios provide sufficiently better VaR

and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions.

7-47
Risk Pooling and the Insurance Principle

At home
• Risk pooling: merging uncorrelated, risky
projects as a means to reduce risk.
– increases the scale of the risky investment by
adding additional uncorrelated assets.
• The insurance principle: risk increases less than
proportionally to the number of policies insured
when the policies are uncorrelated
– Sharpe ratio increases

7-48
Risk Sharing
At home
• As risky assets are added to the portfolio, a
portion of the pool is sold to maintain a risky
portfolio of fixed size.
• Risk sharing combined with risk pooling is the
key to the insurance industry.
• True diversification means spreading a portfolio
of fixed size across many assets, not merely
adding more risky bets to an ever-growing risky
portfolio.
7-49
Investment for the Long Run

At home
Long Term Strategy Short Term Strategy
• Invest in the risky • Invest in the risky
portfolio for 2 years. portfolio for 1 year and
in the risk-free asset for
– Long-term strategy is
riskier. the second year.
– Risk can be reduced
by selling some of the
risky assets in year 2.
– “Time diversification”
is not true
diversification.

7-50
Question 1
Which of the following factors reflect pure

market risk for a given corporation?
a. Increased short-term interest rates.
b. Fire in the corporate warehouse.
c. Increased insurance costs.
d. Death of the CEO.
e. Increased labor costs.

7-51
Question 2
When adding real estate to an asset

allocation program that currently includes
only stocks, bonds, and cash, which of the
properties of real estate returns affect
portfolio risk? Explain.
a. Standard deviation.
b. Expected return.
c. Correlation with returns of the other asset
classes.
7-52
Question 3
Which of the following statements about the
minimum-variance portfolio of all risky securities is
valid? (Assume short sales are allowed.) Explain.
a. Its variance must be lower than those of all other
securities or portfolios.
b. Its expected return can be lower than the risk-free
rate.
c. It may be the optimal risky portfolio.
d. It must include all individual securities.

7-53
Question 4
A pension fund manager is considering three mutual funds. The
first is a stock fund, the second is a long-term government and
corporate bond fund, and the third is a T-bill money market fund
that yields a rate of 8%. The correlation between the fund
returns is .10. The probability distribution of the risky funds is as
follows:
What are the investment proportions in the minimum-variance

portfolio of the two risky funds, and what is the expected value
and standard deviation of its rate of return?
7-54
Question 5
follows:
Solve numerically for the proportions of each asset and for the
expected return and standard deviation of the optimal risky
portfolio.
7-55
Question 6
follows:
What is the Sharpe ratio of the best feasible CAL?

7-56
Question 7
You require that your portfolio yield an expected return of 14%,

and that it be efficient, on the best feasible CAL.
a. What is the standard deviation of your portfolio?
b. What is the proportion invested in the T-bill fund and each of the
two risky funds?

7-57
Question 8
If you were to use only the two risky funds, and still
require an expected return of 14%, what
would be the investment proportions of your portfolio?
Compare its standard deviation to that of
the optimized portfolio in Question 7. What do you
conclude?
7-58
Question 9
Stocks offer an expected rate of return of 18%, with a standard

deviation of 22%. Gold offers an expected return of 10% with a
standard deviation of 30%.
a. In light of the apparent inferiority of gold with respect to both
mean return and volatility, would anyone hold gold?
b. Given the data above, reanswer (a) with the additional
assumption that the correlation coefficient between gold and
stocks equals 1.
c. Could the set of assumptions in part (b) for expected returns,
standard deviations, and correlation represent an equilibrium for
the security market?

7-59
Question 10
Suppose that there are many stocks in the security market and that
the characteristics of stocks A and B are given as follows:
Suppose that it is possible to borrow at the risk-free rate, rf. What

must be the value of the riskfree rate? (Hint: Think about
constructing a risk-free portfolio from stocks A and B.)

7-60
Question 11
Suppose you have a project that has a .7

chance of doubling your investment in a
year and a .3 chance of halving your
investment in a year. What is the standard
deviation of the rate of return on this
investment?

