Markoqitz Optimization

Preliminaries
Analysis with no risk-free asset
Analysis with risk-free asset
Conclusion
Lecture 4: Optimal Risky Portfolios

SAPM [Econ F412/FIN F313 ]
Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15
1/27
Ramana Sonti
Preliminaries
Conclusion
Agenda
1 Preliminaries
Introduction and review

2 Analysis with no risk-free asset
Two risky assets

Three (and more) risky assets
More on efficient frontiers
3 Analysis with risk-free asset
Two risky assets and a risk-free asset

Three (and more) risky assets and a risk-free asset
4 Conclusion
Optimal complete portfolios

Final thoughts
2/27
Ramana Sonti
Preliminaries
Conclusion
The basic problem

Investor has available investment alternatives
n risky assets: random returns
1 risk-free asset: constant return
Question: How should the investor allocate money amongst the
available choices?
Basic assumptions:
Investors care about
Average return: Expected return, E(r)
Risk: Variance of return, 2 (r), or Standard deviation (r)
Investors are greedy: like more return with less risk
Investors are risk averse: as the risk level increases, the extra return
needed to compensate them for taking an unit of extra risk increases
3/27
Ramana Sonti
Preliminaries
Conclusion
Portfolio math review

For a portfolio of two assets (with weights w1 and w2 ),
Portfolio expected return: E(rp ) = w1 E(r1 ) + w2 E(r2 )
Portfolio variance: p2 = w21 12 + w22 22 + 2 w1 w2 1,2
In general, for a portfolio of n assets,
n
X
Portfolio expected return: E(rp ) =
wi E(ri )
Portfolio variance:
p2
n
X
i=1
w2i i2
i=1
n X
n
X
wi wj i,j
i=1 j=1
i,j
In more elegant matrix notation,

Portfolio expected return: E(rp ) = w0
Portfolio variance: p2 = w0 w
Note: is the vector of expected returns, and is the
variance-covariance matrix of asset returns of the set of assets held

according to weights in w
4/27
Ramana Sonti
Preliminaries
Conclusion
Two risky assets
Two risky assets: Example

Two assets X and Y with expected returns, variances, and
covariance (assumed correlation is ) as follows:
"
#
0.10
=
0.20
"
#
0.0049
(0.07)(0.10)
=
(0.07)(0.10)
0.01
What is the expected return and standard deviation of a w : 1 w
portfolio of X and Y ?
Portfolio expected return: E(rp ) = w(0.10) + (1 w)(0.20)
Portfolio variance:
p2 = w2 (0.0049) + (1 w)2 (0.01) + 2w(1 w)(0.07)(0.10)
For a given value of , we can trace out the expected return and
standard deviation of different portfolio combinations of X and Y ,

e.g., 100:0, 60:40,
5/27
Ramana Sonti
Preliminaries
Conclusion
Two risky assets
Diversification in action: Two risky assets

Y
0.2
Portfolio expected return
0.18
0.16
0.14
=-1.0
=-0.5
=0
=0.5
=1.0
0.12
0.1
X
0
6/27
0.02
0.04
0.06
Portfolio standard deviation
0.08
0.1
0.12
Ramana Sonti
Preliminaries
Conclusion
Two risky assets
Mean-Standard deviation diagram

The mean-standard deviation diagram shows the risk-return
characteristics of all portfolios that can be formed using the two

assets. In other words, it traces out the investment opportunity set
When correlation is +1.0 or -1.0, the mean-standard deviation
diagram is linear
When correlation is between the two extremes, the mean-standard
deviation diagram is a hyperbola

As correlation decreases, the diagram curves in to the left, i.e., we
have portfolios which have lesser risk for the same expected return
As we change the correlation, only portfolio variance (standard
deviation) changes, not the expected return

Note that we cannot choose the correlation between any pair of
risky assets, it is what it is
7/27
Ramana Sonti
Preliminaries
Conclusion
Three risky assets

Lets fix the correlation between X and Y at = 0.10, and add a third
risky asset, Z , with the following properties
0.10
0.20
0.15
0.0049
0.0007
0
0.0007
0.01
0.0108
0
0.0108
0.0144
What is the investment opportunity set now?

With two risky assets, the opportunity set was a curve
With three risky assets, the opportunity set is a whole area
Question: Is there an optimal combination of the three assets?

