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Today Portfolio Possibility Curve The Efcient Frontier

Lecture 2.4: Mean-Variance Efcient Frontier
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Today Portfolio Possibility Curve The Efcient Frontier
Readings
Chapters 5 6 of the course textbook (EGBG).
Lecture slides
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Today Portfolio Possibility Curve The Efcient Frontier
Outline
1
Shape of the Portfolio Possibility Curve when there are
N = 2 risky assets with:
Perfect Positive Correlation, = 1
Perfect Negative Correlation, = 1
Zero Correlation, = 0
2
The Efcient Frontier with:
No Short Sales
Short Sales Allowed
Riskless Borrowing and Lending
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Today Portfolio Possibility Curve The Efcient Frontier
Benets of Diversication
The expected return on a portfolio of 2 assets is
E (R
p
) = X
1
E (R
1
) +X
2
E (R
2
) ,
= X
1
E (R
1
) + (1 X
1
) E (R
2
) , since
2

i =1
X
i
= 1
The variance of return on a portfolio of 2 assets is

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

2
X
1
and X
2
= (1 X
1
) are the fractions invested in assets 1 and 2,
respectively.
We rst assume that short sales are not allowed 0 < X
1
, X
2
< 1
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Today Portfolio Possibility Curve The Efcient Frontier
Benets of Diversication
The expected return on a portfolio of 2 assets is
E (R
p
) = X
1
E (R
1
) +X
2
E (R
2
) ,
= X
1
E (R
1
) + (1 X
1
) E (R
2
) , since
2

i =1
X
i
= 1
The variance of return on a portfolio of 2 assets is

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

2
X
1
and X
2
= (1 X
1
) are the fractions invested in assets 1 and 2,
respectively.
We rst assume that short sales are not allowed 0 < X
1
, X
2
< 1
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Today Portfolio Possibility Curve The Efcient Frontier
Benets of Diversication
The expected return on a portfolio of 2 assets is
E (R
p
) = X
1
E (R
1
) +X
2
E (R
2
) ,
= X
1
E (R
1
) + (1 X
1
) E (R
2
) , since
2

i =1
X
i
= 1
The variance of return on a portfolio of 2 assets is

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

2
X
1
and X
2
= (1 X
1
) are the fractions invested in assets 1 and 2,
respectively.
We rst assume that short sales are not allowed 0 < X
1
, X
2
< 1
CMU-logo
Today Portfolio Possibility Curve The Efcient Frontier
Benets of Diversication
The expected return on a portfolio of 2 assets is
E (R
p
) = X
1
E (R
1
) +X
2
E (R
2
) ,
= X
1
E (R
1
) + (1 X
1
) E (R
2
) , since
2

i =1
X
i
= 1
The variance of return on a portfolio of 2 assets is

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

2
X
1
and X
2
= (1 X
1
) are the fractions invested in assets 1 and 2,
respectively.
We rst assume that short sales are not allowed 0 < X
1
, X
2
< 1
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Positive Correlation, = 1
If the correlation coefcient is +1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
1

2
= (X
1

1
+ (1 X
1
)
2
)
2

p
= X
1

1
+ (1 X
1
)
2
the risk and return of the portfolio are linear functions of the risk and
return of each security.
Denition
All combinations of two securities that are perfectly correlated will lie on
a straight line in expected return-standard deviation space:
E (R
p
) =

p

2
E (R
1
) +

1

p

E (R
2
)
=

1
E (R
2
)
2
E (R
1
)

E (R
1
) E (R
2
)

p
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Positive Correlation, = 1
If the correlation coefcient is +1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
1

2
= (X
1

1
+ (1 X
1
)
2
)
2

p
= X
1

1
+ (1 X
1
)
2
the risk and return of the portfolio are linear functions of the risk and
return of each security.
Denition
All combinations of two securities that are perfectly correlated will lie on
a straight line in expected return-standard deviation space:
E (R
p
) =

p

2
E (R
1
) +

1

p

E (R
2
)
=

1
E (R
2
)
2
E (R
1
)

E (R
1
) E (R
2
)

p
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Negative Correlation, = 1
If the correlation coefcient is 1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
2X
1
(1 X
1
)
1

2
= (X
1

1
(1 X
1
)
2
)
2
Therefore, either

p
= X
1

1
(1 X
1
)
2
or

p
= X
1

1
+ (1 X
1
)
2
the relation between the risk and return of the portfolio can be
expressed as two straight lines, one for each expression for
p
Also, in this case, the following portfolio has zero risk, i.e,
p
=0:
X
1
=

2

1
+
2
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Negative Correlation, = 1
If the correlation coefcient is 1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
2X
1
(1 X
1
)
1

