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Techniques for Calculating the Ecient Frontier:

Chapter 6
c Kilenthong 2011
() Techniques for Calculating the Ecient Frontier: Chapter 6 1 / 23
Main Issues
Finding an ecient frontier when

short sales are allowed and riskless borrowing and lending is possible,

short sales are allowed but riskless borrowing and lending is not
possible,

short sales are not allowed but riskless borrowing and lending is
possible,

neither short sales nor riskless borrowing and lending are possible.
Roles of a riskless asset (or riskless lending and borrowing).
Roles of short sales.
() Techniques for Calculating the Ecient Frontier: Chapter 6 2 / 23
Short Sales and Riskless implies Maximum Slope
The existence of riskless asset implies that the ecient frontier in the
mean-standard deviation space is the line between the riskless asset
and the portfolio of risky assets that gives the maximum slope of
the line.
The ecient frontier is the line passing through R
F
and B.
() Techniques for Calculating the Ecient Frontier: Chapter 6 3 / 23
Optimal Portfolio Problem with Short Sales and Riskless
Asset
Mathematically, we can nd the ecient frontier by solving the
following problem.
The problem is to nd a portfolio of risky assets P, whose mean
return and standard deviation are

R
P
and
P
respectively, that
maximize the slope
max
X
i

R
P
R
F

P
(1)
subject to
N

i =1
X
i
= 1 (2)
() Techniques for Calculating the Ecient Frontier: Chapter 6 4 / 23
Mean and Standard Deviation
The mean return of portfolio P is given by

R
P
=
N

i =1
X
i

R
i
(3)
where

R
i
is the mean return of asset i .
The standard deviation of portfolio P is given by

P
=
_
_
N

i =1
X
2
i

2
i
+
N

i =1
N

j =i
X
i
X
j

ij
_
_
1
2
(4)
() Techniques for Calculating the Ecient Frontier: Chapter 6 5 / 23
Solving for Optimal Portfolio
The problem can be written as
max
X
i
_
N

i =1
X
i
_

R
i
R
F
_
_
. .
F
1
(X)
_
_
N

i =1
X
2
i

2
i
+
N

i =1
N

j =i
X
i
X
j

ij
_
_

1
2
. .
F
2
(X)
(5)
Solving this: using rst order conditions (FOCs): dierentiating the
objective function with respect to a choice variable and take it equal
to zero.
The FOC w.r.t. X
k
is
F
1
F
2
X
k
= 0 =F
1
F
2
X
k
+F
2
F
1
X
k
= 0 (6)
() Techniques for Calculating the Ecient Frontier: Chapter 6 6 / 23
Solving for Optimal Portfolio: More Details
Each derivative is
F
1
X
k
=

R
k
R
F
and
F
2
X
k
=
1
2
_
_
N

i =1
X
2
i

2
i
+
N

i =1
N

j =i
X
i
X
j

ij
_
_

3
2
_
_
2X
k

2
k
+ 2

j =k
X
j

jk
_
_
() Techniques for Calculating the Ecient Frontier: Chapter 6 7 / 23
Solving for Optimal Portfolio: More Details
Putting these together:
0 =
_

R
P
R
F

1
2
_
_
_
N

i =1
X
2
i

2
i
+
N

i =1
N

j =i
X
i
X
j

ij
_
_

3
2

_
_
2X
k

2
k
+ 2

j =k
X
j

jk
_
_
+
_

R
k
R
F

_
_
N

i =1
X
2
i

2
i
+
N

i =1
N

j =i
X
i
X
j

ij
_
_

1
2
=
_

R
P
R
F

3
P
_
_
X
k

2
k
+

j =k
X
j

jk
_
_
+
_

R
k
R
F

1
P
() Techniques for Calculating the Ecient Frontier: Chapter 6 8 / 23
Solving for Optimal Portfolio: More Details
Multiplying this equation by
P
and rearranging the terms give
0 =

R
P
R
F

2
P
. .

P
_
_
X
k

2
k
+

j =k
X
j

jk
_
_
+
_

R
k
R
F

which can be rewritten in a compact form as, for each asset k,

R
k
R
F
=
P
X
k
. .
Z
k

2
k
+

j =k

P
X
j
. .
Z
j

jk

R
k
R
F
= Z
k

2
k
+

j =k
Z
j

jk
(7)
() Techniques for Calculating the Ecient Frontier: Chapter 6 9 / 23
System of Simultaneous Equations
After collecting all FOC for every asset together, we will end up with
a system of simultaneous equations:

R
1
R
F
= Z
1

2
1
+Z
2

12
+Z
3

13
+ . . . +Z
N

1N

R
2
R
F
= Z
1

12
+Z
2

2
2
+Z
3

23
+ . . . +Z
N

2N
.
.
.

R
N
R
F
= Z
1

1N
+Z
2

12
+Z
3

1N
+ . . . +Z
N

2
N
() Techniques for Calculating the Ecient Frontier: Chapter 6 10 / 23
System of Simultaneous Equations
This system of simultaneous equations can be written in a matrix
form as

R R
F
1 = Z
where

R =
_
_
_

R
1
.
.
.

R
N
_
_
_
, 1 =
_
_
_
1
.
.
.
1
_
_
_
, Z =
_
_
_
Z
1
.
.
.
Z
N
_
_
_
,
=
_
_
_
_
_

2
1

12
. . .
1N

12

2
2
. . .
2N
.
.
.
.
.
.
.
.
.
.
.
.