Yes, the mean variance frontier plots the optimal combinations of the
three assets
8/27
Ramana Sonti
Preliminaries
Conclusion
Mean variance frontier: Three risky assets

0.25
Efficient Frontier
Y
0.2
0.15
Z
MVP
0.1
X
0.05
0
0.05
9/27
0.06
0.07
0.08
0.09
0.1
0.11
0.12
0.13
Ramana Sonti
Preliminaries
Conclusion
Efficient frontier: Analytical solution

Question: Of the infinite number of portfolios that can be formed of
X , Y and Z , which ones are optimal?

For a given expected return m, what combination of the assets results
in the lowest variance (standard deviation)?

min
w p2 = w0 w
n
X
subject to E(rp ) = w0 = m and
wi = 1
i=1
Alternatively, for a given level of variance s, what combination of the
assets results in the highest expected return?

max
w E(rp ) = w0
n
X
subject to p2 = w0 w = s and
wi = 1
i=1
The bad news: General analytical solution is quite complicated

The good news: we can use Excels Solver quite effectively to
numerically generate the efficient frontier

10/27
Ramana Sonti
Preliminaries
Conclusion
Two fund separation

Two fund separation : Any efficient portfolio can be obtained as the
combination of two efficient portfolios

The efficient portfolio with E(rp ) = 16% consists of wX = 0.54,
wY = 0.74, wZ = 0.28, and that with E(rp ) = 22% consists of
wX = 0.2625, wY = 1.6625, wZ = 0.925. Using this information, how
do we derive the efficient portfolio with E(rp ) = 20%?
Step 1: Given that 20 = 13 (16) + 23 (22), we deduce weights as 13 and 32

Step 2: Now we get the weights of the 20% expected return efficient
portfolio as
wX = 13 (0.54) + 32 (0.2625) = 0.355
wY = 13 (0.74) + 23 (1.6625) = 1.355
wZ = 13 (0.28) + 23 (0.925) = 0.71
Step 3: The mean and std. devn. of this portfolio are 20% and 0.0783
try this calculation!), which puts it right on the efficient frontier, as

advertised!
11/27
Ramana Sonti
Preliminaries
Conclusion
Two fund separation: Example

0.24
Efficient Frontier
0.22
EP 2: 0.2625,1.6625,-0.925
0.2
EP 3: 0.355,1.355,-0.71
0.18
0.16
EP 1: 0.54,0.74,-0.28
0.14
MVP
0.06
0.07
0.08
0.09
0.1
This suggests the following recipe:

Step 1: Use Solver to solve for any two efficient portfolios
Step 2: Form combinations of the two efficient portfolios to trace the
entire efficient frontier

12/27
Ramana Sonti
Preliminaries
Conclusion
Constraints on investment
Say we want to solve a constrained version of the problem, e.g., no
short sales allowed for mutual funds

The constrained efficient frontier lies completely within the
unconstrained efficient frontier (why?)

0.2
Unconstrained frontier
0.18
Constrained frontier
0.16
0.14
0.12
0.1
0.06
13/27
0.07
0.08
0.09
0.1
Ramana Sonti
Preliminaries
Conclusion
Adding a fourth...and a fifth...asset

0.25
0.2
More assets
0.15
0.1
0.05
0
0.04
14/27
0.06
0.08
0.1
0.12
Ramana Sonti
Preliminaries
Conclusion
A second look at diversification

In general, as we keep adding assets to a portfolio, the efficient
frontier moves to the left

Question: Will the efficient frontier ever touch the vertical axis, i.e., is
there a combination of the risky assets that is completely risk-free?

Answer: Generally, no
Start with portfolio variance:p2 =
n
X
w2i i2 +
i=1
n X
n
X
i=1
wi wj i,j
j=1
i,j
Assume all assets have a variance v, and each pair of assets a
covariance c
This means p2 = n 12 v + n(n 1) 12 c = n1 v + n1
c
n
n
n
As n , 1n 0, and n1
1, which implies p2 c
n
Conclusion 1: For a well-diversified portfolio, covariances matter, not
so much the variances

Conclusion 2: If c is not zero, we cannot diversify away all risk: leads
to the idea of diversifiable (idiosyncratic) vs. undiversifiable
(systematic) risk
15/27
Ramana Sonti
Preliminaries
Conclusion
Portfolio variance
Diversification in well-diversified portfolios
Diversifiable risk
Systematic risk
20
40
60
80
100
No. of stocks
16/27
Ramana Sonti
Preliminaries
Conclusion

