Financial Investments

Case 1
Exercise 1
Question 1

2 2
Methodology Summary
In Exercise 1 we applied the Markowitz portfolio
optimization program to solve the optimizations
required.
The goal was to draw the frontier in mean-std space.
To capture the risk and return parameters, we used the
rates of return provided in the 30 Portfolio Spreadsheet.
We assumed that risk and returns could be characterized
by the provided time series. Although estimating
expected returns using historical data can be unreliable,
we choose to use this population moments instead of
developing future forecast for returns, which was out of
scope of this work.
To solve the first problem, we used four major steps, as
described on the right.
Adjusting the data
1 From the data provided we have transformed the percentages in whole numbers.
Calculate covariance matrix
2 With the adjusted time series, we used the Covariance Function, from the Data
Analysis in Excel’s Tools menu, to achieve the Covariance Matrix. The values were
also corrected for the degrees-of-freedom bias.
Characterize the Time Series
3 From the adjusted Covariance Matrix, we characterized the time series samples
computing the Means, Variances, Standard Deviations and Sharp Ratio, both per
sector and for the equally weighted portfolio.
Drawing the efficient frontier
4 Using the Excel’s Solver tool, we develop a series of optimized portfolios with
several constraints, obtaining the points along the efficient frontier, as well as the
Minimum Variance and Tangency Portfolio.
3
1
Changing the data Picture 1 – Converting % in whole numbers

The data format delivered a 120 observations time series that were in
percentage.

In order to transform the percentage in whole numbers we created a

new sheet dividing the input cells by 100.

This was a simple procedure that allowed to work with whole

numbers for the determination of the covariance matrix.

Additionally, the data was used to compute the expected return,

standard deviation and variance of the series.
Picture 2 – Characterizing Sample Moments
These Population Moments were calculated using the following excel
formulas:

❑ E[r] = AVERAGE(B2:B121)

❑ StD = STDEV.S(B2:B121)

❑ VAR=VAR.S(B2:B121)

These functions calculates the sample standard deviation. We have

used this function, instead of P (Population) option, since the range of
values represents a sample of values, rather than an entire
population. In fact, we have only a part of the time series and not the
entire time series of the Portfolios, which justifies our option.

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 Picture 3 – Covariance Matrix – Full (top) and Bias corrected (bottom)

2
Calculate covariance
matrix

The covariance matrix was estimated from the array of the

120 returns converted in whole numbers, using the
COVARIANCE function from “Data Analysis” in Excel’s Tools
menu.

Excel’s function leaves the upper part of the matrix in blank

since it is symmetric to the lower part. We have transposed
the values using the algebraic rule 𝜎1,2 = 𝜎2,1 (Table 5).

The covariance matrix was also corrected for degrees-of-

freedom bias, multiplying each of the elements in the matrix
by 60/59 to eliminate downward bias that results from the
strict application of this Excel function (Table 6).

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 Picture 4 – Estimation of Mean and StD
3 Characterize the Time Sector E[r] σ[r] Var[r] Weight

