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# FINANCE 441

## - Investments Matthew Ringgenberg

Fall 2012
Using Excel to Calculate
Markowitz Optimized Portfolios*
*Citation: these notes were prepared using publicly available information including Bodie, Kane, and
Marcus (9th edition) and lecture notes created by Eric Zivot (http://faculty.washington.edu/ezivot/).

Outline
Markowitz Optimization
Review of matrix algebra
Markowitz with matrix algebra

problem:

=

. . = 1

## The solution to this problem is given by equation

7.13 in Bodie, Kane, and Marcus (9th ed)
3

## Review of Matrix Algebra: Definitions

First, lets define a matrix:
11
21
=

And a vector:

1
2
=

1
2

a dimension of n
rows x m columns

a dimension of n
rows x 1 column
4

## Review of Matrix Algebra: Notation

A bold capital letter is a matrix (i.e., )

## Italic capital letters refer to elements in a matrix

(i.e., is the element in row n column m)

## Italic lower case letters refer to elements in a vector

(i.e., is the element in row n)

=

4
7

3
5
, =
1
2

2
4

7
4+3 5+2
+ =
=
8
7+1 2+4

7
6

1 3
43 52
=
=
6 2
71 24

## Note: for addition and subtraction, the matrices must have

the same dimension
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## Review of Matrix Algebra: Transpose and Inverse

The transpose of a matrix (denoted by )
interchanges the rows and columns:
1 4
1 2 3
=
then = 2 5
4 5 6
3 6
The inverse of a matrix (denoted by -1) is like the
reciprocal of a number
i.e., the reciprocal of 8 is 1/8
The inverse of is
When you multiply any matrix by its inverse you get the
identity matrix, which is like getting 8 * 1/8 = 1

## Review of Matrix Algebra: Scalar Multiplication

We can also multiply matrices
Scalar multiplication
Matrix multiplication
Scalar multiplication is when we multiply each
element in a matrix by a number
4 5
=
= 4
7 2
We can multiply matrix by the scalar, c
44
c =
74

16
54
=
28
24

20
8

## Review of Matrix Algebra: Matrix Multiplication

Matrix multiplication is when we multiply a matrix
by a matrix
It can only happen when the dimensions are
correct: the number of columns in must equal
the number of rows in
4
= 7
2

5
3
2 , =
1
3

2 5
7 8

## Review of Matrix Algebra: Matrix Multiplication

We multiply the elements in the first row of by
the elements in the first column of and add
them together
4 5
=

43+51
= 73+21
23+31

3 2 5
7 2
1 7 8
2 3
42+57 45+58
72+27 75+28
22+37 25+38
17 43 60
23 28 51
9 25 34

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## Using Matrix Algebra to Create Optimal Portfolios

Lets develop a portfolio with three risky assets
Well define the return vector, r, and the weight

vector, w
=

[ ]

[] = [ ] = =

[ ]

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## Using Matrix Algebra to Create Optimal Portfolios

We can also calculate the variance of returns:
cov( , )
() = cov( , )
cov( , )
2
=

cov( , )
cov( , )
cov( , )

=
2

cov( , )
cov( , )
cov( , )

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## Using Matrix Algebra to Create Optimal Portfolios

What is the expected return on the portfolio?
Using regular algebra we have:
= + +

= = [ ] = + +

13

## Using Matrix Algebra to Create Optimal Portfolios

What about the variance of the portfolio?
Last class we saw (for 3 assets) it was:

2
p

2
A

2
A

2
B

2
B

2
C

2
C

2 = ww = [

2
]

14

Remember:

## 1. Maximizes expected return for a given level

of risk
2. Or, minimizes risk for a given level of return

15

In

method:

min 2 = ww s.t.

= w = ,0

and

w1 = 1
16

## Well skip over the Lagrange multiplier part of the

calculation (although its relatively easy to do)

## Instead, well go straight to the solution of the

problem (in matrix notation) and well plug it into
Excel

## If we specify a target rate of return, the solution (the

optimal weight vector z) is given by:

zx = A1
x b0

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## Using Matrix Algebra to Create Optimal Portfolios

zx = A1
where:
x b0
Ax is a matrix that has 2 the covariance matrix
in the top left and adds two more rows & columns
The

## 2nd to last column and row contain the expected

return for each asset ()
22 2 2
The last column & row
2 22 2
contains a 1 for each
2
Ax = 2
2
2

0
otherwise
1
1
1
0

1
1
1
0
0

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where:

zx =

A1
x b0

## zx is a vector and the first n rows contain

the optimal weights for our n risky assets
b0 is vector that contains a zero for each
of the n risky assets (in this case, three
zeros for three assets) and then the
second to last row is our target return,
,0 , and the last row is a 1

zx =
4
5
0
0
b0 = 0
,0
1

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## The vector zx gives us the optimal weights that

determine the most efficient portfolio, given our
target rate of return

zx = A1
x b0

## Note: if we calculate zx for different target rates of

return, we can trace out the efficient frontier

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the frontier?

1 ( 1)
=
1 1 ( 1)
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## Calculating the Efficient Frontier

Solving for frontier portfolios in Excel is easy:
1. Pick a target expected return, ,0
2. Type Ax and b0 into Excel

x )

## Use the function =MINVERSE() & hit ctr+shift+enter

4. Multiply A1
x b0 to get the optimal weights, zx

## Use the function =MMULT() & hit ctr+shift+enter

See Example Markowitz with Matrix Algebra in Excel.xlsx
The bullet numbers correspond to the steps in the Excel file
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## As you pick different target rates of return (,0 ) youll

get different portfolios on the efficient frontier
In fact, you can trace-out the frontier by calculating zx
for many different target returns
It turns out, you can also trace-out the frontier by
combining any two frontier portfolios

## If you calculate two frontier portfolios, you can trace-out

the rest of the frontier by creating a portfolio of these two
frontier portfolios and varying the portfolio weights

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## Calculating the Optimal (Tangency) Portfolio

What if you want the best frontier portfolio?
Solving for the optimal portfolio in Excel is easy too:
7. Type in (the covariance matrix), a row vector of
1s, and (the expected return vector - rf)
8. Compute the inverse of (i.e., compute 1 )

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## Calculating the Optimal (Tangency) Portfolio

9. Calculate the numerator by multiplying 1 and
the vector ( )
Use the function =MMULT() & hit ctr+shift+enter

## 10.Calculate the denominator by multiplying 1

and the vector ( ) and then take the
vector of 1s (transposed) and multiply it by the
solution of 1 ( )
11.Finally, divide the numerator and the
denominator

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## You can invest in 3 possible risky assets and you

calculate the expected return (), standard deviation
() and covariance matrix ()
Stock i i
A
8.9%
B
12.7%
C
5.9%

i
0.10
0.16
0.14

Covariance Matrix ()
A
B
C
0.0100 0.0020 0.0010
A
B
0.0020 0.0256 0.0030
C
0.0010 0.0030 0.0196

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## What are the portfolio weights for the efficient portfolio

that has a target expected return of 9%?
WA = 56.53%
WB = 20.65%
WC = 22.82%
What are the optimal (tangency) portfolio weights?
WA = 56.38%
WB = 30.20%
WC = 13.42%
Which portfolio has the better Sharpe ratio and why?

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