Let us add a risk-free asset to our two assets X and Y . Further,
assume rf = 0.05. What happens?
The opportunity set now expands dramatically
The investor can now combine the risk-free asset and X , and choose
any portfolio along the line CALX

The investor can also combine the risk-free asset and Y , and choose
any portfolio along the line CALY

Better yet, the investor can combine the risk-free asset and any
portfolio of X and Y pivoting about the risk-free asset until the CAL
which passes through the risk-free asset and the portfolio labelled
MVE
The portfolio of X and Y at the point of tangency is called the Mean
Variance Efficient (MVE) portfolio. It provides the maximum

reward-to-risk ratio, a.k.a. Sharpe ratio
17/27
Ramana Sonti
Preliminaries
Conclusion
Two risky assets: Tangency and MVE

0.25
CAL
Y
0.2
MVE
0.15
CAL Y
0.1
X
CAL X
0.05
0
0
18/27
0.02
0.04
0.06
0.08
0.1
0.12
Ramana Sonti
Preliminaries
Conclusion
Analytics of the MVE (2 asset case)

The problem to be solved is
max
w
E(rp ) rf
p
where E(rp )
and p
wE(rX ) + (1 w)E(rY )
h
i1
w2 X2 + (1 w)2 Y2 + 2w(1 w)X ,Y 2
The solution to this problem is
wX
h
i
h
i
E(rX ) rf Y2 E(rY ) rf X ,Y
h
i
h
i
h
i
E(rX ) rf Y2 + E(rY ) rf X2 E(rX ) rf + E(rY ) rf X ,Y
wY
1 wX
Try using this formula in our example to get wX = 0.3607 and

wY = 0.6393
19/27
Ramana Sonti
Preliminaries
Conclusion
Three risky assets and a risk-free asset

Let us add the risk-free asset with rf = 0.05 to our three risky assets
X , Y and Z
Now, Sharpe ratio is maximized at the point where the CAL is
tangent to the efficient frontier

The MVE, or tangency portfolio is
wX = 0.2274, wY = 1.7793, wZ = 1.0067
0.25
MVE
H0.2274, 1.7793,-1.0067L
0.2
0.15
CAL
0.1
0.05
0
0
20/27
0.02
0.04
0.06
0.08
0.1
0.12
Ramana Sonti
Preliminaries
Conclusion
Analytical solution (3 asset case)

Set up the following equation system
0.0049x + 0.0007y + 0.0000z =
0.10 0.05 = E(rX ) rf
0.0007x + 0.0100y + 0.0108z =
0.20 0.05 = E(rY ) rf
0.0000x + 0.0108y + 0.0144z =
0.15 0.05 = E(rZ ) rf
Solve: x = 4.8186, y = 37.6984, z = 21.3294

Rescale weights to add up to 1, i.e., divide by the sum of the three
numbers, 21.1876
wX
wY
wZ
4.8186
= 0.2274,
21.1876
37.6984
= 1.7793,
21.1876
21.3294
= 1.0067,
21.1876
which are the same values as before!

21/27
Ramana Sonti
Preliminaries
Conclusion
The MVE portfolio
It turns out that the MVE portfolio has an interesting property
E(rX ) rf
E(rY ) rf
E(rZ ) rf
=
=
Cov(rX , rMVE ) Cov(rY , rMVE ) Cov(rZ , rMVE )
Intuition: In the MVE portfolio, the marginal reward-to-risk ratio is
equalized across all risky assets, and there is nothing to be gained

by changing the portfolio composition further
It is this important property underlies our earlier analytical method
22/27
Ramana Sonti
Preliminaries
Conclusion
The MVE portfolio...Contd.

Sketch of proof:
Say we start with the MVE portfolio T of X , Y , and Z (expected return
of T and variance of T2 )
Suppose we try to improve upon the Sharpe ratio of this portfolio as
follows: For every $1 invested in T , buy $X amount of X (financed by
borrowing at rf ), and, sell $Y amount of Y from this portfolio (proceeds
invested at rf )
New (dollar) expected return N = T + X (X rf ) Y (Y rf )

New (dollar) variance N2 T2 + 2X Cov(rX , rT ) 2Y Cov(rY , rT )
Cov(rY ,rT )
Set N2 T2 = 0, by choosing X = Y Cov(r
, i.e., we have rigged this
,r )
X T
to make sure the portfolio variance does not change due to the
modifications we made with X and Y
But since we started with the MVE portfolio, we must have
X (X rf ) Y (Y rf ) = 0, otherwise Portfolio T must not have been
MVE to begin with
Combining the last two equations, we get the desired property
E(rX )rf
Cov(rX ,rT )
23/27
E(rY )rf
Cov(rY ,rT )
Ramana Sonti
Preliminaries
Conclusion

Suppose we have two investors: one with a coefficient of risk
aversion A = 15, and another with A = 40. How will their money be
allocated among the risk-free asset and the three risky assets?
Key insight 1: Risk aversion does not play any role in determining
the optimal risky portfolio, a.k.a. the MVE portfolio.