Series Food
Beer
Smoke
0,008218
0,010425
0,013648
0,033715
0,034777
0,046010
0,001137
0,001209
0,002117
9,52%
26,22%
3,97%
Games 0,008126 0,080557 0,006489 -8,87%
Books 0,001619 0,069910 0,004887 -9,58%
From the adjusted Covariance Matrix, we characterized the time Hshld 0,007160 0,039379 0,001551 -4,77%
series samples computing the Means, Variances, Standard Clths 0,012063 0,064153 0,004116 4,15%
Picture 5 – Estimation of
Hlth 0,009692 0,037629 0,001416 3,60%
Deviations and Sharp Ratio, both per sector and for the equally Chems 0,010982 0,063731 0,004062 6,21% Mean and StD for a equally
weighted portfolio, applying the following: Txtls
Cnstr
0,012918
0,005373
0,105093
0,072699
0,011045
0,005285
2,33%
-14,62%
weighted Portfolio
Steel 0,006315 0,091005 0,008282 -17,99%
❑ Mean: FabPr 0,010588 0,072347 0,005234 -0,74% Rf 0,0001
ElcEq 0,008945 0,066430 0,004413 -6,81%
Autos 0,006683 0,090887 0,008260 -3,21% E[r] 0,015000
𝜇𝑃 = σ30
𝑖=1 𝑤𝑖 ∗ 𝐸[𝑟𝑖 ] | Carry 0,011649 0,057325 0,003286 18,01% σ^2[r] 0,000641
EXCEL= SUMPRODUCT(weights; expected returns). Mines 0,007082 0,088715 0,007870 4,00%
σ[r] 0,025323
Coal 0,004618 0,126642 0,016038 -8,97%
Oil 0,009070 0,061176 0,003743 20,26%
❑ Variance and Standard Deviation Util 0,008998 0,038169 0,001457 23,51%
Sharpe Ratio 0,588399
Telcm 0,008729 0,044846 0,002011 -12,96%
2 Servs 0,008170 0,048929 0,002394 6,38%
𝜎𝑖1 … 𝜎𝑖𝑛,𝑖1 BusEq 0,008795 0,057404 0,003295 -10,77%
𝑉𝐴𝑅𝑃 = 𝑤𝑖 × 𝑐𝑜𝑣 𝑤 , where 𝑤 = 𝜎𝑖1,𝑖2 … ⋮ → 𝜎𝑃 = 𝑉𝐴𝑅𝑃 Paper
Trans
0,008460
0,010766
0,053126
0,053374
0,002822
0,002849
2,74%
20,55%
2 Whlsl 0,009529 0,047904 0,002295 48,48%
𝜎𝑖1,𝑖𝑛 … 𝜎𝑖𝑛
Rtail 0,008911 0,043980 0,001934 15,51%
EXCEL= Meals 0,011318 0,043547 0,001896 16,15%
Fin 0,003878 0,061024 0,003724 -17,80%
MMULT(TRANSPOSE($G$5:$G$34);MMULT(Covariance_Analysis!$C$5:$AF Other 0,005488 0,058738 0,003450 -14,50%
$34;Exercise_1!$G$5:$G$34))
0,015000 1

❑ Sharp Ratio

𝜇𝑃 −𝑟𝑓
𝑆𝑅 = 𝜎𝑃
EXCEL=(J7-J6)/J9

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 1

4
Drawing the efficient
frontier
2
With the Equally Weighted Portfolio characterized we used Excel’s Solver
function to draw the efficient frontier.

1. We began by identifying the global minimum variance portfolio

(MVP). This provided the starting point of the efficient part of the
frontier: We minimize the Standard Deviation by changing the 3
weights, constraining the sum of the portfolio weights to1.

2. We minimized variance for each E[r] determined and constraining

the sum of weights equal to 1.This process was repeated for
different values of E[r], choosing more points in the neighborhood
of portfolio MVP because the frontier has the greatest curvature in
that region.

3. We look for the portfolio with the highest Sharpe ratio. This is the
efficient frontier portfolio that is tangent to the CAL. To find it, we
set Solver to maximize the Sharpe ratio, constraining the sum of the
portfolio weights to1. The Solver now yields the optimal risky
portfolio.

We did not constraint non-negative values allowing for short selling

strategies.

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Exercise Solution

6,00%

5,00%

4,00%

3,00%

2,00%

1,00%

0,00%
0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00%

8
Exercise 1
Question 2

9 9
 Drawing the CAL
6,00%

The CAL that identifies the optimal risky portfolio. This CAL has a slope
equal to the Sharpe ratio of the optimal risky portfolio. Therefore, we 5,00%
obtain the values of the line by multiplying the SD of each column’s
portfolio by the Sharpe ratio of the optimal risky portfolio. This results
in the CAL efficient frontier. 4,00%

This procedure is based on the CAL equation:

𝜇 = 𝑆𝑅∗𝜎 + 𝑟𝑓𝜇 = SR∗𝜎 + rf; 3,00%

where 𝑆𝑅=0,6580SR=0,6580; and
𝑟𝑓=0,01%
2,00%
The CAL is tangent to the tangency Portfolio, which we had already
determined in the previous question by maximizing the Sharp Ratio.

Since we were unable to put the values in the chart, we draw a straight 1,00%
line starting in the x-axis at the risk-free rate value connecting the line
with the Tangency Portfolio.

0,00%
0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00%

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Exercise 1
Question 3

11 11
Tangency Portfolio
6,00%

5,00%

The tangency portfolio is simply the portfolio with the

highest Sharpe Ratio, which was obtained in the previous 4,00%
question.

