Economics 122

F I N AN CIA L ECO N O MICS (O PTI M AL R I SKY PO RTFO LIO 1)

M . D E B UQ UE - GO N ZALES
1ST S E M ESTE R , 2014 - 2 0 1 5

SOURCE: BODIE ET AL. (2009)

The Investment Decision
 Top-down process with 3 steps:
 Capital allocation between the risky
portfolio and risk-free asset.
 Asset allocation across broad asset classes.
 Security selection of individual assets
within each asset class.

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Diversification
and Portfolio Risk
 Market risk (Macro Risk)

Systematic or nondiversifiable

(Micro Risk)
 Firm-specific risk
Diversifiable or nonsystematic

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Portfolio Risk as a Function of the
Number of Securities in the Portfolio

7-4
Portfolio Diversification

7-5
Covariance and Correlation
 Portfolio risk depends on the correlation
between the returns of the assets in the
portfolio.
 Covariance and the correlation coefficient
provide a measure of the way returns of
two assets vary.

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Two-Security Portfolio: Return
𝑟 =𝑤 𝑟 +𝑤 𝑟
𝑟 portfolio return
𝑤 bond weight
𝑟 bond return
𝑤 equity weight
𝑟 equity return
𝐸 𝑟 =𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟

7-7
Two-Security Portfolio: Return
 We can express the expected return
equation as:
𝐸 𝑟 =𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟
= 1−𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟
=𝐸 𝑟 −𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟
=𝐸 𝑟 +𝑤 𝐸 𝑟 −𝐸 𝑟

7-8
Two-Security Portfolio: Return
 𝑤 > 1 and 𝑤 < 0, means short-selling the
equity fund and investing the proceeds of the
short sale in the debt fund.
 𝑤 > 1 and 𝑤 < 0, means short-selling the debt
fund and investing the proceeds of the short sale
in the equity fund.

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Portfolio Expected Return as a
Function of Investment Proportions

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Two-Security Portfolio: Risk
𝑣𝑎𝑟 𝑟 = 𝑣𝑎𝑟 𝑤 𝑟 + 𝑤 𝑟

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝑐𝑜𝑣 𝑟 , 𝑟

𝜎 variance of Security D
𝜎 variance of Security E
𝑐𝑜𝑣 𝑟 , 𝑟 covariance of returns for Security
D and Security E
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Covariance
 Correlation coefficient of returns:
,
𝜌 =
𝜎 standard deviation of returns for Security D
𝜎 standard deviation of returns for Security E

 Covariance:
𝑐𝑜𝑣 𝑟 , 𝑟 =𝜌 𝜎 𝜎

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Two-Security Portfolio: Risk
 Another way to express the variance of the
portfolio:
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝑐𝑜𝑣 𝑟 , 𝑟

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜌 𝜎 𝜎

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Computation of Portfolio Variance
From the Covariance Matrix

7-14
Correlation Coefficients:
Possible Values
 Range of values for 𝜌 :
−1 ≤ 𝜌 ≤ 1
If 𝜌 = 1, the securities are perfectly
positively correlated.
If 𝜌 = 0, the securities are uncorrelated.
If 𝜌 = −1, the securities are perfectly
negatively correlated.

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Correlation Effects
 For −1 ≤ 𝜌 ≤ 1:
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜌 𝜎 𝜎

= 1−𝑤 𝜎 +𝑤 𝜎 +2 1−𝑤 𝑤 𝜌 𝜎 𝜎

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Correlation Coefficients
 When 𝜌 = 1, there is no diversification.

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜌 𝜎 𝜎
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜎 𝜎
= 𝑤 𝜎 +𝑤 𝜎

𝜎 =𝑤 𝜎 +𝑤 𝜎

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Correlation Coefficients
 When 𝜌 = −1,  a  “perfect  hedge”  (i.e.,  a  
riskless position) is possible.

