Optimal risky portfolios

Investment & Securities Markets

Lecture 3
 Today…

 Last week we looked at how to calculate return and risk for individual
assets.

 Today we are looking at portfolio risk and return

 Portfolio return depends on returns on individual assets.

 Portfolio risk depends on risk of individual assets (variance) and

covariance between assets.
 Not only how these assets move but also how they move together.

BUST10032 Lecture 3 2
 Readings

 Key readings
 BKM 7.1 (same in 11ed and 12ed)

 EGBG Chapter 4 (pp. 47—59) and Chapter 5 (pp. 65—85)

 Additional readings
 Markowitz, Harry. "Portfolio selection." Journal of Finance 7, no. 1 (1952): 77-91.

 EGBG Chapter 5 (pp. 85—92) and Chapter 6.

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Portfolio risk and returns

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Let’s define 𝑅𝑖 as a discrete random variable that denotes the return on
security 𝑖.

𝑅𝑖,𝑗 is the 𝑗𝑡ℎ possible outcome of this random variable, which occurs with
probability 𝑝𝑗 .

𝒊=𝟏 𝒊=𝟐 𝒊=𝟑

𝒋 Economy 𝒑𝒋 IBM GE general electric T-bill
1 Bad 0.25 –4.00% 0.00% 1.00%

2 OK 0.50 8.00% 4.00% 1.00%

3 Good 0.25 16.00% 12.00% 1.00%

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 Measure of return

 Expected return of a single asset 𝑖:

𝜇𝑖 = 𝐸 𝑅𝑖 = ෍ 𝑝𝑗 𝑅𝑖,𝑗
𝑗=1

 Sample mean return of a single asset 𝑖:

𝑇
1
ത
𝑅𝑖 = ෍ 𝑅𝑖,𝑗
𝑇
𝑡=1

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 Measure of risk

 Variance of returns for a single asset 𝑖:

𝑁
2
𝜎𝑖2 = 𝑉 𝑅𝑖 = ෍ 𝑝𝑗 𝑅𝑖,𝑗 − 𝐸 𝑅𝑖
𝑗=1

 Sample variance of returns for a single asset 𝑖:

𝑇
1 2
𝑠𝑖2 =෍ 𝑅𝑖,𝑡 − 𝑅ത𝑖
𝑇−1
𝑡=1

The standard deviation is the square root of the variance.

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 Example 1
𝒊=𝟏 𝒊=𝟐 𝒊=𝟑
𝒋 Economy 𝒑𝒋 IBM GE T-bill
1 Bad 0.25 –4.00% 0.00% 1.00%

2 OK 0.50 8.00% 4.00% 1.00%

3 Good 0.25 16.00% 12.00% 1.00%

What is the expected return and the standard deviation of returns on

IBM?

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Expected return on IBM
𝐸 𝑅1 = .25 −0.04 + .50 0.08 + .25 0.16
= 0.07 = 𝟕%

Standard deviation of returns on IBM

𝜎12 = 0.25 −0.04 − 0.07 2

2
+ 0.50 0.08 − 0.07
2
+ 0.25 0.16 − 0.07
= 0.0051
𝜎1 = 0.0051 = 0.0714 = 𝟕. 𝟏𝟒%

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 𝒊=𝟏 𝒊=𝟐 𝒊=𝟑
𝒋 Economy 𝒑𝒋 IBM GE T-bill
1 Bad 0.25 –4.00% 0.00% 1.00%

2 OK 0.50 8.00% 4.00% 1.00%

3 Good 0.25 16.00% 12.00% 1.00%

Expected return 7.00% 5.00% 1.00%

Standard deviation 7.14% 4.36% 0.00%

Variance 0.0051 0.0019 0.0000

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 Portfolio return

 Expected return on a portfolio of 𝑁 assets:

𝜇𝑃 = 𝐸 𝑅𝑃 = ෍ 𝑤𝑖 𝜇𝑖
𝑖=1

 Sample mean return of a portfolio of 𝑁 assets:

𝑅ത𝑃 = ෍ 𝑤𝑖 𝑅ത𝑖
𝑖=1

𝜔𝑖 is the proportion of asset 𝑖 in the portfolio.

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 Example 2

The expect returns on IBM and GE are 16% and 12% respectively.