The figure on the right shows the portfolio as well as its 3,00%
corresponding mean and standard deviation. These figures
can be obtained in table 8:
2,00%

𝐸 𝑟 = 2,43
𝜎𝑇 = 3,68 1,00%

0,00%
0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00%

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Exercise 1
Question 4

13 13
Compute the expected
return and standard 6,00%

deviation of the optimal

portfolio 5,00%

The optimal portfolio of an investor with A (Risk Aversion) of 30, can be

4,00%
calculated with the following formula:

(𝜇 𝑇 − 𝑟𝑓 )
𝑤𝑇 = = 59,52%
𝐴 × 𝜎𝑇2
3,00%
Where 𝜇 𝑇 and 𝜎𝑇2 are the mean and standard deviation of the tangency
portfolio calculated in the previous question, A=30 and 𝑟𝑓 =0,01%.
2,00%
Thus, 59,52 %, is the weight allocated to risky assets. The remaining will
be invested in the risk-free assets such as T-Bills.

The Optimal Portfolio mean, and standard deviation were calculated as 1,00%
follows:
𝜎𝑂𝑃 = 𝑤𝑇 × 𝜎𝑇 = 59,52% × 0,368% = 2,19%

𝜇𝑂𝑃 = 𝑆𝑅 × 𝜎𝑂𝑃 + 𝑟𝑓 = 0,658 × 0,00219′ 0,0001 = 1,45% 0,00%

0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00%

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 Picture 6 – Estimation of Optimal Portfolio for specific investor

Compute the amount of Tang. Portf. Risk-free 40,46% $404 571,89

money that the investor E[r]

σ^2[r]
A
2,4337%
0,1357%
30
Food
Beer
Smoke
-26,01%
32,96%
15,54%
-$260 089,69
$329 571,34
$155 410,63
E[r]
σ[r]
0,10%
2,1933%

should put in the risk- Rf 0,0001 Games

Books
-7,34%
-19,50%
-$73 430,01
-$194 958,87

free asset. Wt 59,54% Hshld

Clths
-10,73%
3,98%
-$107 321,08
$39 848,02
Wrf 40,46% Hlth 7,29% $72 898,17
Chems 12,84% $128 352,59
Capital Alloc. $1 000 000 Txtls 10,05% $100 512,47
According to the Risk Aversion Degree which provided the Cnstr -12,39% -$123 853,67
Steel -12,05% -$120 460,27
Optimal Portfolio for such an investor, and considering that
FabPr 16,53% $165 340,56
this investor wants to allocate $1M: ElcEq -18,20% -$182 037,17
Autos 0,62% $6 158,89
Carry 30,90% $309 023,41
❑ The Risk-free asset allocation is 40,46% -> $404,460
Mines -1,50% -$15 017,88
Coal -10,31% -$103 134,81
❑ The Risky Assets allocation is 59,54% > $595,440 Oil 13,61% $136 132,14
Util 14,64% $146 422,73
Telcm -13,33% -$133 344,62
Servs 5,22% $52 210,44
BusEq -11,86% -$118 576,46
Paper 5,38% $53 775,18
Trans 13,65% $136 536,36
Whlsl 46,12% $461 190,19
Rtail 1,91% $19 100,92
Meals 17,01% $170 109,92
Fin -25,62% -$256 226,29
Other -19,87% -$198 715,01

100,00% $1 000 000

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Exercise 2
Alínea 1

16 16
 1
Methodology
2

The methodology for this exercise is the some as the

previous one, with the exception that in solving for the
portfolios in the efficient frontier, we define an addition
3
restriction in Microsoft’s Excel Solver, which is to to keep all
weights positive.

In financial terms this means that the investor is not allowed

to short-sell assets.

The exercise was made by copying the Exercise 1 sheet and

by using solver, wuth the additionnal restriction for
replacing the portfolios in the efficient frontier.

On the right one can find the screenshots of the Solver Tool
for all of the necessary portfolios estimation. The numbers
follows the same approach as in slide 7.

17
 Picture 7 – Estimation of Optimal Portfolio for specific investor with no

Expected return and short-sales

standard deviation of the Tang. Portf. Risk-free 64,16% $641 646,66 Optimal P

optimal portfolio E[r]