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜌 𝜎 𝜎
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 − 2𝑤 𝑤 𝜎 𝜎
= 𝑤 𝜎 −𝑤 𝜎

𝜎 = absval 𝑤 𝜎 − 𝑤 𝜎

7-18
 Correlation Coefficients
if
Perfect hedge:
𝜎 =0= 𝑤 𝜎 −𝑤 𝜎
𝑤 𝜎 =𝑤 𝜎 = 1−𝑤 𝜎
𝑤 𝜎 +𝑤 𝜎 =𝜎
𝜎
𝑤 = =1−𝑤
𝜎 +𝜎
𝜎
𝑤 = =1−𝑤
𝜎 +𝜎

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Correlation Effects
 In summary, the amount of possible risk
reduction through diversification depends
on the correlation.
 The risk reduction potential increases as the
correlation approaches -1.
If 𝜌 = 1, no risk reduction is possible.
If 𝜌 = −1, a riskless hedge is possible.

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Correlation Effects
 Note that if 𝜌 = 1:
𝜎 =𝑤 𝜎 +𝑤 𝜎 = 1−𝑤 𝜎 +𝑤 𝜎
=𝜎 + 𝜎 −𝜎 𝑤

 The graph is linear and there is no benefit from

diversification (the SD of the risky portfolio is the simple
weighted average of the component asset SDs).
 In all other cases (𝜌 < 1), the portfolio SD is less than
the weighted average of the component SDs.
 In general, the lower the correlation between assets,
the greater the gain in efficiency (i.e., diversification is
more effective and portfolio risk is lower).

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Correlation Effects
 If 𝜌 = 0:
𝜎 = 𝑤 𝜎 +𝑤 𝜎 = 1−𝑤 𝜎 +𝑤 𝜎

 If 𝜌 = −1:
𝜎 = absval 𝑤 𝜎 − 𝑤 𝜎

= absval 1 − 𝑤 𝜎 − 𝑤 𝜎
= absval 𝜎 − 𝜎 + 𝜎 𝑤
 With perfect negative correlation (𝜌 = −1), there is
“perfect  hedge”  potential  where  portfolio  variance  and  SD  is  
zero.

7-22
Portfolio Standard Deviation as a
Function of Investment Proportions

7-23
The Minimum Variance
Portfolio
 The minimum variance portfolio is the
portfolio composed of the risky assets that has
the smallest standard deviation, i.e., the
portfolio with least risk.
 In general, to get the minimum-variance
portfolio, the minimization problem is
min 𝜎
where
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟

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The Minimum Variance
Portfolio
min 𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
min 𝜎 = 𝑤 𝜎 + 1 − 𝑤 𝜎 + 2𝑤 1 − 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟

Solution: =0
0 = 2𝑤 𝜎 + 2 1 − 𝑤 −1 𝜎 + 2 1 − 2𝑤 𝐶𝑜𝑣 𝑟 , 𝑟

0 = 2𝑤 𝜎 + 𝜎 − 2𝐶𝑜𝑣 𝑟 , 𝑟 − 2 𝜎 − 𝐶𝑜𝑣 𝑟 , 𝑟

∗ ,
𝑤 =
,

𝑤∗ = 1 − 𝑤∗

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The Portfolio Opportunity Set
 Graphing the portfolio expected return, E r ,
against portfolio SD, σ , based on various
allocations of the risky portfolio, we get the
portfolio opportunity set (POS):
 The POS shows all the combinations of the portfolio
expected return and SD that can be constructed from
the two available risky assets.
 With perfect positive correlation (𝜌 = 1), the POS is
linear and there is no benefit from diversification (i.e.,
the POS is not pushed to the northwest).
 With perfect negative correlation (𝜌 = −1), the POS is
linear but offers a perfect hedging opportunity and the
maximum advantage from diversification (σ = 0).

