CLASS 5 DIVERSIFICATION AND OPTIMAL PORTFOLIOS

Bridge Program 2005 Finance module

Finance, Bridge Program 2005

Contents
1 2 3 Combining risk-free asset with one-risky asset Combining two risky assets Optimal portfolios 3.1 Two risky assets case . . . . . . . . . . . . . . . . 3.2 The general case . . . . . . . . . . . . . . . . . . . 4 9 14 14 20

Finance, Bridge Program 2005

Recap
Estimating expected returns and variance-covariance matrix. Finding expected returns and standard deviations of the returns of given portfolios.

In this class we will use the techniques from class 4 to determine optimal portfolios.

Finance, Bridge Program 2005

1 Combining risk-free asset with one-risky asset

We will follow problem 1. Risky asset with expected return 0.2 and standard deviation 0.3. Risk-free asset yielding 0.08. Invest w in risky. The expected return of the portfolio is: E[RP ] = 0.2w + 0.08(1 w) = 0.08 + 0.12w. And its variance and standard deviation: Var[RP ] = w2 (0.30)2 p = 0.3|w|.

Finance, Bridge Program 2005

Risk-return tradeo
We can further summarize the risk-return trade-o by noting that w = p /0.3, and E[RP ] = = 0.08 + 0.12w 0.12 0.08 + p = 0.08 + 0.4p 0.3

In general, given a risky asset with expected return E [Ri ] and standard deviation SD(Ri ) this can be written as (E [Ri ] Rf ) E[RP ] = Rf + p SD(Ri ) i.e. the expected return is a linear function of the standard deviation of the portfolio, with slope (E(Ri ) Rf ) . SD(Ri )
Finance, Bridge Program 2005 5

Interpreting the weights

For w < 0 we are short in the risky asset (i.e. we are selling it). For w < 1 we are lending (i.e. buying the risk-free asset). For w > 1 we are borrowing (i.e. selling the risk-free asset).

Finance, Bridge Program 2005

The mean-variance ecient frontier

w 0 are the mean-variance ecient portfolios.

Finance, Bridge Program 2005

Questions
If you would like to tolerate a risk of 20%, what portfolio should you invest in? Equate the standard deviation of the portfolio to 20%: w0.3 = 0.2; so that w = 2/3 or 67% in the risky asset. If you would like to earn a return of 10%? Equate the expected return of the portfolio to 10%: w0.2 + (1 w)0.08 = 0.10 so that w = 1/6 16.7% in the risky asset.
Finance, Bridge Program 2005 8

2 Combining two risky assets

Data Stock A B Weights w 1-w E[r] 0.20 0.25 SD[r] 0.3 0.4 covariance 0.5(0.3)(0.4)

The expected return is then: E[RP ] = 0.20w + (1 w)0.25 = 0.25 0.05w. For the variance calculation we need some more work: Var(RP ) = w2 (0.30)2 +(1w)2 (0.40)2 +2w(1w)(0.30)(0.40)0.5; So that: p = w2 (0.30)2 + (1 w)2 (0.40)2 + 2w(1 w)(0.30)(0.40)0.5
9

Finance, Bridge Program 2005

Sample portfolios
Weight w 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 E[RP ] 0.250 0.245 0.240 0.235 0.230 0.225 0.220 0.215 0.210 0.205 0.200 p 0.400 0.376 0.354 0.334 0.317 0.304 0.295 0.289 0.288 0.292 0.300

Variance starts going up at w 0.77, and expected return goes down: the mean-variance ecient portfolios are those with w 0.77. Finance, Bridge Program 2005 10

The ecient frontier

Finance, Bridge Program 2005

11

Relationship between E [RP ] and SD(RP )

One can actually be more explicit about the relationship between P and E[RP ] simply by solving from the expected return equation for w: E [RP ] = 0.25 0.05w w = 5 20E [RP ] ;

and then using this expression in the variance formula:

2 P

(5 20E [RP ])2 (0.30)2 + (20E [RP ] 4)2 (0.40)2 +2(5 20E [RP ])(20E [RP ] 4)(0.30)(0.40)0.5

Note that this can be expressed (by solving a quadratic) with E [RP ] on the left hand side (which makes plots easier).
2 Note: write x for E [RP ] and y = P when thinking about the above equation.

Finance, Bridge Program 2005

12

Questions
If you would like to tolerate a risk of 30%, what portfolio should you invest in? Equating the standard deviation to 0.30, we have that we should invest w 54% in asset A. If you would like to earn a return of 30%? Equating the expected return of the portfolio to 0.30 we have that w = 100%, short asset A and invest twice your wealth in asset B.