What is the expected return on a portfolio with 70% invested in IBM and
30% invested in GE?
𝐸 𝑅𝑃 = 0.70 16% + 0.30 12%
= 𝟏𝟒. 𝟖%

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 Portfolio risk
 Variance of returns for a portfolio of 𝑁 assets:
can be asked to derive this

𝑁 𝑁 𝑁

𝜎𝑃2 = 𝑉 𝑅𝑃 = ෍ 𝑤𝑗2 𝜎𝑗2 + ෍ ෍ 𝑤𝑗 𝑤𝑘 𝜎𝑗,𝑘

𝑗=1 𝑗=1 𝑘=1
𝑘≠𝑗 potential question why k should not equal J

 Sample variance of returns for a portfolio of 𝑁 assets:

𝑁 𝑁 𝑁

𝑠𝑃2 = ෍ 𝑤𝑗2 𝑠𝑗2 + ෍ ෍ 𝑤𝑗 𝑤𝑘 𝑠𝑗,𝑘

𝑗=1 𝑗=1 𝑘=1
𝑘≠𝑗

𝜎𝑗,𝑘 is the covariance between assets 𝑗 and 𝑘.

𝑠𝑗,𝑘 is the sample covariance between assets 𝑗 and 𝑘.

Derivation in Elton, Gruber, Brown and Goetzmann p. 50-57

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 Covariance and correlation coefficient

 Covariance is a measure of how returns move together.

𝜎𝑗,𝑘 = 𝐸 𝑅𝑗 − 𝜇𝑗 𝑅𝑘 − 𝜇𝑘
𝑁

= ෍ 𝑝𝑖 (𝑅𝑗,𝑖 − 𝜇𝑗 )(𝑅𝑘.𝑖 − 𝜇𝑘 )
𝑖=1

 Sample Covariance
𝑇
1
𝑠𝑗,𝑘 =෍ 𝑅𝑗,𝑡 − 𝑅ത𝑗 𝑅𝑘,𝑡 − 𝑅ത𝑘
𝑇−1
𝑡=1

 Correlation coefficient is a standardized measure

 allowing for comparisons between asset pairs
 minimum = -1, maximum = +1.
corr x sd of both
𝜎𝑗,𝑘
𝜌𝑗,𝑘 = → 𝜎𝑗,𝑘 = 𝜎𝑗 𝜎𝑘 𝜌𝑗,𝑘
𝜎𝑗 𝜎𝑘

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 Covariance and correlation matrices

1 2 ⋯ N 1 2 ⋯ N

1 𝜎12 𝜎1,2 ⋯ 𝜎1,𝑁 1 1 𝜌1,2 ⋯ 𝜌1,𝑁

2 𝜎2,1 𝜎22 ⋯ 𝜎2,𝑁 2 𝜌2,1 1 ⋯ 𝜌2,𝑁

⋮ ⋮ ⋮ ⋱ ⋮ ⋮ ⋮ ⋮ ⋱ ⋮

⋮ 𝜎𝑁,1 𝜎𝑁,2 ⋯ 𝜎𝑁2 ⋮ 𝜌𝑁,1 𝜌𝑁,2 ⋯ 1

Covariance matrix Correlation matrix

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 Portfolio with two assets

 Expected portfolio return is:

𝜇𝑃 = 𝑤1 𝜇1 + 𝑤2 𝜇2

 Portfolio variance is:

𝜎𝑃2 = 𝐸{ 𝑅𝑃 − 𝜇𝑃 2 }

We will now derive this following formula:

𝑁 𝑁 𝑁

𝜎𝑃2 = ෍ 𝑤𝑗2 𝜎𝑗2 + ෍ ෍ 𝑤𝑗 𝑤𝑘 𝜎𝑗,𝑘

𝑗=1 𝑗=1 𝑘=1
𝑘≠𝑗

(𝑁 = 2) 𝜎𝑃2 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝑤1 𝑤2 𝜎1,2

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𝜎𝑃2 = 𝐸 𝑅𝑃 − 𝜇𝑃 2

2
=𝐸 𝑤1 𝑅1 + 𝑤2 𝑅2 − 𝑤1 𝜇1 + 𝑤2 𝜇2

2
= 𝐸 𝑤1 𝑅1 − 𝜇1 + 𝑤2 𝑅2 − 𝜇2

= 𝐸 𝑤12 𝑅1 − 𝜇1 2
+ 𝑤22 𝑅2 − 𝜇2 2
+ 2𝑤1 𝑤2 𝑅1 − 𝜇1 𝑅2 − 𝜇2

= 𝑤12 𝐸 𝑅1 − 𝜇1 2
+ 𝑤22 𝐸 𝑅2 − 𝜇2 2

+ 2𝑤1 𝑤2 𝐸 𝑅1 − 𝜇1 𝑅2 − 𝜇2

= 𝑤12 𝜎12 + w22 𝜎22 + 2𝑤1 𝑤2 𝜎1,2

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 Example 3
𝒊=𝟏 𝒊=𝟐 𝒊=𝟑
IBM GE T-bill IBM GE T-bill
Expected return 7.00% 5.00% 1.00% IBM 1.0000
Standard deviation 7.14% 4.36% 0.00% GE 0.9316 1.0000
Variance 0.0051 0.0019 0.0000 T-bill 0.0000 0.0000 0.0000

Based on the above expected return, variance, and correlation matrix.

