MODERN PORTFOLIO THEORY

Recap of last module

• How to optimally split investment b/w a risk-free asset and
a risky ‘portfolio’
• Utility function – subjective and varies from individual to individual
based on one’s propensity to take (avoid) risk.

• Capital Allocation Line – One risk-free asset and a risky

portfolio.

• Capital Market Line – Using well diversified portfolios in

CAL.
 Key Takeaways…
• Constructing a risky portfolio.

• The optimal risky portfolio.

• Modern portfolio theory.

• Applications.

• Reference Textbook Chapter: Chapter 7

 The Investment Decision
• Step one – identifying how much of my money goes into a
risky portfolio and how much goes into a risk-free asset
(mutual funds/equity vs FD).

• Step two – Within the risky portfolio, where do I park my

money w.r.t. asset classes? (equity/debt/derivative/forex)

• Step three – Within an asset class, how do I select

securities?
 Let’s talk risk
• Market Risk
• What is happening to your stock-market challenge now?
• Are you observing blood baths on many days?
• Regardless of the choice of securities, do you find days of uniform
stock crashes?
• Welcome to market risk, risk attributable to market wide risk sources
and remains even after extensive diversification.
• Also called ‘systematic’ or ‘non-diversifiable’.

• Firm-specific risk
• Think of those poor souls who held shares of Enron or Sathyam or
Lehman Brothers or Kingfisher Airlines when some real news about
these firms came out!!!
• Risk that actually can be eliminated by diversification
• Called diversifiable or non-systematic risk.
 Portfolio Risk and the Number of Stocks in the
Portfolio

Panel A: All risk is firm specific. Panel B: Some risk is systematic or marketwide.
Portfolio Diversification
 Let’s start with two risky assets
• Portfolio risk (variance) 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 move together (covary)
 Portfolios returns with two risky assets
• Assume you choose to invest in a debt fund and equity
fund
• Portfolio return: rp = wDrD + wErE
• wD = Bond weight
• rD = Bond return
• wE = Equity weight
• rE = Equity return

E(rp) = wD E(rD) + wEE(rE)

 Portfolio risk with two risky assets
• Portfolio variance:

 p2  wD2  D2  wE2 E2  2wD wE Cov  rD , rE 

•  D = Bond variance
2

•  2
E = Equity variance

Cov  rD , rE 
•
• = Covariance of returns for bond and equity
 Let’s go back to statistics!
• Covariance of returns on bond and equity:
Cov(rD,rE) = DEDE

• D,E = Correlation coefficient of returns

• D = Standard deviation of bond returns
• E = Standard deviation of equity returns
 Revisiting the correlation co-efficient
• Range of values for 1,2
- 1.0 >  > +1.0
• If  = 1.0, the securities are perfectly positively correlated

• If  = - 1.0, the securities are perfectly negatively correlated

 Correlation and diversification
• When ρDE = 1, there is no diversification

 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible
• In reality can you find this?

D
wE   1  wD
 D  E
Computation of Portfolio Variance From the
Covariance Matrix
 An Example

Debt Fund Equity Fund

Expected Return 8% 13%
Standard Deviation 12% 20%
Covariance 72
Correlation Coefficient 0.3

Using WD = 0 and WE = 1 and going up to WD = 1 and WE = 0 with

increments of 0.1, estimate the portfolio expected returns and portfolio
standard deviation. Use correlation values of -1, 0, 0.3 and1.0.

Increase the weightage to both debt and equity to greater than 1

values and extend the tables. Plot the final results as expected
returns vs weights and standard deviation vs weights.
Portfolio Expected Return
Portfolio Standard Deviation
 The Minimum Variance Portfolio
• The minimum variance portfolio is the portfolio
composed of the risky assets that has the
smallest standard deviation; the portfolio with
least risk
• The amount of possible risk reduction through
diversification depends on the correlation:
• If  = +1.0, no risk reduction is possible

• If  = 0, σP may be less than the standard deviation

of either component asset
• If  = -1.0, a riskless hedge is possible
 Optimal Weights
• Recall portfolio variance as

 p2  wD2  D2  wE2 E2  2wD wE Cov  rD , rE 

σ2𝐸 − 𝐶𝑜𝑣 (𝑟𝐷 , 𝑟𝐸 )
𝑊𝐷∗ = 2
σ𝐷 + σ2𝐸 − 2𝐶𝑜𝑣 (𝑟𝐷 , 𝑟𝐸 )
• Using calculus, we can identify minimum variance
portfolio.