Key insight 2: All investors, irrespective of risk aversion, choose to
be on the CAL with the highest slope. In other words, all investors
hold portfolios of the risk-free asset and the MVE portfolio. This is
two-fund separation in the presence of a risk-free asset
In summary, all investors follow a two step process
Step 1: Come up with the MVE portfolio (common to all) the
investment decision
Step 2: Decide on the split of their money between T-bills and the MVE
portfoliothe financing decision
24/27
Ramana Sonti
Preliminaries
Conclusion
Investor with A = 15
The MVE portfolio consists of
wX = 0.2274, wY = 1.7793, wZ = 1.0067. The expected return and
standard deviation of this portfolio are 0.2276 and 0.0916
respectively
Recall that the relative split between the risk-free asset and the MVE
portfolio is given by our old formula
w =
E(rMVE )rf
2
AMVE
0.22760.05
15(0.0916)2
= 141.25%
If the investor had a capital of $1 M to start with, she would borrow
$412,500 (at the risk-free rate), and invest the total, i.e. $1.4125 M in
the MVE portfolio, i.e. split this amount among X , Y , and Z according
to the proportions wX = 0.2274, wY = 1.7793, wZ = 1.0067
Exercise: Work out the allocation for an investor with A = 40, and
compare it to this allocation. It is useful to understand the

differences between the two allocations
25/27
Ramana Sonti
Preliminaries
Conclusion
The big picture

0.45
CAL
0.4
Risky asset efficient frontier
0.35
A=15
0.3
0.25
MVE
0.2
0.15
A=40
0.1
0.05
0
0
T-bills
0.04
0.08
0.12
0.16
0.2
0.24
0.28
Both investors choose portfolios of the same two assets: T-bills and the MVE
Locate on the CAL according to their risk aversion
26/27
Ramana Sonti
Preliminaries
Conclusion
Final thoughts
Final thoughts
Markowitz optimization is elegant and easy to implement if we are
willing to assume that all investors care about are the mean and
variance of risky assets
This is strictly true if (a) all investors really have quadratic utility
functions, or if (b) asset returns are always normally distributed

Both assumptions are a bit problematic. Nevertheless, as a first
approximation, they will do
This procedure suggests that an investment advisor should
recommend the same optimal risky portfolio to different investors,

irrespective of their risk aversion
Ignores real-world issues such as taxation
This is a one-period problem,and not a multi-period formulation. Here,
the long run is essentially a series of short runs
We have still not talked about the inputs for this optimization, i.e.,
expected returns and variances/covariances

This turns out to be the most problematic thing to do, and is the stuff of
asset pricing, which we shall study next

27/27
Ramana Sonti

Markoqitz Optimization

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Preliminaries

Analysis with no risk-free asset

Analysis with risk-free asset

Lecture 4: Optimal Risky Portfolios

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Introduction and review

Two risky assets

Two risky assets and a risk-free asset

Optimal complete portfolios

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Introduction and review

The basic problem

Question: How should the investor allocate money amongst the

needed to compensate them for taking an unit of extra risk increases

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Introduction and review

Portfolio math review

In more elegant matrix notation,

Note: is the vector of expected returns, and is the

variance-covariance matrix of asset returns of the set of assets held

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Two risky assets

Two risky assets: Example

standard deviation of different portfolio combinations of X and Y ,

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Two risky assets

Diversification in action: Two risky assets

Portfolio expected return

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Two risky assets

Mean-Standard deviation diagram

characteristics of all portfolios that can be formed using the two

deviation diagram is a hyperbola

deviation) changes, not the expected return

risky assets, it is what it is

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Three (and more) risky assets

Three risky assets

risky asset, Z , with the following properties

What is the investment opportunity set now?

Question: Is there an optimal combination of the three assets?

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset

Analysis with risk-free asset

Three (and more) risky assets

Mean variance frontier: Three risky assets

Portfolio expected return

Lecture 4: Optimal Risky Portfolios

Analysis with no risk-free asset