Summer 2020

Optimal Portfolio, Efficient

Frontier
Chapter 05

Efficient Portfolio Assumptions: Two Asset case

• What efficiency?
• Interplay of correlation b/w two assets
influences ‘overall risk’
• Highest expected return for any degree of risk
• Goal: Maximizing profits & minimizing the risk
• Simple of a two asset portfolio
- Stock A
- Stock B
• Range of values for Correlation Coefficient
between stock ρAB (Can’t realistically happen)
- Case 1: ρAB = +1
- Case 2: ρAB = 0
- Case 3: ρAB =-1
• 05 Weight Allocations for stock A & B
- Stock A: 0, 25, 50, 75, 100
- Stock B: 100,…………….,0

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 Return & SD for entire range of ‘ρAB’
Two Asset Case
values with 05 weight positions
• Consider a 02 asset
portfolio A & B Wt Stock AWt Stock B Portfolio Portfolio SD of Portfolio
AB for ρ
• Stock A: Wa Wb
Allocation Return, Rp 1: AB=1 2: AB=0 3: AB=-1
- Average return ‘A’: 5% 1.00 0.00 1 5.00% 4.00% 4.00% 4.00%
0.75 0.25 2 5.75% 5.50% 3.91% 0.50%
- SD ‘A’: 4%
0.50 0.50 3 6.50% 7.00% 5.39% 3.00%
• Stock B: 0.25 0.75 4 7.25% 8.50% 7.57% 6.50%
- Average return ‘B’: 8% 0.00 1.00 5 8.00% 10.00% 10.00% 10.00%
– SD ‘B’: 10%

Graph: Portfolio Return Graph: Portfolio Risk (SD)

12.00%
Rp: same for 1,0,-1 S
9.00% t
E Linear function
a 10.00%
x 8.00% (no effect of
n
p diversification)
7.00% d
8.00%
e a
6.00%
c r
AB=1
t 5.00% d 6.00%
AB=0
e Rp Some AB=-1
4.00%
d D Diversification
4.00%
3.00% e
R v
2.00%
e i 2.00%
t 1.00% a
u t Complete diversification
0.00% 0.00%
r 0 1 2 3 4 5 6 i 0 1 2 3 4 5 6
n B 100% o B 100%
A 100% Weight Allocations A 100% Weight Allocations
s n

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 Graph: Portfolio Return/ Return Graph: Portfolio Return/ Return
Combinations Combinations
E 9.00% E 9.00%

x x
8.00% 8.00%
p p
Attainable efficient Positions
e 7.00% e 7.00%
c c
t6.00% t 6.00%
Highest
e e
5.00% return
5.00%
d AB=1
d AB=1
AB=0 of least AB=0
4.00% 4.00%
AB=-1 amount AB=-1
R R
3.00% of risk
e3.00% e
t2.00% t 2.00%
u u
r 1.00% r 1.00%

n n
s 0.00% 2.00% 4.00% 6.00%
0.00%
8.00% 10.00% 12.00% s
0.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

Standard Deviation of Portfolio Standard Deviation of Portfolio

Result Optimal Portfolio

- When Case 1: ρAB = +1
• No benefit at attempts of diversification
-When Case 2: ρAB = 0
• Reduces risk from diversification, but
cannot eliminate inherent risk
- Case 3: ρAB =-1
• Risk completely eliminated, but unrealistic expectation
to find such stocks

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 Feasible Vs Efficient Set
• The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
• An efficient portfolio is one that offers:
- the most return for a given amount of risk, or
- the least risk for a give amount of return.
• The collection of efficient portfolios is called
the efficient set or efficient frontier.
Optimal Portfolio
• Indifference curves reflect an investor’s
attitude toward risk as reflected in his or her
risk/return tradeoff function. They differ
among investors because of differences in risk
aversion.
- Based on utility theory: Same level of utility
(indifference) on each point on curve.
• An investor’s optimal portfolio is defined by
the tangency point between the efficient set
and the investor’s indifference curve.

Risk/ Return Indifference curve Selecting Optimal portfolio

• “Map” of indifference
curves for individuals Y
&Z
• Every individual has
unique indifference
map
• Different curves denote
different levels of utility
- Higher curves denote
more utility

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 Assumptions: CAPM
1. Single holding period, Portfolio for maximizing
wealth on the basis of expected return & SD
2. Lending & borrowing on risk free rate, short
sales allowed
3. Identical estimates, homogenous expectations
4. Assets: liquid & divisible
5. No transaction costs
6. No Taxes
7. Price takers: buying selling won’t effect prices
8. Assets: Quantities Fixed
CAPM: Introducing Risk Free Asset
• When a risk-free asset is added to the feasible
set, investors can create portfolios that
combine this asset with a portfolio of risky
assets.
• The straight line connecting r RF with M, the
tangency point between the line and the old
efficient set, becomes the new efficient
frontier.

Capital Market Line Capital Market Line

• Including risk-free Beyond M, Slightly
Risk averse investor: • Investor can achieve any
asset (SD=0) with a Buying on margin, combination of risk & return
return of rRF available at Rrf, or b/w rRF & M
CAPM will not be
valid • M = point of tangency b/w
• Feasible set was efficient frontier & rRF
shaded area but • CAPM: All investors hold
portfolio with combination
after rRF more of risk free security & risky
possibilities portfolio M
• Reach higher • If capital market in
Risk Averse equilibrium, M is market
indifference curve, Investor portfolio
more utility • Line rRF MZ is CML
• Move from N to R

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 Capital Market Line Capital Market Line
• Intercept: Rrf • Intercept = rRF
• Slope = (rm - rRF)/ σm
• Slope
(Remember: σRF = 0)
• Hence, CML: • CML Equation(Return of
portfolio rp)
• rp = rRF + ( (rm- rRF)/ σm )σp
• CML: specifies
• The expected rate of return on an “efficient relationship b/w risk &
portfolio” is Rrf plus a risk premium, return of an efficient
multiplied by portfolio’s SD. portfolio

CML: example CAPM: Capital Asset Pricing Model

• Return of Individual Stock i held in market
portfolio (derivation from pervious equations)

Beta Coefficient formula as per

CAPM

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 Security Market line Issues in beta calculation: Variances
Substituting the value of
• Individual stock return: beta in CML • Time Frame
- Risk Free Rate
• Time Interval
- Risk Premium
- Into risk of individual • Different Index
stock • Inclusion of Capital gain and/ or Dividend
• SML Vs. CML: SD of
individual stock should
be used as measure of
risk (Beta should be
used)

Diversification - International markets