7-61
Question 11
Suppose you have a project that has a .7

chance of doubling your investment in a
year and a .3 chance of halving your
investment in a year. What is the standard
deviation of the rate of return on this
investment?
Probability Rate of Return Mean = [0.7 × 100%] + [0.3 × (-50%)] = 55%
0.7 100%
Variance = [0.7 × (100 − 55)2] + [0.3 × (-50 − 55)2] = 4725
0.3 −50
Standard deviation = 47251/2 = 68.74%

7-62
Question 12
Suppose that you have $1 million and the

following two opportunities from which to
construct a portfolio:
a. Risk-free asset earning 12% per year.
b. Risky asset with expected return of 30% per
year and standard deviation of 40%.
If you construct a portfolio with a standard
deviation of 30%, what is its expected rate of
return?

7-63
Question 13
The correlation coefficients between several pairs of

stocks are as follows: Corr(A, B) = .85; Corr(A, C) = .60;
Corr(A, D) = .45. Each stock has an expected return of
8% and a standard deviation of 20%.
If your entire portfolio is now composed of stock A and
you can add some of only one stock to your portfolio,
would you choose (explain your choice):
a. B
b. C
c. D
d. Need more data

7-64
Question 14
Would the answer to Question 13 change

for more risk-averse or risk-tolerant
investors? Explain.

7-65
Question 15
Suppose that in addition to investing

in one more stock you can invest in T-
bills as well. Would you change your
answers to Question13 and 14 if the
T-bill rate is 8%?

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CHAPTER 7

Optimal Risky Portfolios

INVESTMENTS | BODIE, KANE, MARCUS

The Investment Decision

INVESTMENTS | BODIE, KANE, MARCUS

The Investment Decision

INVESTMENTS | BODIE, KANE, MARCUS

Diversification and Portfolio Risk

What would be the sources of risk to

INVESTMENTS | BODIE, KANE, MARCUS

Diversification and Portfolio Risk

INVESTMENTS | BODIE, KANE, MARCUS

Diversification and Portfolio Risk

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.1 Portfolio Risk as a Function of the

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.2 Portfolio Diversification

INVESTMENTS | BODIE, KANE, MARCUS

Covariance and Correlation

• Covariance and the correlation

INVESTMENTS | BODIE, KANE, MARCUS

Covariance and Correlation

Backward-looking scenario analysis

INVESTMENTS | BODIE, KANE, MARCUS

Covariance and Correlation

INVESTMENTS | BODIE, KANE, MARCUS

Two-Security Portfolio: Return

INVESTMENTS | BODIE, KANE, MARCUS

Two-Security Portfolio: Risk

 = w  + w  + 2wD wE Cov (rD , rE )

Cov (rD , rE ) = Covariance of returns for

INVESTMENTS | BODIE, KANE, MARCUS

Two-Security Portfolio: Risk

• Another way to express variance of the

 P2 = wD wD Cov ( rD , rD ) + w E w E Cov ( rE , rE ) + 2 w D w E Cov ( rD , rE )

INVESTMENTS | BODIE, KANE, MARCUS

D,E = Correlation coefficient of

Correlation Coefficients: Possible Values

Range of values for 1,2

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Table 7.2 Computation of Portfolio

INVESTMENTS | BODIE, KANE, MARCUS

Table 7.2 Computation of Portfolio

INVESTMENTS | BODIE, KANE, MARCUS

 p2 = w12 12 + w22 22 + w32 32

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.3 Portfolio Expected Return as a

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.4 Portfolio Standard Deviation as

INVESTMENTS | BODIE, KANE, MARCUS

The Minimum Variance Portfolio

INVESTMENTS | BODIE, KANE, MARCUS

The Minimum Variance Portfolio

INVESTMENTS | BODIE, KANE, MARCUS

The Minimum Variance Portfolio

wMin (E)= 1- wMin(D)

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.5 Portfolio Expected Return as a

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Figure 7.6 The Opportunity Set of the Debt and Equity

INVESTMENTS | BODIE, KANE, MARCUS