The Optimal Risky Portfolio

Lecture No.3 SAPM

Portfolio construction Process

Capital allocation between risky portfolio and risk-free assets
Depends upon risk aversion and risk-return trade-off

Asset allocation among asset classes

Broad outlines of portfolio established

Security selection
Specific securities selected for the portfolio

Steps 2 and 3 lead to optimal risky portfolio Optimal risky portfolio is the combination of risky assets that provides the best risk-return trade-off

Diversification and portfolio risk

Two sources of risk firm-specific risk or unique risk Market risk or systematic risk (inflation, business cycles, exchange rates etc ) Diversification can reduce firm-specific risk to zero if specific risk is independent (known as the insurance principle) Diversification cannot eliminate the systematic risk, i.e. risk attributable to market-wide sources Hence investors only care about systematic risks Return on assets compensates only for systematic risks

Portfolio expected return and risk

Consider 2 risky assets, a debt mutual fund D and an equity mutual fund E If the weights of the 2 assets are Wd and We then portfolio expected return E(rp) is

and portfolio risk ( p) is given as

Correlation and Portfolio Risk

Expected return of the portfolio is the weighted average of expected returns of component assets with their proportions as weights Portfolio variance is driven by the covariance between component assets If correlation between assets is 1 (perfect positive correlation) then portfolio standard deviation = weighted average of component standard deviations If correlation less than 1, portfolio standard deviation is less than weighted average of component standard deviations If correlation is -1 (perfect negative correlation), portfolio variance is lowest we can construct a zero-variance portfolio

Case of perfect positive correlation

When rho=1, equation for portfolio variance becomes Or Hence standard deviation of portfolio = weighted average of component standard deviations Thus no benefit from diversification

Correlation > 0 < 1

When assets are less than perfectly positively correlated we can construct the minimum variance portfolio The Minimum Variance Portfolio has a standard deviation less than that of the component assets Equation for obtaining weights for Minimum Variance Portfolio for portfolio consisting of 2 assets D and E

Example

When correlation is zero

The equation for portfolio variance becomes

The weights for the minimum variance portfolio are and

Case of perfect negative correlation

For assets with perfect negative correlation

The weights for the zero variance portfolio are and

Example-Portfolio return and risk

The expected return and risk of the two assets are E(rd)= 0.08, E(re)=0.13, ( d) =0.12 and ( e)=0.20
Wd 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 We 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 E( rp) 0.1300 0.1250 0.1200 0.1150 0.1100 0.1050 0.1000 0.0950 0.0900 0.0850 0.0800
Portfol i o Std Devi ati on for the given correl a ti on

-1 0.2000 0.1680 0.1360 0.1040 0.0720 0.0400 0.0080 0.0240 0.0560 0.0880 0.1200

0 0.2000 0.1804 0.1618 0.1446 0.1292 0.1166 0.1076 0.1032 0.1040 0.1098 0.1200

0.3 0.2000 0.1840 0.1688 0.1547 0.1420 0.1311 0.1226 0.1170 0.1145 0.1156 0.1200

1 0.2000 0.1920 0.1840 0.1760 0.1680 0.1600 0.1520 0.1440 0.1360 0.1280 0.1200

Observations
For =1, portfolio standard deviation is simply weighted average of asset standard deviation (no benefit of diversification) For =0.30 and =0, portfolio standard deviation decreases initially as equity component increases indicating diversification benefit and increases as portfolio becomes concentrated in equity we can find the minimum-variance portfolio which has standard deviation less than that of individual assets For =-1, diversification is most effective due to perfect hedge For =-1, we can construct a zero-variance portfolio

Portfolio expected return and SD

Exhibit 4.5: Mean Standard Deviation Diagram: Portfolios of Two Risky Securities with Arbitrary Correlation, V

The Minimum Variance Frontier

We plot the set of portfolios with the lowest variance at a given level of expected return ( recall the mean variance criterion) Above set known as the Mean Standard Deviation frontier or Minimum Variance frontier Portion of mean-SD frontier below the global minimum variance portfolio is inefficient For each frontier portfolio on the lower portion there exists another frontier portfolio on the upper portion with same but a higher E(r) Portion above the global minimum variance portfolio is known as the efficient frontier in the absence of a risk-free asset Investors will only choose a portfolio on the efficient frontier

The Efficient Frontier

Risky Portfolio with a risk-free asset

Given a risky portfolio of 2 risky assets, a debt mutual fund and an equity mutual fund and a risk-free asset with return rf How do we find the optimal risky portfolio? Plot CALs starting from the risk-free rate and passing through the opportunity set of risky assets debt and equity funds The highest CAL will have highest slope, i.e. Max S = (E(rp)rf)/ p Optimal risky portfolio is the tangency point of the highest CAL to the portfolio opportunity set Tangency portfolio consists of risky assets only

Risky portfolio + risk-free asset

We draw CALs from the risk-free rate to various portfolios on the efficient frontier

The Optimal risky portfolio

We find the CAL from the risk-free rate to the point of tangency to the efficient frontier Portfolio at tangency point will have highest Reward-to-risk ratio

Optimal Risky Portfolio 2 assets

Equation for determining weights of optimal risky portfolio with 2 risky assets

And where RD and RE are excess returns on debt and equity funds i.e. Expected return less the risk-free rate

Optimal Complete Portfolio

Calculate the weights of the optimal risky portfolio as above Compute the E(r ) and of the optimal risky portfolio We have the risk-free rate and the investors degree of risk aversion Proportion to be invested in risky portfolio is

Balance is the proportion invested in risk-free asset

Optimal Complete Portfolio

Point P where the CAL is tangent to the efficient frontier depicts the optimal risky portfolio At Points 1 and 2 the indifference curves of 2 different investors are tangent to the CAL Points 1 and 2 depict the Optimum complete portfolio for those investors

Summary
Note that optimal risky portfolio is the same for all investors Formula for computation of weights of optimal risky portfolio does not include the investors degree of risk aversion Hence the fund manager will offer the same optimal risky portfolio to all his investors- his job becomes easier ! The optimal complete portfolio for each investor (the allocation of funds between the risky portion and risk-free portion) will be different It will depend on investors preferences, i.e. his degree of risk aversion and indifference curve More risk averse investors will have lower proportion of the optimal risky portfolio in their complete portfolio than less riskaverse investors