Finding the Efficient Set

(Chapter 5)

Feasible Portfolios
Minimum Variance Set & the Efficient Set
Minimum Variance Set Without Short-Selling
Key Properties of the Minimum Variance Set
Relationships Between Return, Beta, Standard
Deviation, and the Correlation Coefficient

FEASIBLE PORTFOLIOS
When dealing with 3 or more securities, a complete
mass of feasible portfolios may be generated by varying
the weights of the securities:
Expected Rate of Return (%)
25

Stock 1

20

Portfolio of Stocks 1 & 2

15
10

Stock 2

Stock 3

Portfolio of Stocks 2 & 3

0
0

10

20

30

40

Standard Deviation of Returns (%)

Minimum Variance Set and the

Efficient Set

Minimum Variance Set: Identifies those portfolios that

have the lowest level of risk for a given expected rate of
return.
Efficient Set: Identifies those portfolios that have the
highest expected rate of return for a given level of risk.Expected Rate of Return (%)
25

Efficient Set (top half of the

Minimum Variance Set)

20
15
10

Minimum Variance Set

MVP

5
0
0

20

40

Note: MVP is the global minimum

variance portfolio (one with the
lowest level of risk)

Standard Deviation of Returns

Finding the Efficient Set

In practice, a computer is used to perform the
numerous mathematical calculations required. To
illustrate the process employed by the computer,
discussion that follows focuses on:
1. Weights in a three-stock portfolio, where:
Weight of Stock A = xA
Weight of Stock B = xB
Weight of Stock C =1 - xA - xB

and the sum of the weights equals 1.0

2. Iso-Expected Return Lines
3. Iso-Variance Ellipses
4. The Critical Line

Weights in a Three-Stock Portfolio

(Data Below Pertains to the Graph That Follows)

Point on Graph
xA
xB
xC
____________ ______ ______ ______
a
0
1.0
0 Invest in only one stock
b
1.0
0
0 (Corners of the triangle)
c
0
0
1.0
d
.5
.5
0
Invest in only two stocks
e
.5
0
.5 (Perimeter of the triangle)
f
0
.5
.5
g
.25
.25
.5 Invest in all three stocks
(Inside the triangle)
h
0
1.5
-.5
I
0
-.5
1.5 Short-selling occurs
j
1.5
0
-.5 when you are outside
k
-.5
0
1.5 the triangle
l
-.5
-.5
2.0
m
-.5
1.8
-.3
n
1.8
-.3
-.5

Weights in a Three-Stock Portfolio

(Continued)
(Graph of Preceding Data)
Weight of Stock B
2.5

-2

-1

1.5

0.5

k 0
c
l -0.5
-1
-1.5

d
g

b
e

Weight of Stock A
2

Iso-Expected Return Lines

In the graph below, the iso-expected return line
is a line on which all portfolios have the same
expected return.
Given xA = weight of stock (A), and xB = weight
of stock (B), the iso-expected return line is:
xB = a0 + a1xA
Once a0 + a1 have been determined, we can
solve for a value of xB and an implied value of
xC, for any given value of xA

Iso-Expected Return Line

(A graphical representation)
Weight of Stock B
2.5
2

xB = a0 + a1xA

1.5

a0 = the intercept

a1 = the slope

0.5
0
-2

-1

-0.5
-1
-1.5

Iso-Expected
Return Line

Weight of
3 Stock A

Computing the Intercept and Slope of

an
Iso-Expected Return Line
E(rp ) x A E(rA ) x B E(rB ) (1 x A x B ) E(rC )

= x A E(rA ) x B E(rB ) E(rC ) x A E(rC ) x B E(rC )

Rearranging algebraically :
xB

E(rp ) E(rC )
E(rB ) E(rC )

E(rC ) E(rA )
[x A ]
E(rB ) E(rC )

a0

a1

Example : E(rA ) 5%, E(rB ) 10%, E(rC ) 15%,

Iso- Expected Return Line for E(rp ) 13%
xB

E(rp ) E(rC )
E(rB ) E(rC )

E(rC ) E(rA )
[x A ]
E(rB ) E(rC )

13 15 15 5

[x A ]
10 15 10 15
x B .40 2.00 x A
xB

Iso-Expected Return Line for a

Portfolio Return of 13%
xA
_____
-.5
0
.5
1.0

xB = .40 - 2.00xA
_____________
1.4
.4
-.6
-1.6
2

xC = 1 - x A - x B
____________
.1
.6
1.1
1.6

xB

1.5
1
0.5
0
-2

-1

-0.5
-1
-1.5
-2

xA

Iso-Expected Return Line

For E(rp) = 13%

A Series of Iso-Expected Return Lines

By varying the value of portfolio expected return, E(rp),
and repeating the process above many times, we could
generate a series of iso-expected return lines.
xB

E(rp ) E(rC )
E(rB ) E(rC )

E(rC ) E(rA )
[x A ]
E(rB ) E(rC )

Note: When E(rp) is changed, the intercept (a0) changes,

but the slope (a1) xremains unchanged.
B

1.5
1
0.5
0
-2

-1

-0.5
-1

Series of Iso-Expected Return

Lines in Percent

-1.5
-2

xA

17 15 13 11

Iso-Variance Ellipse
(A Set of Portfolios With Equal
Variances)

