Teaching Note on Portfolio Theory

NOTE: you should know that there are two portfolios that we are trying to construct.
The complete portfolio (C) and the risky portfolio (P)

- When deciding to allocate funds within your complete portfolio (C) you are
faced with two major decisions:
1. How much to invest in a
f
R (1-y) asset and how much to invest in a risky
(y) portfolio
2. Within the risky portfolio (P) how much will go to the different risky
assets: say how much will go to debt ) (
D
W how much will go to equity
) (
E
W

I. DECISION 1: To answer question 1 one needs to look at the utility function
of a risk averse investor.

2
2
1
) (
C c
A r E U o = .a
- The only factor that distinguishes investors from each other is A
the parameter of risk aversion.
- If the complete portfolio has two assets one
f
r and one risky then
equation a changes to:

2 2
2
1
] ) ( [
p f p f
Ay r r E y r U o + = b
- To find the weights (y) and (1-y) that maximizes the utility
function we need to maximize the utility function with respect to
(y). or take the partial derivative of the utility function with respect
to (y)
y
U
c
c
and set that equal to zero and solve for ) (
*
y your optimal
weight.
2
*
) (
p
f p
A
r r E
y
o

=

But in order to use this equation we need to know the expected
return and risk on our risky portfoliobut how do we choose the
risky portfolio?


II. DECISION 2: Answering question 2 is a little tricky compared to question 1.
Question 2 is only valid if your risky portfolio P contains more than 2 risky
assets.
In this class we will only assume that P contains two assets: debt portfolio and equity
portfolio. This means that we will be looking for optimal weights
* *
&
D E
w w , where
* *
1
D E
w w = . This requires that we draw the Portfolio Opportunity Set (EXCEL).


Choosing the optimal weights depends on the portfolio managers objective:

Objective 1: If you want to reduce your portfolio Ps risk to zero.

We know that:

) , ( 2
) , ( ) , cov(
) , cov( 2
2 2 2 2 2
2 2 2 2 2
D E D E D E E E D D p
D E D E D E
D E D E E E D D p
r r w w w w
r r r r
r r w w w w
p o o o o o
o o p
o o o
+ + =
=
+ + =


To completely eliminate your risk, both of your constituent assets
should hedge each other. Mathematically the correlation coefficient
should be (-1)
Thus:
* *
*
2 2
1
0
) ( 0
D E
E D
E
D
E E D D p
E E D D p
w w
w
w w
w w
=
+
=
= =
= =
o o
o
o o o
o o o


Objective 2: What if you want to choose the risky portfolio (P) that will minimize
variance or risk.
We know that:

) , cov( 2
2 2 2 2 2
D E D E E E D D p
r r w w w w + + = o o o

To find the weights ) ( & ) (
E D
w w that minimize the variance we
need to minimize the variance equation with respect to ) (
D
w
(knowing that
D E
w w =1 ). So, take the partial derivative of the
variance equation with respect to
D
p
D
w
w
c
c
2
.
o
and set that equal to
zero. Now you can solve for
*
D
w the optimal weight allocated
towards debt within your risky portfolio that will minimize your
risk.

* *
2 2
2
*
1
) , cov( 2
) , cov(
D E
E D E D
E D E
D
w w
r r
r r
w
=
+

=
o o
o


Objective 3: What if you want to choose the risky portfolio that will maximize your
reward to variability ratio (R2V)?

The risky portfolio represented by the efficiency frontier of the
portfolio opportunity set touches the R2V line or the CAL at so many
points. The point of tangency is the most efficient and most feasible.
We know that the slope of CAL is:

Slope=R2V=
p
f p
r r E
o
) (
..c
Substituting into c, ) ( ) ( ) (
E E D D p
r E w r E w r E + = and
) , cov( 2
2 2 2 2
D E D E E E p D p
r r w w w w + + = o o o and maximizing R2V
with respect to
D
w (knowing again that
D E
w w =1 ). Again take
the partial derivative of R2V with respect to
D
w and set it equal to
zero. Now you can solve for
*
D
w the optimal weight within the
risky portfolio P that will maximize the R2V ratio.

| | | |
| | | | | | ) , cov( ) ( ) ( ) ( ) (
) , cov( ) ( ) (
2 2
2
*
E D f E f D D f E E f D
E D f E E f D
D
r r r r E r r E r r E r r E
r r r r E r r E
w
+ +

=
o o
o


* *
1
D E
w w =

THE COOK BOOK

To sum up, here are the steps that you will need in order to formulate an Optimal
Portfolio for your client.

1) Specify the return characteristics of all securities inside the debt portfolio and the
equity portfolio (Expected return, variances, and covariances).





2) Establish the risky portfolio:
a. Calculate the optimal risky portfolio P (solve question #2).
b. Calculate the properties of portfolio P using the weights determined in
step (a).





3) Allocate funds between the risky portfolio and the risk-free asset:
a. Calculate the fraction of the complete portfolio allocated to Portfolio P
(risky portfolio) and to the risk-free asset.
b. Calculate the share of the complete portfolio invested in each risky asset
as well as the risk-free one.