Finance, Bridge Program 2005

13

3 Optimal portfolios 3.1 Two risky assets case

We can invest in three assets: risk-free, asset A and asset B. First only A and B in isolation. Then we are allowed to invest arbitrary amounts in each asset. First-remark: nal conclusion is always going to be of the form invest part of your wealth in risk-free and the rest in a portfolio that has weights w in asset A and 1 w in asset B. Graphically, move along the tangency line depending on your risk-aversion. How much you put in the risk-free asset versus in the optimal fund (w , 1 w ) of the two risky assets will depend on the investors risk aversion.

Finance, Bridge Program 2005

14

Investing in the risky assets in isolation

Consider investing in stock A. From problem 1, we have that the ecient frontier (plot of combinations of risk-free and asset A) is given by E [RP ] = = Rf + (E [RA ] Rf ) SD(RP ) Var (RA ) (1)

1 (0.20 0.10) SD(RP ) = 0.10 + SD(RP ) (2) 0.10 + 0.3 3

Similar for asset B E [RP ] = 0.10 + 3 SD(RP ) 8 (3)

Since 3/8 > 1/3 we see that for any portfolio of the risk-free and asset A there exists a portfolio of the risk-free and asset B which does better. Therefore if we could only invest in these assets in isolation we would prefer asset B. Finance, Bridge Program 2005 15

Sharpe ratios
Given an asset with returns Ri , the quantity E [Ri ] Rf si = SD(Ri ) is called the Sharpe ratio of asset i. Note that if asset i is a portfolio, we can use the same denition and talk about the Sharpe ratio of a given portfolio. The Sharpe ratio is the slope of the line in the previous equations: therefore if we had to choose between A and B in isolation the problem boils down to looking at which of the two assets has a higher Sharpe ratio. With Rf = 4%: sA = 0.533 and sB = 0.525, so asset A is actually preferred under this scenario.

Finance, Bridge Program 2005

16

Optimal portfolios
The interesting question is what happens if we can invest arbitrary amounts in each asset. Consider a given portfolio characterized by w. We can easily compute the Sharpe ratio of this portfolio. Finding the optimal portfolio boils down to nding the portfolio with the highest Sharpe ratio (a graphical argument comes in handy). Literally it solves E [RP ] Rf max w SD(RP ) Since we have explicit expressions for E [RP ] and SD(RP ) the above is a well-dened problem (analytically challenging, but in principle straightforward). In the assignment one can check that the optimal portfolio of risky assets is w 48.3% and 1 w 51.7%. Finance, Bridge Program 2005 17

A handy graph

Finance, Bridge Program 2005

18

Questions
If you would like to tolerate a risk of 20%, what portfolio should you invest in? x(0.306) = 0.2 65.3% in the optimal risky portfolio. In other words: put about 34.7% in the risk-free asset, 31.5% in asset A and 33.8% in asset B. If you would like to earn a return of 25%? x0.226 + (1 x)0.1 = 0.25, or x 1.19 in the risky portfolio. In other words: put about 57.5% in asset A, 61.6% in asset B, and borrow an amount equivalent to 19.2% Very important remark: the optimal portfolio of risky assets is independent of the investors preferences for risk (dierent risk-aversion implies dierent mixes between the riskless asset and this optimal fund of risky assets).

Finance, Bridge Program 2005

19

3.2 The general case

The same type of arguments yield the conclusion that the optimal portfolio of risky assets must maximize the Sharpe ratio (the slope of the line that joins an portfolio to the risk-free asset). The book actually gives a precise analytical treatment of this problem in the Appendix of chapter 16. Easy to compute it in a spreadsheet numerically: just create a cell with the Sharpe ratio of an arbitrary portfolio of risky assets and then maximize this value.

Finance, Bridge Program 2005

20

Some fun facts

1. The optimal portfolio is proportional to 1 ( rf ), where is the variance-covariance matrix of the risky assets returns, and rf is a vector with typical element E [Ri ] rf (the excess expected return of an asset). 2. When all assets are uncorrelated, then the optimal portfolio is proportional to a vector with typical element (E [Ri ] rf ) SRi = . Var (Ri ) SD(Ri ) You invest in each asset proportionally ot its Sharpe-ratio divided by the assets standard deviation.

Finance, Bridge Program 2005

21

One fancy example

Historical data on three international indexes: E [r] S&P500 Nikkei Footsie Variance-covariance matrix: S&P500 S&P500 Nikkei Footsie 0.0144 0.00432 0.0144 Nikkei 0.00432 0.0324 0.0162 Footsie 0.0144 0.0162 0.0225 0.13 0.15 0.18 SD[r] 0.12 0.18 0.15

Optimal portfolio when Rf = 5% (check!!) w = (0.0685, 0.0342, 1.0342) 22

Finance, Bridge Program 2005

Recap
The optimal portfolio is given by a combination of the risk-free asset and a fund of the other (risky) assets. The optimal fund is obtained by maximizing the Sharpe ratio of the portfolio of risky assets.

Upcoming
Thinking about risk in a portfolio context. How to determine discount rates for assets as a function of their risk.

Finance, Bridge Program 2005

23