2 2
2 (rp ) x 2A 2 (rA ) x B
(rB ) (1 x A x B ) 2 2 (rC )

+ 2 x A x BCov(rA , rB )
+ 2 x A (1 x A x B ) Cov(rA , rC )
+ 2 x B (1 x A x B ) Cov(rB , rC )

First, note that the formula for portfolio

variance can be rearranged algebraically in
order to create the following quadratic
equation:
2
ax B
bx B c 0

where :
a, b, and c, can be found as follows :

Iso-Variance Ellipse (Continued)

a 2 (rB ) 2 (rC ) 2 Cov(rB , rC )
b 2 x A [Cov(rA , rB ) 2 (rC ) Cov(rA , rC ) Cov(rB , rC )]
+ 2[Cov(rB , rC ) 2 (rC )]
c x 2A [ 2 (rA ) 2 (rC ) 2 Cov(rA , rC )] 2 x A [Cov(rA , rC )
- 2 (rC )] 2 (rC ) 2 (rp )

Next, the equation can be simplified further by

substituting the values for individual security
variances and covariances into the formula.

Iso-Variance Ellipse (An Example)

Given the covariance matrix for Stocks A, B, and C:
Cov(rA , rA ) Cov(rA , rB ) Cov(rA , rC )

Cov(rB , rA ) Cov(rB , rB ) Cov(rB , rC )

Cov(r , r ) Cov(r , r ) Cov(r , r )
C A
C B
C C

a .21 + .28 - 2(.09) = .31

.25 .15 .17

.15 .21 .09

.17 .09 .28

b = 2 x A (.15 + .28 - .17 - .09) + 2(.09 - .28)

= .34 x A - .38
c = x 2A [.25 + .28 - 2(.17)] + 2 x A (.17 - .28) + .28 - 2 (rp )
= .19 x 2A - .22 x A + .28 - 2 (rp )

Therefore, in terms of axB2 + bxB + c = 0

2
.31 x B
[.34 x A .38] x B [.19 x 2A .22 x A .28 2 (rp )] 0

Now, for a given 2(rp), we can create an iso-variance

ellipse.

Generating the Iso-Variance Ellipse

for a
Portfolio Variance of .21
1. Select a value for xA
2. Solve for the two values of xB
Review of Algebra:
Given the quadratic equation :
2
ax B
bx B c 0

b b 2 4 ac
xB
2a

3. Repeat steps 1 and 2 many times for

numerous values of xA

Generating the Iso-Variance Ellipse

for a
Portfolio Variance of .21 (Continued)

Example: xA = .5

2
.31 x B
[.34 x A .38] x B [.19 x 2A .22 x A .28 2 (rp )] 0
2
.31 x B
[.34(.5) .38] x B [.19(.5)2 .22(.5) .28 .21] 0
2
.31 x B
.21 x B .0075 0

xB
xB

( .21) ( .21) 2 4(.31)(.0075)

2(.31)
( .21) ( .21) 2 4(.31)(.0075)
2(.31)

.64
.038

Generating the Iso-Variance Ellipse

for a
Portfolio Variance of .21 (Continued)
A weight of .5 is simply one possible value for the
weight of Stock (A). For numerous values of xA you
could solve for the values of xB and plot the points in xB
xA space:
xB

1.2

Iso-Variance Ellipse for

2(rp) = .21

.21

0.8
0.6
0.4
0.2

xA

0
-1

-0.5

0.5

1.5

Series of Iso-Variance Ellipses

By varying the value of portfolio variance and
repeating the process many times, we could generate a
series of iso-variance ellipses. These ellipses will
converge on the MVP (the single portfolio with the
lowest level of variance).
xB

1.5
1

.21
.19 .17
MVP

0.5
0
-1

-0.5

0.5

xA

The Critical Line

Shows the portfolio weights for the portfolios in the minimum
variance set. Points of tangency between the iso-expected return
lines and the iso-variance ellipses. (Mathematically, these points of
tangency occur when the 1st derivative of the iso-variance formula
is equal to the 1st derivative of the iso-expected return line.)

1.5

xB
16.9 15.6 13.6

.21

9.4

7.4 6.1

.19 .17

Critical Line

MVP

0.5
0
-1

-0.5

0.5

xA

Finding the Minimum Variance Portfolio

(MVP)
Previously, we generated the following quadratic equation:
2
.31 x B
[.34 x A .38] x B [.19 x 2A .22 x A .28 2 (rp )] 0

Rearranging, we can state:

2
2 (rp ) .31 x B
.34 x A x B .38 x B .19 x 2A .22 x A .28

1. Take the 1st derivative with respect to xB, and set it equal to 0:
2 (rp )
xB

.62 x B .34 x A .38 0

2. Take the 1st derivative with respect to xA, and set it equal to 0:
2 (rp )
.34 x B .38 x A .22 0
xA
3. Simultaneously solving the above two derivatives for xA & xB:
xA = .06

xB = .58

xC = .36

Relationship Between the Critical

Line and the Minimum Variance Set
xB

1.4
1.2

MVP

Critical Line

0.8
0.6
0.4

0.2

0
-2

-1

-0.2 0
-0.4
-0.6

xA

Relationship Between the Critical

Line and the Minimum Variance Set
(Continued)
Expected Return

0.25
Minimum Variance Set

0.2

0.15
MVP

0.1

0.05
D

0
0

0.1 0.2 0.3 0.4 0.5 0.6

Standard Deviation of Returns

Minimum Variance Set When Short-Selling

is Not Allowed (Critical Line Passes
Through the Triangle)

xB

Critical Line Passes

Through the Triangle

1.4
1.2

1
MVP

0.8
0.6
0.4

0.2
0
-2

-1

-0.2 0
-0.4
-0.6

xA

Minimum Variance Set When Short-Selling

is Not Allowed (Critical Line Passes Through
the Triangle)
CONTINUED
Expected Return

0.25

With Short-Selling

0.2

Stock (C)

0.15
MVP

0.1
0.05

Without Short-Selling
Stock (A)

0
0

0.1 0.2 0.3 0.4 0.5 0.6

Standard Deviation of Returns

Minimum Variance Set When ShortSelling is Not Allowed (Critical Line

Does Not Pass Through the Triangle)
xB

Critical Line Does Not Pass

Through the Triangle

1.5
1
0.5

xA

0
-2

-1

0
-0.5
-1

Minimum Variance Set When ShortSelling is Not Allowed (Critical Line

Does Not Pass Through the Triangle)
CONTINUED
Expected Return

0.25

With Short-Selling

0.2
0.15
0.1

Without Short Selling

0.05
0
0

0.1 0.2 0.3 0.4 0.5 0.6

Standard Deviation of Returns

The Minimum Variance Set:

(Property I)
If we combine two or more portfolios on the minimum
variance set, we get another portfolio on the minimum
variance set.
Example: Suppose you have $1,000 to invest. You sell
portfolio (N) short $1,000 and invest the total $2,000 in
portfolio (M). What are the security weights for your
new portfolio (Z)?
Portfolio N: xA = -1.0, xB = 1.0, xC = 1.0
Portfolio M: xA = 1.0, xB = 0, xC = 0
Portfolio Z: xA = -1(-1.0) + 2(1.0) = 3.0
xB = -1(1.0) + 2(0) = -1.0
xC = -1(1.0) + 2(0) = -1.0

The Minimum Variance Set: (Property

I)
CONTINUED
XB

1.5

1
0.5

0
-2

-1

XA
2

-0.5
-1
-1.5

The Minimum Variance Set:

(Property II)
Given a population of securities, there will be
a simple linear relationship between the beta
factors of different securities and their
expected (or average) returns if and only if the
betas are computed using a minimum variance
market index portfolio.

The Minimum Variance Set:

(Property II)
CONTINUED
E(r)

E(r)

0.3

0.3

0.25

0.25

0.2

0.2

0.15

0.15

0.1

0.1

E(rZ)

B
A

E(rZ)

0.05

0.05

(r)

0
0

0.16 0.32 0.48

0
0

The Minimum Variance Set:

(Property II)
CONTINUED
0.25

E(r)

E(r)

0.25

0.2

0.2

E(rZ)

0.15

0.15

0.1

0.05

(r)

0.1

0.05

E(rZ)
A

0.16 0.32 0.48

0
-1

Notes on Property II
The intercept of a line drawn tangent to the
bullet at the position of the market index
portfolio indicates the return on a zero beta
security or portfolio, E(rZ).
By definition, the beta of the market portfolio is
equal to 1.0 (see the following graph).
Given E(rZ) and the fact that Z = 0, and E(rM)
and the fact that M = 1.0, the linear
relationship between return and beta can be
determined.

Notes on Property II
CONTINUED

0.3

rM

0.2

= M = 1.00
0.1

rM

0
-0.1

0
-0.1
-0.2

0.1

0.2

0.3

Return, Beta, Standard Deviation,

and the Correlation Coefficient
In the following graph, portfolios M, A, and B,
all have the same return and the same beta.
Portfolios M, A, and B, have different standard
deviations, however. The reason for this is that
portfolios A and B are less than perfectly
positively correlated with the market portfolio
(M).
j

Cov(rj , rM )
2

(rM )

j,M (rj ) (rM )

2

(rM )

j,M (rj )
(rM )

Return, Beta, Standard Deviation,

and the Correlation Coefficient
(Continued)
E(r)

E(r)

0.3

0.3

j,M = 1.0

0.25
0.2

j,M = .7
j,M = .5

0.15

A B

0.1

0.2
M, A, B

0.15
0.1

E(rZ)

E(rZ)

0.05

0.05

(r)

0
-0.16

0.25

0.16 0.32 0.48

0
0

Return Versus Beta When the

Market Portfolio (M**) is Inefficient
E(r)

0.3

0.3

0.25

0.25

0.2
M

0.15

0.2

C
M**

0.15

0.1

E(r)

0.1

0.05

C
M**

0.05

(r)

0
0

0.16 0.32 0.48

0
0