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Correlation Effects
 Expected return:
𝐸 𝑟 =𝐸 𝑟 +𝑤 𝐸 𝑟 −𝐸 𝑟
 Standard deviation:
𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜌 𝜎 𝜎

= 1−𝑤 𝜎 +𝑤 𝜎 +2 1−𝑤 𝑤 𝜌 𝜎 𝜎

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Portfolio Expected Return as a
Function of Standard Deviation

7-28
Numerical example
Debt Equity
8% 13%
12% 20%

7-29
Portfolio Expected Return as a
Function of Investment Proportions

7-30
Portfolio Standard Deviation as a
Function of Investment Proportions

7-31
Portfolio Opportunity Sets

7-32
Summary:
Portfolio Risk and Return
 Although the expected return of any portfolio is
simply the weighted average of the assets’  
expected returns, this is not true of the standard
deviation.
 Potential benefits from diversification arise when
the correlation between assets returns is less than
perfectly positive.
 In the extreme case of perfect negative
correlation, we have a perfect hedging
opportunity and can construct a zero-risk (zero
variance or zero SD) portfolio.

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Two risky assets and a risk-free
asset (asset allocation decision)
 The  objective  is  to  find  the  “optimal  risky  
portfolio,”  which  is  the  portfolio  that  has  the  
highest reward-to-volatility (Sharpe) ratio.
 Recall that the slope of the capital allocation line
(CAL) is the reward-to-volatility (Sharpe) ratio:
𝐸 𝑟 −𝑟 𝐸 𝑟 −𝑟
𝑆 = = =𝑆
𝜎 𝜎
Two risky assets and a risk-free
asset (asset allocation decision)
To find the weights 𝑤 and 𝑤 that result in the
highest (or steepest) Sharpe ratio (𝑆 ), the
optimization problem is:
max 𝑆 , ∑𝑤 = 1

max =
max
,
Optimal Risky Portfolio
 In this case of two risky assets, the solution for the
weights of the “optimal risky portfolio” is given by:
∗ ,
𝑤 =
,

where 𝑅 represents excess rates of return rather

than total returns (𝑟).

𝑤∗ = 1 − 𝑤∗
The Opportunity Set of the Debt
and Equity Funds and Two
Feasible CALs
The Opportunity Set of the Debt and
Equity Funds with the Optimal CAL and
the Optimal Risky Portfolio
Optimal Complete Portfolio
 To get the optimal complete portfolio, we
make use of the derived optimal risky portfolio
to construct CAL, and then use the  investor’s  
degree of risk aversion to calculate the optimal
proportion of the complete portfolio to invest
in the risky component:
𝑤∗ = =𝑦
𝑤∗ = 1 − 𝑤∗ = 1 − 𝑦
Determination of the Optimal
Overall Portfolio
Numerical example
Debt Equity
8% 13%
12% 20%

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Numerical Example
 Suppose 𝜌 = 0.3 and that the investor can also
invest in risk-free T-bills with yield of 5%, the
“optimal  risky  portfolio”  (ORP) is:
∗ ,
𝑤 =
,
( )
=
( )
= 0.40 𝑜𝑟 40%
𝑤 ∗ = 1 − 40% = 60%

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Numerical Example
 The expected return of this ORP is:
𝐸 𝑟 = 0.4 ∗ 8 + .6 ∗ 13 = 11%.
 The standard deviation of this ORP is:
𝜎 = .4 ∗ 144+.6 ∗ 400 + 2 ∗ .4 ∗ .6 ∗ 72
= 14.2%.
 The CAL of this ORP has slope:
𝑆 = = 0.42 (slope of the best feasible
.
CAL).
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Numerical Example
 With  risk  aversion  parameter  of  4,  the  “optimal  
complete  portfolio”  (OCP)  is  given  by:
∗ . .
𝑤 = = 74.39%
∗ .
𝑤 ∗ = 25.61%
 The investor will invest 74.39% of his or her
money in risky assets and the balance to the risk-
free asset.
 That means 44.63% (.6 ∗ 74.39%) invested in
stocks overall and 29.76% in bonds (.4 ∗ 74.39%).
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The Proportions of the
Optimal Overall Portfolio

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