FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 8A
Diversification and Optimal
Portfolios

FINA 3080 Prof. Chao Ying 1

 Lecture 8A Outline
• Correlation and diversification

• The benefit of diversification

– Constructing the efficient frontier by many risky asset

• Optimal risky portfolio and complete portfolio

– Portfolio separation theorem
– Summary of portfolio theory

FINA 3080 Prof. Chao Ying 2

 Mean and Variance of Portfolio
• Asset A: E ( rA ) = rA , Var( rA ) = σ 2
A

• Asset B: E ( rB ) = rB , Var( rB ) = σ B2
• Correlation: Corr(rA ,rB )=ρ AB
• Portfolio C has a proportion y on asset A
and (1-y) on asset B
• E(rC ) = yrA + (1 − y ) rB
Var( r ) = y σ
2 2 22
+ (1 − y )σ
𝑉𝑉𝑉𝑉𝑉𝑉(𝑉𝑉C𝑐𝑐 ) = 𝑦𝑦 𝜎𝜎A𝐴𝐴 + (1 − 𝑦𝑦)B +
22 2
𝜎𝜎𝐵𝐵2 + − y )σ
y (12𝑦𝑦(1 σ Bρ
− A𝑦𝑦)𝜎𝜎𝐴𝐴 𝜎𝜎
AB𝐵𝐵 𝜌𝜌𝐴𝐴𝐵𝐵

3
FINA 3080 Prof. Chao Ying
 Q1: Asset Allocation with two
risky assets
Based on the outcomes in the following table, choose
which of the statements below is (are) correct?
Scenario Security A Security B Security C
Recession Return > E(r) Return = E(r) Return < E(r)
Normal Return = E(r) Return = E(r) Return = E(r)
Boom Return < E(r) Return = E(r) Return > E(r)

I. The covariance of security A and security B is zero. ✓

II. The correlation coefficient between securities A and C is negative. ✓

III. The correlation coefficient between securities B and C is positive.

A) I only
0
B) I and II only
C) II and III only
D) I, II, and III

FINA 3080 Prof. Chao Ying

 Q1: Asset Allocation with two
risky assets
Based on the outcomes in the following table, choose
which of the statements below is (are) correct?
Scenario Security A Security B Security C
Recession Return > E(r) Return = E(r) Return < E(r)
Normal Return = E(r) Return = E(r) Return = E(r)
Boom Return < E(r) Return = E(r) Return > E(r)

I. The covariance of security A and security B is zero.

II. The correlation coefficient between securities A and C is negative.
III. The correlation coefficient between securities B and C is positive.
A) I only
B) I and II only
C) II and III only
D) I, II, and III

FINA 3080 Prof. Chao Ying

 Correlation and Diversification
• Portfolio risk depends on the correlation between
the returns of the assets in the portfolio
• Correlation coefficients [min=-1 & max =1] provide
a measure of how the returns of two assets vary
• The smaller the correlation, the greater the risk
reduction potential of diversification
• If Correlation = 1, the securities would be perfectly
positively correlated, no risk reduction is possible
• If Correlation = - 1, the securities would be perfectly
negatively correlated, which helps reduce risk
FINA 3080 Prof. Chao Ying 6
 Example: Portfolio of Two Mutual Funds

𝐸𝐸 𝑉𝑉𝑐𝑐 = 𝑦𝑦𝑉𝑉𝐷𝐷 + 1 − 𝑦𝑦 𝑉𝑉𝐸𝐸

𝑉𝑉𝑉𝑉𝑉𝑉(𝑉𝑉𝑐𝑐 ) = 𝑦𝑦 2 𝜎𝜎𝐷𝐷2 + (1 − 𝑦𝑦)2 𝜎𝜎𝐸𝐸2 + 2𝑦𝑦(1 − 𝑦𝑦)𝜎𝜎𝐷𝐷 𝜎𝜎𝐸𝐸 𝜌𝜌𝐷𝐷𝐸𝐸
FINA 3080 Prof. Chao Ying 7
Portfolio Return and Risk as a Function of Proportions

𝐸𝐸 𝑉𝑉𝑐𝑐 = 𝑤𝑤𝑉𝑉𝐷𝐷 + 1 − 𝑤𝑤 𝑉𝑉𝐸𝐸

𝑉𝑉𝑉𝑉𝑉𝑉(𝑉𝑉𝑐𝑐 ) = 𝑤𝑤 2 𝜎𝜎𝐷𝐷2 + (1 − 𝑤𝑤)2 𝜎𝜎𝐸𝐸2 + 2𝑤𝑤(1 − 𝑤𝑤)𝜎𝜎𝐷𝐷 𝜎𝜎𝐸𝐸 𝜌𝜌𝐷𝐷𝐸𝐸
FINA 3080 Prof. Chao Ying 8
 Portfolio Expected Return as a Function of
Standard Deviation
mean
DNE in
reality

volatility

When the correlation becomes smaller, portfolio’s risk decreases.