If you invest half of your money in IBM and the rest in GE, what is the
expected return and standard deviation of your portfolio?

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Expected portfolio return

1 1
𝜇𝑃 = × 7.00% + × 5.00%
2 2
= 0.06 = 6.00%

Portfolio standard deviation

The covariance between returns of IBM and GE:

𝜎1,2 = 𝜌1,2 𝜎1 𝜎2
= 0.9316 × 0.0714 × 0.0436
= 0.0029

Portfolio variance:
2 2
1 1 1 1
𝜎𝑃2 = 0.0051 + 0.0019 + 2 0.0029
2 2 2 2
= 0.0032

Portfolio standard deviation:

𝜎𝑃 = 0.0032 = 0.0566 = 5.66%

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 Portfolio with three assets
try for 4 assets

 Expected portfolio return is:

𝜇𝑃 = 𝑤1 𝜇1 + 𝑤2 𝜇2 + 𝑤3 𝜇3

 Portfolio variance is:

𝜎𝑃2 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 𝑤32 𝜎32
+ 2𝑤1 𝑤2 𝜎1,2 + 2𝑤1 𝑤3 𝜎1,3 + 2𝑤2 𝑤3 𝜎2,3

Try deriving this! Starting from 𝜎𝑃2 = 𝐸 𝑅𝑃 − 𝜇𝑃 2

.
TRY

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 Example 4
𝒊=𝟏 𝒊=𝟐 𝒊=𝟑
IBM GE T-bill IBM GE T-bill
Expected return 7.00% 5.00% 1.00% IBM 1.0000
Standard deviation 7.14% 4.36% 0.00% GE 0.9316 1.0000
Variance 0.0051 0.0019 0.0000 T-bill 0.0000 0.0000 0.0000

If you invest a third of your money in IBM, a third in GE and the rest in T-
bill, what is the expected return and standard deviation of your portfolio?

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Expected portfolio return

1 1 1
𝜇𝑃 = × 7.00% + × 5.00% + × 1%
3 3 3
= 0.0433 = 4.33%

Portfolio standard deviation

The covariance between returns of IBM and GE is 0.0029. Both returns on IBM and GE
are not correlated with T-bill returns (𝜎1,3 = 0 and 𝜎2,3 = 0).
Portfolio variance:
2 2 2
1 1 1
𝜎𝑃2 = 0.0051 + 0.0019 + 0.0000
3 3 3

1 1 1 1 1 1
+2 0.0029 + 2 0.0000 + 2 0.0000
3 3 3 3 3 3
= 0.0014

Portfolio standard deviation:

𝜎𝑃 = 0.0014 = 0.0377 = 3.77%

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 Portfolio with N assets

𝑁 𝑁 𝑁

𝜎𝑃2 = ෍ 𝑤𝑗2 𝜎𝑗2 + ෍ ෍ 𝑤𝑗 𝑤𝑘 𝜎𝑗,𝑘

𝑗=1 𝑗=1 𝑘=1
𝑘≠𝑗
1
If we invest equal amount in each asset (𝑤𝑗 = ):
𝑁
𝑁 2 𝑁 𝑁
1 1 1
𝜎𝑃2 = ෍ 𝜎𝑗2 + ෍ ෍ 𝜎
𝑁 𝑁 𝑁 𝑗,𝑘
𝑗=1 𝑗=1 𝑘=1
𝑘≠𝑗
𝑁 𝑁 𝑁
1 𝜎𝑗2 𝑁−1 𝜎𝑗,𝑘
= ෍ + ෍෍
𝑁 𝑁 𝑁 𝑁(𝑁 − 1)
𝑗=1 𝑗=1 𝑘=1
1 2 𝑁−1
= 𝜎 + 𝜎𝑗,𝑘
𝑁 𝑗 𝑁

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 Portfolio with N assets

1 2 𝑁−1
𝜎𝑃2 = 𝜎𝑗 + 𝜎
𝑁 𝑁 𝑗,𝑘
 Portfolio variance is a sum of two terms, both of which are averages.
 Average variance
 Average covariance

 As N becomes larger the effect of asset variance on portfolio variance

approaches zero.

 But the effect of covariance between assets remains.

 This is the basis of diversification.

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BUST10032 Lecture 3 25
 Summary
 We look at how combining assets into a portfolio affect return and risk.

 A portfolio’s return depends on individual returns on the assets in the

portfolio.

 A portfolio’s risk depends not only on individual risks of the assets in the
portfolio, but also the correlations between the returns of those assets.

 In the presence of a risk-free asset, there is one portfolio that allows for the
best risk-return tradeoff, the optimal risky portfolio.

 Based on their risk preferences, investors can choose to invest a fraction of

their wealth in the optimal risky portfolio and the rest in the risk-free asset.

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