Introduction to Finance

Case Study 1: Basics of Modern Portfolio Theory

Team members of Group 18:
Felix Starke

371747

[felix.starke@uni-muenster.de]

Tom Eggers

416931

[tom.eggers@uni-muenster.de]

Jonas Bungert

416749

[jonasbungert@gmx.de]

Tim Echterling

424032

[timechterling@web.de]

Index of abbreviations:
CAL

Capital allocation line

SD

Standard deviation

SR

Sharpe ratio

T-Bills

Treasury-Bills

Index of symbols:
X,Y

Random variables (e.g. rate of return)

Standard deviation of the random variables X and Y
Standard deviation of the complete portfolio
Standard deviation of the risky portfolio
Standard deviation of the risk free asset
Risk free interest rate
Return of the risky portfolio P
Correlation of the random variables X and Y

,
A

Weight of the random variables X and Y

Risk aversion factor

List of figures:
Figure 1

Illustration of the efficient frontier, CAL, investor's

indifference curve and optimal risky or complete portfolio

Group 18: Starke, Felix; Eggers, Tom; Bungert, Jonas; Echterling, Tim

Exercise 1:
a. Shorting/short sales: is the selling of borrowed financial assets which will be subsequently
purchased in the future enables the investor to make a profit from declining asset prices

b. Covariance:
shows the linear relation of two random variables, however it does not describe the magnitude of
the relation
Correlation:

describes the magnitude of the linear relation of two random variables

c. Set of risky assets: sum of all possible risk-return combinations for portfolios of risky assets
Efficient frontier: dominant portfolios of risky assets that provide the best risk-return combinations,
given
or .
Left boundary of the opportunity set, upwards from the minimum variance portfolio
d. Global minimum variance portfolio: The efficient portfolio of risky assets that has the lowest
variance

e. Risk-free asset: security without risk (

, e.g. T-Bill
Capital allocation line (CAL): represents all possible risk-return combinations of the optimal risky
portfolio and the risk-free asset:
Sharpe ratio =

= slope of the CAL measures the risk-return

combination of a portfolio the higher the SR the better the portfolio performance
f. Optimal portfolio and the related indifference curve/utility function: The combination of risky
and risk-free assets that generates the highest feasible utility for an individual investor
Optimization condition: slope of indifference curve = slope of the CAL

Group 18: Starke, Felix; Eggers, Tom; Bungert, Jonas; Echterling, Tim

Exercise 2:
Figure 1:

Illustration of the efficient frontier, CAL, investor's indifference curve

and optimal risky or complete portfolio

20%
Optimal
risky
portfolio

18%
16%
14%

Minimum
variance
portfolio

E (r)

12%

Optimal complete
portfolio

10%
8%
6%

Optimal risky
portfolio

4%
2%
0%
0%

5%

10%

15%

20%

25%

30%

Inefficient frontier

Efficient frontier

Capital allocation line

Investor's indifference curve

Source: own illustration.

Group 18: Starke, Felix; Eggers, Tom; Bungert, Jonas; Echterling, Tim

a. The efficient frontier:

Starts upwards from the Minimum-Variance-Portfolio (MVP) with

b. The capital allocation line:

The capital allocation line starts at

with the slope 0.4479

c. The investors indifference curve:

Can be determined by converting the utility function

to

with =0.0657 from the optimal complete portfolio

d. The optimal risky portfolio:
The point of intersection of the investors indifference curve and the CAL represents the location of
the optimal portfolio Can be determined by
1. Calculating the optimal composition of the risky portfolio by using either
i. Excel Solver
ii. Formula
iii. Estimation through a data table
and maximizing the Sharpe ratio
2. Calculating the optimal weights of the risky portfolio P and the risk-free asset by using either
i. Excel Solver
ii. Formula
e. Weights of X, Y and of the risk-free asset in the optimal complete portfolio:
The portfolio is composed of
, thus is leveraged by 69%,
generating
with

Group 18: Starke, Felix; Eggers, Tom; Bungert, Jonas; Echterling, Tim

Exercise 3: Influence of the following ceteris paribus input variations on the portfolio optimization:
Slope of the CAL = Sharpe ratio =

a. The risk-free rate :

The higher the smaller the excess return

The CAL has a higher intercept and
flatter slope, resulting in a riskier tangential portfolio The investor allocates a higher proportion to
the risk-free security his indifference curve is tangent to the CAL further left, i.e. towards
- For a decreasing the contrary logic holds
b. The risk aversion A:
The higher A the lower the utility of a given portfolio
combination
Investor is more risk averse The investor specific complete portfolio
therefore allocates more in and less in
- For a declining the opposite is true
c. The

1. For

Diversification not useful Optimal risky portfolio via specialization into the asset with the higher
Sharpe ratio Investor specific portfolio is a mix of and that asset, with maximized utility
2. For
with
3. For

If then

A perfect hedge is possible:

, the individual invests all in
, else in

Diversification is sufficient with weights depending on

Optimal complete portfolio splits between resulting

For
: The higher
the less risky is
risky portfolio, due to hedging possibilities
For 0
: The higher
the riskier is
risky portfolio

combination and , maximizing utility

, so the larger is the investment in the
, so the smaller is the investment in the

Exercise 4: Weights of X and Y if borrowing and lending at the risk-free rate is prohibited:
If borrowing and lending at the risk-free rate is prohibited, only the risky assets X and Y are available,
thus representing the tangential portfolio with
and
,

Group 18: Starke, Felix; Eggers, Tom; Bungert, Jonas; Echterling, Tim