1N

2N
. . .
2
N
_
_
_
_
_
() Techniques for Calculating the Ecient Frontier: Chapter 6 11 / 23
Recovering the Optimal Portfolio
In principle, we will be able to solve for Z
i
using several methods,
e.g.,
.
.
.1
inverse matrix
Z =
1
_

R R
F
1
_
(8)
.
.
.2
repetitive substitution (see example)
The solution of this mathematical problem is Z
i
but what we really
want is X
i
. How can we get X
i
?
From Z
i
=
P
X
i
, we can show that

i
Z
i
=
P

i
X
i
=
P
(9)
Hence we can recover the optimal portfolio X from Z using
X
k
=
Z
k

P
=
Z
k

i
Z
i
(10)
() Techniques for Calculating the Ecient Frontier: Chapter 6 12 / 23
Example
Suppose there are three risky assets, say CP (asset 1), Centrals (asset
2), and PTT (asset 3).
Using past information, we can calculate mean returns and variance
covariance matrix of these assets as

R =
_
_
14
8
20
_
_
,
=
_
_
6 6 0.5 6 3 0.2 6 15
0.5 6 3 3 3 0.4 3 15
0.2 6 15 0.4 3 15 15 15
_
_
Suppose that the riskless rate is 5 %.
() Techniques for Calculating the Ecient Frontier: Chapter 6 13 / 23
Example
Hence, a system of equations for this problem is
9 = 36Z
1
+ 9Z
2
+ 18Z
3
3 = 9Z
1
+ 9Z
2
+ 18Z
3
15 = 18Z
1
+ 18Z
2
+ 225Z
3
Students do it on the broad!
The solution is
Z =
_
_
14
63
1
63
3
63
_
_
() Techniques for Calculating the Ecient Frontier: Chapter 6 14 / 23
Example
We can then nd portfolio weight X as
X
1
=
14
18
, X
2
=
1
18
, X
3
=
3
18
The mean return of the optimal portfolio is

R
P
=
14
18
14 +
1
18
8 +
3
18
20 = 14.67%
The variance of the optimal portfolio is

2
P
= X
T
X = 33.83%
() Techniques for Calculating the Ecient Frontier: Chapter 6 15 / 23
Example: Solution
The slope of the ecient frontier is equal to 1.66.
() Techniques for Calculating the Ecient Frontier: Chapter 6 16 / 23
Short Sales without Riskless
We will now consider a case where short sales are allowed but there is
no riskless asset.
We can use the same technique as before but with an assumed rate

R
F
. Dierent assumed rates will lead to dierent ecient portfolios.
() Techniques for Calculating the Ecient Frontier: Chapter 6 17 / 23
Example Continued.
Suppose that the riskless rate is now

R
F
= 2.
The system of equations now becomes
12 = 36Z
1
+ 9Z
2
+ 18Z
3
6 = 9Z
1
+ 9Z
2
+ 18Z
3
18 = 18Z
1
+ 18Z
2
+ 225Z
3
whose solution is
Z
1
=
42
189
, Z
2
=
72
189
, Z
3
=
6
189
and X
1
=
7
20
, X
2
=
12
20
, X
3
=
1
20
and

R
P
= 10.7,
2
P
= 13.70
() Techniques for Calculating the Ecient Frontier: Chapter 6 18 / 23
Example Continued
In principle, we need to nd only two of them (Two Fund Theorem).
That is, any combination of these two portfolios (which themselves
are assets) is on the ecient frontier.
For example: put 50 50 weight. We can show that
2
P
= 21.859.
Then we can nd the covariance between the two portfolios: using

2
P
= X
2
1

2
1
+X
2
2

2
2
+ 2X
1
X
2

12
This leads to
12
= 19.95.
With the information of expected returns, variances, and covariance
between the two portfolios, we can trace out the whole frontier.
() Techniques for Calculating the Ecient Frontier: Chapter 6 19 / 23
Example Continued
() Techniques for Calculating the Ecient Frontier: Chapter 6 20 / 23
Riskless but No Short Sales
We will now consider a case where short sales are not allowed but
there is a riskless asset.
In principle, an ecient portfolio problem is a constrained
maximization problem. In this case, we can write
max
X
i

R
P
R
F

P
(11)
subject to

i
X
i
= 1 (12)
X
i
0, i (13)
where the last one represents the no short-sales constraint.
() Techniques for Calculating the Ecient Frontier: Chapter 6 21 / 23
Riskless but No Short Sales: Example
Consider again the example with three assets and risk-free rate
R
F
= 5%.
Recall that the ecient portfolio in this case is
X
1
=
14
18
, X
2
=
1
18
, X
3
=
3
18
Remember that this solution is solved under an assumption that short
sales are allowed.
What if we now impose the no short-sales constraint, should we get a
dierent answer?
() Techniques for Calculating the Ecient Frontier: Chapter 6 22 / 23
More General Ecient Portfolio Problem
This problem started from the seminal work by Markowitz (1959).
max
X

i
X
2
i

2
i
+

j =i
X
i
X
j

ij
(14)
subject to

i
X
i
= 1 (15)

i
X
i

R
i


R
P
(16)
X
i
0, i (17)

i
X
i
d
i
D (18)
where the last constraint is the so called dividend requirement
constraint.
The role of a riskless asset is to simplify the objective function as a
slope.
() Techniques for Calculating the Ecient Frontier: Chapter 6 23 / 23

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