σ^2[r]
1,1519%
0,1062%
Food
Beer
0,00%
13,02%
$0,00
$130 150,65
E[r]
σ[r]
0,05%
1,1679%
A 30 Smoke 11,32% $113 162,73
Rf 0,0001 Games 0,00% $0,00
Books 0,00% $0,00
The efficient frontier equation is: Wt 35,84% Hshld 0,00% $0,00
Clths 0,00% $0,00
The
𝜇𝑃 optimal
= 𝑆𝑅 ×portfolio
𝜎𝑇 + 𝑟𝑓of=an0,03628
investor ×
with A (Risk Aversion)
0,044136 + 0,0001 of 30, can be
= 1,14% Wrf 64,16% Hlth 0,00% $0,00
calculated with the following formula: Chems 0,00% $0,00
The tangency portfolio is simply the portfolio with the highest Capital Alloc. $1 000 000 Txtls 0,00% $0,00
𝑇 (𝜇 − 𝑟 )
𝑓 Cnstr 0,00% $0,00
Sharpe Ratio and the𝑤Optimal
𝑇 = Portfolio can be computed
2 = 59,52% Steel 0,00% $0,00
𝐴 × 𝜎𝑇
according to: FabPr 0,00% $0,00
ElcEq 0,00% $0,00
Where 𝜇 𝑇 and 𝜎𝑇2 are the mean and standard deviation of the tangency Autos 0,00% $0,00
(𝜇𝑇 − 𝑟𝑓 ) Carry 0,00% $0,00
portfolio calculated in𝑤the
𝑇 = 2 = 35,84%
previous question, A=30 and 𝑟𝑓 =0,01%.
𝐴 × 𝜎𝑇 Mines 0,00% $0,00
Coal 0,00% $0,00
Thus, 59,52 %, is the weight allocated to risky assets. The remaining will Oil 0,00% $0,00
Thus, 35,84% of the money will be allocated to risky assets. The Util 3,25% $32 454,13
be invested in the risk-free assets such as T-Bills.
remaining 64,16 % will be allocated to risk-free asset Telcm 0,00% $0,00
Servs 0,00% $0,00
The Optimal Portfolio mean, and standard deviation were calculated as BusEq 0,00% $0,00
The Optimal Portfolio mean, and standard deviation were Paper 0,00% $0,00
follows:
calculated as follows: Trans 0,00% $0,00
𝜎𝑃 = 𝑤𝑇 × 𝜎𝑇 = 59,52% × 0,368% = 2,19% Whlsl 0,00% $0,00
𝜎𝑂𝑃 = 𝑤𝑇 × 𝜎𝑇 = 59,52% × 0,368% = 2,19% Rtail 0,00% $0,00
𝜇𝑃 = 𝑆𝑅 × 𝜎𝑇 + 𝑟𝑓 = 0,658 × 0,00219′ 0,0001 = 1,45% Meals 8,26% $82 585,84
𝜇𝑂𝑃 = 𝑆𝑅 × 𝜎𝑂𝑃 + 𝑟𝑓 = 0,303628 × 0,00117 + 0,0001 Fin 0,00% $0,00
Other 0,00% $0,00
= 0,05%
100,00% $1 000 000

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Optimal portfolio

1,6000%

1,4000%

1,2000%

1,0000%

0,8000%

0,6000%

0,4000%

0,2000%

0,0000%
0,0000% 2,0000% 4,0000% 6,0000% 8,0000% 10,0000% 12,0000% 14,0000%

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 Picture 7 – Estimation of Optimal Portfolio for specific investor with no

Portfolio weights short-sales

Tang. Portf. Risk-free 64,16% $641 646,66 Optimal P

E[r] 1,1519% Food 0,00% $0,00 E[r] 0,05%
σ^2[r] 0,1062% Beer 13,02% $130 150,65 σ[r] 1,1679%
A 30 Smoke 11,32% $113 162,73
Rf 0,0001 Games 0,00% $0,00
Books 0,00% $0,00
Wt 35,84% Hshld 0,00% $0,00
The optimal portfolio investment for this Clths 0,00% $0,00
Wrf 64,16% Hlth 0,00% $0,00
investor is to buy 64,16% of risk-free asset, Chems 0,00% $0,00
Capital Alloc. $1 000 000 Txtls 0,00% $0,00
Cnstr 0,00% $0,00
which represents $641,647, and 35,84% of Steel 0,00% $0,00
FabPr 0,00% $0,00
risky assets, with a value of $358,353. ElcEq
Autos
0,00%
0,00%
$0,00
$0,00
Carry 0,00% $0,00
Mines 0,00% $0,00
Coal 0,00% $0,00
Oil 0,00% $0,00
Util 3,25% $32 454,13
Telcm 0,00% $0,00
Servs 0,00% $0,00
BusEq 0,00% $0,00
Paper 0,00% $0,00
Trans 0,00% $0,00
Whlsl 0,00% $0,00
Rtail 0,00% $0,00
Meals 8,26% $82 585,84
Fin 0,00% $0,00
Other 0,00% $0,00

100,00% $1 000 000

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 Team

Rui Trindade Filipe Luz Campina Tiago Cunha Rocha

57099@novasbe.pt 25092@novasbe.pt 56426@novasbe.pt

21
Thank You