Finance case 3 Timon Bol (621441) and Jesse van der Ende (622894)

1. The efficient frontier using assets A and B is as follows:

Efficient Frontier A and B

0,02
0,018
0,016
Expected return

0,014
0,012
0,01
0,008
0,006
0,004
0,002
0
0 0,01 0,02 0,03 0,04 0,05 0,06 0,07 0,08
Return standard deviation

Portfolie Frontier (non-efficient) Efficient Frontier

Figure 1, efficient frontier using assets A and B

2. By adapting the steps in question 1, we have found the following global minimum variance
Portfolio:

Global Minimum Weight A Weight B Weight C Return St. Dev

variance
A, B and C 1,44414 -0,10941 -0,33473 0,3% 0,0106905

A and B 1,13052 -0,13052 N/A 0,3% 0,0112059

Asset C will be a beneficial addition to the portfolio, because if you compare the global
minimum variance portfolios, both have a return of 0.3% but in the portfolio including asset C
the variance of the portfolio is lower and thus so will be the risk. Therefore, adding asset C to
the portfolio will be a beneficial addition.
3. The efficient frontier using assets A, B and C is as follows:

Efficient Frontier A, B and C

0,02
0,018
0,016
Expected return

0,014
0,012
0,01
0,008
0,006
0,004
0,002
0
0 0,01 0,02 0,03 0,04 0,05 0,06 0,07 0,08
Return standard deviation

Portfolio Frontier (non-efficient) Efficient Frontier Asset C

Figure 2, efficient frontier using assets A, B and C

In comparison to the frontier in 1, it is shifted a little bit to the left, but the shape is still the
same. This means that by including asset C to our portfolio, we can get to combinations of risk
and return which we could not reach before. Therefore, including asset C to the portfolio can be
useful.

4. From these figures we are unable to draw any conclusion whether C is useful to have in the
investment portfolio or not. In Figure 2 you can see that the asset is almost efficient, but not
quite. Because it is possible for all assets in the portfolio to be non-efficient, and still reach an
efficient frontier thanks to the benefits of diversification, it is possible that C is a valuable and
beneficial addition to the investment. Also, when we look at the covariance between the three
assets, you can see that they are positively correlated, but not very strong. This means that
when taking a combination of the 3 assets, you can still get a better portfolio with less risk.
5. In theory we would generate D to have a very high return and a very small variance, that way
the covariances are even kind of irrelevant if you make these values large enough. However, in
practice this is not the case, so we decided to generate something more realistic. For asset D we
would come up with a negative covariance to all A, B and C, because all these assets have a
positive covariance and if D has negative covariance this will decrease the variance and
therefore the risk of the portfolio. For generating the variance, it depends on the kind of risk
preference the investor has. For very risk-averse investors D would have to have a very small
variance and for investors who are less risk-averse D could have a higher variance so the return
will also be bigger. In our instance we choose D to be small as we assume that the investor is
very risk averse. This would come with a not so high return because of the low level of risk in
this case.
We looked at the risks and returns of the other 3 assets to come up with the following realistic
values: 0,55% for the return and 2% for the variance. For the extra reduction of risk, we chose to
 have a negative correlation of -0,5 for asset A, -0,4 for asset B and -0,6 for asset C. Having a
more negative correlation would not be very realistic, since the three assets A,B and C are not
perfectly correlated and asset D could not be very negatively correlated with all three of them in
that case.
6. For computing the efficient frontier with a risk-free asset, we still want to minimize the variance
of the portfolio, but the constraint will be different. We lose the constraint where all the
weights must add up to one and we replace it with: 𝑤 ′ 𝜇 + (1 − 𝑤 ′ 𝜄)𝑅𝑓 = 𝜇∼ .
In which 𝑤 is equal to the vector of the weights, 𝜄 is a vector of ones and 𝑅𝑓 is equal to the risk-
free rate and in this case that is the T bill rate.
The result of this minimization will result in an efficient frontier with the steepest line that
connects the risk free-asset with any point to the old efficient frontier. The new efficient frontier
will be a line with as slope the Sharpe ratio between the optimal portfolio T and the risk free
asset.