2
= (X
1

1
(1 X
1
)
2
)
2
Therefore, either

p
= X
1

1
(1 X
1
)
2
or

p
= X
1

1
+ (1 X
1
)
2
the relation between the risk and return of the portfolio can be
expressed as two straight lines, one for each expression for
p
Also, in this case, the following portfolio has zero risk, i.e,
p
=0:
X
1
=

2

1
+
2
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Negative Correlation, = 1
If the correlation coefcient is 1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
2X
1
(1 X
1
)
1

2
= (X
1

1
(1 X
1
)
2
)
2
Therefore, either

p
= X
1

1
(1 X
1
)
2
or

p
= X
1

1
+ (1 X
1
)
2
the relation between the risk and return of the portfolio can be
expressed as two straight lines, one for each expression for
p
Also, in this case, the following portfolio has zero risk, i.e,
p
=0:
X
1
=

2

1
+
2
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Today Portfolio Possibility Curve The Efcient Frontier
Perfect Negative Correlation, = 1
If the correlation coefcient is 1, the portfolio variance simplies to

2
p
= X
2
1

2
1
+ (1 X
1
)
2

2
2
2X
1
(1 X
1
)
1

2
= (X
1

1
(1 X
1
)
2
)
2
Therefore, either

p
= X
1

1
(1 X
1
)
2
or

p
= X
1

1
+ (1 X
1
)
2
the relation between the risk and return of the portfolio can be
expressed as two straight lines, one for each expression for
p
Also, in this case, the following portfolio has zero risk, i.e,
p
=0:
X
1
=

2

1
+
2
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Today Portfolio Possibility Curve The Efcient Frontier
Arbitrary Correlation,
For a general correlation coefcient, the standard deviation of the
portfolio is

p
=

X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

1/2
the relation between the risk and return of the portfolio is
represented by a curve (instead of straight line(s) as in the cases of
= +1 and = 1)
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Today Portfolio Possibility Curve The Efcient Frontier
Arbitrary Correlation,
For a general correlation coefcient, the standard deviation of the
portfolio is

p
=

X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

1/2
the relation between the risk and return of the portfolio is
represented by a curve (instead of straight line(s) as in the cases of
= +1 and = 1)
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Today Portfolio Possibility Curve The Efcient Frontier
Portfolio Expected Return as a Function of Standard
Deviation
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Today Portfolio Possibility Curve The Efcient Frontier
Minimum Variance Portfolio
To nd the minimum variance portfolio, we take the derivative of the
portfolio standard deviation with respect to X
1
, set the derivative to zero,
and solve for X
1
:

p
X
1
=
1
2
2X
1

2
1
2 (1 X
1
)
2
2
+ 2 (1 X
1
)
12

2
2X
1

12

X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

1/2
= 0
Solving for X
1
gives
X
1
=

2
2
2
12

2
1
+
2
2
2
12

2
In the special case that = 0, this reduces to
X
1
=

2
2

2
1
+
2
2
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Today Portfolio Possibility Curve The Efcient Frontier
Minimum Variance Portfolio
To nd the minimum variance portfolio, we take the derivative of the
portfolio standard deviation with respect to X
1
, set the derivative to zero,
and solve for X
1
:

p
X
1
=
1
2
2X
1

2
1
2 (1 X
1
)
2
2
+ 2 (1 X
1
)
12

2
2X
1

12

X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

1/2
= 0
Solving for X
1
gives
X
1
=

2
2
2
12

2
1
+
2
2
2
12

2
In the special case that = 0, this reduces to
X
1
=

2
2

2
1
+
2
2
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Today Portfolio Possibility Curve The Efcient Frontier
Minimum Variance Portfolio
To nd the minimum variance portfolio, we take the derivative of the
portfolio standard deviation with respect to X
1
, set the derivative to zero,
and solve for X
1
:

p
X
1
=
1
2
2X
1

2
1
2 (1 X
1
)
2
2
+ 2 (1 X
1
)
12

2
2X
1

12

X
2
1

2
1
+ (1 X
1
)
2

2
2
+ 2X
1
(1 X
1
)
12

1/2
= 0
Solving for X
1
gives
X
1
=

2
2
2
12

2
1
+
2
2
2
12

2
In the special case that = 0, this reduces to
X
1
=

2
2

2
1
+
2
2
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Today Portfolio Possibility Curve The Efcient Frontier
The Portfolio Possibilities Curve with No Short Sales
Plotting all conceivable risky assets and combinations of risky assets in
the expected return-standard deviation space, generates a diagram like
the following:
Efcient Frontier: is the efcient set of portfolios that consists of the
envelope curve of all portfolios that lie between the global minimum
variance portfolio and the maximum return portfolio.
The efcient frontier has a concave shape.
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Today Portfolio Possibility Curve The Efcient Frontier
The Portfolio Possibilities Curve with No Short Sales
Plotting all conceivable risky assets and combinations of risky assets in
the expected return-standard deviation space, generates a diagram like
the following:
Efcient Frontier: is the efcient set of portfolios that consists of the
envelope curve of all portfolios that lie between the global minimum
variance portfolio and the maximum return portfolio.
The efcient frontier has a concave shape.
CMU-logo
Today Portfolio Possibility Curve The Efcient Frontier
The Portfolio Possibilities Curve with No Short Sales
Plotting all conceivable risky assets and combinations of risky assets in
the expected return-standard deviation space, generates a diagram like
the following:
Efcient Frontier: is the efcient set of portfolios that consists of the
envelope curve of all portfolios that lie between the global minimum
variance portfolio and the maximum return portfolio.
The efcient frontier has a concave shape.
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with No Short Sales
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Today Portfolio Possibility Curve The Efcient Frontier
The Portfolio Possibilities Curve with Short Sales
Allowed
Short selling: is the process of selling a security that the investor does
not own.
short selling makes sense when:
1
the investor expects the return on a security to be negative
2
even when the return is positive, the cash ow received from short
selling the security can be used to purchase a security with higher
expected return
The expected return standard deviation combinations when short sales
are allowed are shown in the gure below
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Short Sales Allowed
The efcient set still starts with the minimum variance portfolio, but
when short sales are allowed it has no nite upper bound.
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending
Let the certain rate of return on the riskless asset be R
F
the standard
deviation of the return on the riskless asset must be zero,
F
= 0
The expected return on a combination of the riskless asset and the
optimal risky portfolio A is
E (R
p
) = XE (R
A
) + (1 X) R
F
,
The risk on the combination is

p
=

X
2

2
A
+ (1 X)
2

2
F
+ 2X (1 X)
AF

1/2
=

X
2

2
A

1/2
= X
A
Solving this equation for X gives
X =

p

A
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending
Let the certain rate of return on the riskless asset be R
F
the standard
deviation of the return on the riskless asset must be zero,
F
= 0
The expected return on a combination of the riskless asset and the
optimal risky portfolio A is
E (R
p
) = XE (R
A
) + (1 X) R
F
,
The risk on the combination is

p
=

X
2

2
A
+ (1 X)
2

2
F
+ 2X (1 X)
AF

1/2
=

X
2

2
A

1/2
= X
A
Solving this equation for X gives
X =

p

A
CMU-logo
Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending
Let the certain rate of return on the riskless asset be R
F
the standard
deviation of the return on the riskless asset must be zero,
F
= 0
The expected return on a combination of the riskless asset and the
optimal risky portfolio A is
E (R
p
) = XE (R
A
) + (1 X) R
F
,
The risk on the combination is

p
=

X
2

2
A
+ (1 X)
2

2
F
+ 2X (1 X)
AF

1/2
=

X
2

2
A

1/2
= X
A
Solving this equation for X gives
X =

p

A
CMU-logo
Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending
Let the certain rate of return on the riskless asset be R
F
the standard
deviation of the return on the riskless asset must be zero,
F
= 0
The expected return on a combination of the riskless asset and the
optimal risky portfolio A is
E (R
p
) = XE (R
A
) + (1 X) R
F
,
The risk on the combination is

p
=

X
2

2
A
+ (1 X)
2

2
F
+ 2X (1 X)
AF

1/2
=

X
2

2
A

1/2
= X
A
Solving this equation for X gives
X =

p

A
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending contd.
Substituting this expression for X into the expression for expected
return on the combination yields
E (R
p
) =

p

A
E (R
A
) +

1

p

R
F
,
= R
F
+

E (R
A
) R
F

p
This is the equation of a straight line with intercept R
F
and slope
E(R
A
)R
F

A
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending contd.
This straight line is called the capital allocation line (CAL)
The slope of the CAL, denoted S, equals the increase in the expected
return of the complete portfolio per unit of additional standard deviation,
i.e. incremental return per incremental risk
the slope is called the reward-to-volatility ratio or the Sharpe ratio:
Sharpe Ratio =
E (R
A
) R
F

A
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Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending contd.
This straight line is called the capital allocation line (CAL)
The slope of the CAL, denoted S, equals the increase in the expected
return of the complete portfolio per unit of additional standard deviation,
i.e. incremental return per incremental risk
the slope is called the reward-to-volatility ratio or the Sharpe ratio:
Sharpe Ratio =
E (R
A
) R
F

A
CMU-logo
Today Portfolio Possibility Curve The Efcient Frontier
The Efcient Frontier with Riskless Borrowing and
Lending contd.
This straight line is called the capital allocation line (CAL)
The slope of the CAL, denoted S, equals the increase in the expected
return of the complete portfolio per unit of additional standard deviation,
i.e. incremental return per incremental risk
the slope is called the reward-to-volatility ratio or the Sharpe ratio:
Sharpe Ratio =
E (R
A
) R
F