FINA 3080 Prof. Chao Ying 9
 Benefits of Diversification
• Exist when assets are not perfectly correlated
& 4
• Decrease with the correlation between the assets
• Come from reduction in portfolio variance
• Can be represented on a mean-volatility graph
• Result mainly from eliminating firm-specific risk
instead of market or systematic risk
• Q: how about the correlation is -1? (last figure)
but still have risk
can
be
zen↓na life ,
actually risk )
Credit
real assets
impossible in & more than 2 in
10
FINA 3080 Prof. Chao Ying a
portfolio
 Optimal portfolio with many assets
• So far we only study portfolios of 2 assets
• How about if there are 100 risky assets and 1 riskfree?
• P: risky portfolio that only contains 100 risky assets
• C: complete portfolio that contain 101 assets
• There are infinite combinations to get P and C
• We want to find C* to maximize utility

• We first need to find P* in the Efficient Frontier

FINA 3080 Prof. Chao Ying 11

 Efficient Frontier of Risky Assets
• These portfolios are not dominated by any others
– Lowest volatility for a given expected return I need

– Highest expected return for a given volatility

to
satisfy
< both

• Minimum variance portfolio is on the frontier

• Global mini-variance portfolio (G) has the lowest risk
• Efficient Frontier usually is the part above G

• Portfolios on efficient frontier is called efficient portfolio

and well-diversified (no idiosyncratic risk )

FINA 3080 Prof. Chao Ying 12

The Minimum-Variance Frontier of
Risky Assets

§
①
G Boo ••

So we find P* in the Efficient Frontier. How about C*?

FINA 3080 Prof. Chao Ying 13

 Complete Portfolios
• Capital allocation lines (CAL) combine riskless
asset with risky assets within efficient frontier
• CALs with higher slopes dominate other CALs
– Slope is the Sharpe ratio ( heward risk ratio
-

,
risk
risk
premium )
• Highest CAL is tangent to the efficient frontier
– Tangency point is the optimal risky portfolio
– CAL describes all optimal complete portfolios
• Weighted average of riskless and optimal risky portfolio

FINA 3080 Prof. Chao Ying 14

The Efficient Frontier of Risky Assets
with the Optimal CALwhinges slope -1

• Highest CAL is tangent to the efficient frontier

• Investors choose different C* on the CAL due
to different risk aversions. 𝑦𝑦 ∗ = 𝐸𝐸 𝑉𝑉𝑝𝑝 − 𝑉𝑉𝑓𝑓
optimal portfolio weight
for diff risk
.
>
aversion
𝐴𝐴𝜎𝜎𝑃𝑃2
FINA 3080 Prof. Chao Ying 15
 Portfolio Separation Theorem
• Optimal risky portfolio (P*) is technically determined
– By risky assets risk/returns not investors’ preference
– All investors face the same optimal CAL
– Thus, they all pick the same risky portfolio
– But NOT the same complete portfolio (risk aversion)
• Preferences determine their complete portfolio C*
– Risk averse investors have less of the risky portfolio
– Very risk tolerant investors use leverage
– All investors hold some of the risky portfolio
• Insight: We can “separate” the risky portfolio and
complete portfolio choice tasks
FINA 3080 Prof. Chao Ying 16
 Portfolio Theory Summary
• Step 1: Find the efficient frontier of risky assets
– Eliminate all dominated risky portfolios

• Step 2: Find the optimal risky portfolio (P*)

– Draw the optimal CAL through P*

• Step 3: Find the optimal complete portfolio (C*)

– Depends on investor utility (e.g., risk aversion)

FINA 3080 Prof. Chao Ying 17

 Example: Two Risky Assets + one risk free

• Suppose the means and volatilities are:

– GE: 6% and 20%; MSFT: 9% and 30%
– Correlation coefficient between GE and MSFT is 0.3
• Draw the investment opportunity set
• Suppose the riskless rate is 3%
• Find the optimal risky portfolio and CAL
• Suppose an investor has risk aversion of A = 2
• Find the optimal complete portfolio
FINA 3080 Prof. Chao Ying 18
 Summary of Results
Exp Ret Std Dev GE Wt MSFT Wt T-Bill Wt
T-Bill (risk-free) 3.0% 0%
General Electric (GE) 6.0% 20% Given

Microsoft (MSFT) 9.0% 30%

Min variance portfolio 6.7% 18.7% 76.6% 23.4% 0.0%
Optimal risky portfolio (P*) 7.6% 20.8% 46.4% 53.6% 0.0%
Optimal complete portfolio 5.5% 11.1% 24.7% 28.5% 46.8%
Notes: GE and MSFT correlation is 0.3 and client's risk aversion is A = 2.
The reward-risk ratio is (7.6% - 3.0%) / (20.8%) = 0.22 on the optimal CAL.