• W D = 1 – WE

• Using this in the equation and differentiating the result

with WD yields the optimal weight that results in a
minimum variance portfolio.
 Optimal Weights

2
∗
σ 𝐸 − 𝐶𝑜𝑣 (𝑟𝐷 , 𝑟𝐸 )
𝑊𝐷 = 2
σ𝐷 + σ2𝐸 − 2𝐶𝑜𝑣 (𝑟𝐷 , 𝑟𝐸 )

For our example, estimate the minimum variance portfolio.

What do you observe at the variance of the portfolio?

Graph Expected Return vs Standard Deviation including the

minimum variance portfolio weights using your tabulation.
Portfolio Expected Return as a Function of
Standard Deviation
 The Opportunity Sets
• The resulting graphs for given correlation values provides the
opportunity sets.

• Portfolio opportunity set shows all combinations of portfolio

expected return and standard deviation from the two available
assets.

• When correlation is -1, linear opportunity set with perfect

hedging.

• Once we have these graphs, we go subjective.

• Best portfolio depends upon your risk aversion
• Portfolios north east of the graph are high risk, high expected return
• Best trade-off is personal preference, if you’re highly risk averse,
you’re likely to find your portfolio south-west.
 Let’s complicate things a bit..
• Your risky portfolio contains debt and equity funds.

• What if you want to further invest in t-bills yielding 5%?

• Therefore, we have two risky assets and a risk-free asset.

• Last class we did one risky asset and risk-free asset.

• Draw CAL with minimum variance portfolio – Portfolio A

• What if you choose 70% in bonds and 30% in stocks – Portfolio B

• Estimate slope (sharpe ratio) of both portfolios.

The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs
 The Sharpe Ratio
• Maximize the slope of the CAL for any possible portfolio,
P
• The objective function is the slope:

E rp   rf
Sp 
p
• The slope is also the Sharpe ratio
 A different optimization problem
• Unlike previous case, now we optimize the sharpe ratio
(maximize SR) subject to σ 𝑤𝑖 = 1.

• When we have only 2 risky assets,

𝐸 𝑅𝐷 ×σ2𝐸 −𝐸(𝑅𝐸 )×𝐶𝑜𝑣(𝑅𝐷 ,𝑅𝐸 )

• 𝑤𝐷 =
𝐸 𝑅𝐷 ×σ2𝐸 +𝐸 𝑅𝐸 ×σ2𝐷 −[𝐸 𝑅𝐷 +𝐸 𝑅𝐸 ×𝐶𝑜𝑣 𝑅𝐷 ,𝑅𝐸 ]

• W E = 1 – WD

• Where R represents excess returns.

• Estimate the optimal weights with risky assets.

Debt and Equity Funds with the Optimal Risky
Portfolio
 What about the optimal complete
portfolio?
• Refer back to previous class’s discussion on the optimal
weightage to invest in a risk-free asset and risky asset
portfolio.

E(rp) – rf
• y* =
𝐴×σ2𝑝

• For a A = 4, what is your portfolio weights for complete

portfolio?
Determination of the Optimal Overall Portfolio
The Proportions of the Optimal Complete Portfolio
Markowitz Portfolio Optimization Model
• Security selection
• The first step is to determine the risk-return opportunities available
• All portfolios that lie on the minimum-variance frontier from the
global minimum-variance portfolio and upward provide the best
risk-return combinations
The Minimum-Variance Frontier of Risky Assets
Markowitz Portfolio Optimization Model
• Search for the CAL with the highest reward-to-variability
ratio
• Everyone invests in P, regardless of their degree of risk
aversion
• More risk averse investors put more in the risk-free asset
• Less risk averse investors put more in P
The Efficient Frontier of Risky Assets with the
Optimal CAL
Markowitz Portfolio Optimization Model
• Capital Allocation and the Separation Property
• Portfolio choice problem may be separated into two independent
tasks
• Determination of the optimal risky portfolio is
purely technical
• Allocation of the complete portfolio to risk-free
versus the risky portfolio depends on personal
preference
Capital Allocation Lines with Various Portfolios from
the Efficient Set
THANK YOU