Optimal Risky Portfolios

Risk Reduction with Diversification

St. Deviation

Unique Risk

Market Risk
Number of
Securities

8-2
1-2
 Two-Security Portfolio: Return

rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expectedn return on Security 2
w 1
i 1
i

8-3
1-3
Measurement of co-movements in security returns
Co-movement between return of securities are
measured by Covariance and Coefficient of
Correlation.
Covariance and Coefficient of Correlation are
conceptually analogous in the sense that both of them
reflect the degree of co-movement between two
variables.
Covariance reflect the degree to which the returns of
the two securities vary or change together.

8-4
1-4
 Two-Security Portfolio: Risk

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

12 = Variance of Security 1

22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

8-5
1-5
 Covariance

Cov(r1r2) = 1,212
1,2 = Correlation coefficient of
returns
1 = Standard deviation of
returns for Security 1
2 = Standard deviation of
returns for Security 2
8-6
1-6
Correlation Coefficients: Possible Values

Range of values for 1,2

+ 1.0 >  > -1.0
If = 1.0, the securities would be perfectly
positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated

8-7
1-7
 Three-Security Portfolio

rp = W1r1 + W2r2 + W3r3

2p = W1212 + W2212 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
8-8
1-8
In General, For An N-Security Portfolio:

rp = Weighted average of the

n securities
p2 = (Consider all pairwise
covariance measures)

8-9
1-9
 Correlation Effects

The relationship depends on correlation

coefficient.
-1.0 <  < +1.0
The smaller the correlation, the greater
the risk reduction potential.
If = +1.0, no risk reduction is possible.

8-10
1-10
 Minimum-Variance Combination

Sec 1 E(r1) = .10  1 = .15

12 = .2
Sec 2 E(r2) = .14  2 = .20
 22 - 
W1 =
21 + 22 - 2
W2 = (1 - W1)
8-11
1-11
Minimum-Variance Combination:  = .2

(.2)2 - (.2)(.15)(.2)
W1 =
(.15)2 + (.2)2 - 2(.2)(.15)(.2)

W1 = .6733
W2 = (1 - .6733) = .3267

8-12
1-12
Risk and Return: Minimum Variance

rp = .6733(.10) + .3267(.14) = .1131

 p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
1/2
2(.6733)(.3267)(.2)(.15)(.2)]

1/2
 p = [.0171] = .1308

8-13
1-13
Chart Q-2

8-14
1-14
8-15
1-15
Solution for weight of Optimum Risky
Portfolio

W b=1-wS

8-16
1-16
Solution for weight of Optimum
Complete Portfolio

Y =( E(R p)- r f ) / Ap

Where Y=weight of risky portfolio

And
1-Y=Weight of risk free investment

8-17
1-17
Extending Concepts to All Securities

The optimal combinations result in

lowest level of risk for a given return.

The optimal trade-off is described as the

efficient frontier.

These portfolios are dominant.

8-18
1-18
Extending to Include Riskless Asset

The optimal combination becomes

linear.

A single combination of risky and

riskless assets will dominate.

8-19
1-19
Minimum-Variance Frontier of Risky Assets

E(r)

Efficient
frontier

Global Individual
minimum assets
variance
portfolio Minimum
variance
frontier
St. Dev.

8-20
1-20
Extending to Include Riskless Asset

The optimal combination becomes

linear.

A single combination of risky and

riskless assets will dominate.

8-21
1-21
8-22
1-22
 Separation Property
The portfolio choice problem is separated into
two independent tasks:

First task: Determining the optimal risky

portfolio (the portfolio made up of risky
assets);
Second task: The allocation between the
risk-free asset (T-bills) versus the risky
portfolio depends on the investor’s personal
preferences for risk-taking (his utility
function).