• P* is given and what is C*? Let y* be the weight on P*.

𝐸𝐸 𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓 7.6%−3%
𝑦𝑦 ∗ = = = 53.2%, so 46.8% on T-Bill
𝐴𝐴𝜎𝜎𝑃𝑃2 2∗ 20.8% 2
• GE: 53.2%*46.4%=24.7%; MSFT: 53.2%*53.6%=28.5%;
• What if A=3? 19
FINA 3080 Prof. Chao Ying
 Elr )=
.
w Elrp ) -1 ( tw ) E- ( re )
46.4%+62-1 ( 1-46.4%1×9 % 7.6%
=
=

Var ( ra ) wait a- wife? tzwltw ) 6. G-o-P.se

-
_

= 46.4%2×2024 (I -46.4%12×30%+2 (46.4%14-46.421122) / 303 )

( 0.3 )
= 20.822
of P*&T for
Finding find
weight
bills
-

highest utility
y-%EE.io?t---Y??!-.-- 53.2%

of
*
53.2%
weight T bills 46.82 weight of P =
- =
,

Height of
E¥=}%É%
weight #GE MSF , -

=
5. g- % 53.2% 46.4%
✗
5-3.2%+5-3 6%
.

Varlk ) =
20.8%2153.2%12 = 24.7% = is .5%
=
11.1%2
 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 8B
CAPM

FINA 3080 Prof. Chao Ying 20

 Lecture 8B Outline
• Capital asset pricing model (CAPM)
– Intuition
– Implications

FINA 3080 Prof. Chao Ying 21

Risk Decomposition: Single Factor Model
𝑉𝑉𝑖𝑖 − 𝑉𝑉𝑓𝑓 ) = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑉𝑉�
(� 𝑀𝑀 − 𝑉𝑉𝑓𝑓 + 𝑒𝑒
�𝑖𝑖

Excess Return Market Excess Return

𝛼𝛼𝑖𝑖 = the stock’s expected excess return if the

�𝑀𝑀 − 𝑉𝑉𝑓𝑓 ) = 0
market’s excess return is zero (𝑉𝑉
𝑀𝑀 − 𝑉𝑉𝑓𝑓 = the component of return due to
𝛽𝛽𝑖𝑖 𝑉𝑉�
movements in the market index
𝑒𝑒�𝑖𝑖 = firm specific component, not due to market
movements, Corr � 𝑉𝑉𝑀𝑀 , 𝑒𝑒�𝑖𝑖 = 0
FINA 3080 Prof. Chao Ying 22
 Capital Asset Pricing Model (CAPM)

• Equilibrium model that underlies all modern

financial theory

• Derived using principles of diversification with

simplified assumptions

FINA 3080 Prof. Chao Ying 23

 CAPM Intuition
• Rational investors want the same risky portfolio
– They all demand the optimal risky portfolio
• At equilibrium, asset demand equals supply
– Supply of risky assets is the market portfolio, which
contains all securities and the proportion of each
security is its market value as a percentage of total
market value
– Thus all investors must hold the market
• Assets only contribute to portfolio risk if they
are correlated with the market

FINA 3080 Prof. Chao Ying 24

 Why shall we learn CAPM?
It help to answer two important questions:

1. Why does market risk premium vary over time?

𝐸𝐸 𝑉𝑉𝑚𝑚 − 𝑉𝑉𝑓𝑓 =?

2. Why do different stocks have different return at the same

time?/ What determine the individual asset risk premium?
𝐸𝐸 𝑉𝑉𝑖𝑖 − 𝑉𝑉𝑓𝑓 =?

FINA 3080 Prof. Chao Ying 25

• Start Homework 2: due by 11am on
November 16th, 2022 (Wednesday)
• Do not accept any late submissions and
revisions.
• Final Exam: 7 pm to 9 pm on Nov. 28th
(Monday) at LSK LT5

FINA 3080 Prof. Chao Ying 26