Determining the Minimum Variance Portfolio Consider the two risky securities listed below. Expected Return 15.

0% 6.0% Standard Deviation 21.0% 11.0%

Stocks (S) Bonds (B)

1) If the correlation between these two securities is 0.15, what are the portfolio weights for the minimum variance portfolio created by combining these two securities? The general formula for the portfolio weight that gives the minimum variance portfolio is given by (see attached appendix for the derivation of this formula):
MVP wS = 2 B Cov S , B 2 2 S + B 2Cov S , B

Here the covariance equals SB = 0.15(0.21)(0.11) = 0.003465, so the formula gives:

w
MVP S

(0.11) 2 0.003465 (0.21) 2 + (0.11) 2 2(0.003465)

= 0.1753 = 17.53%

MVP MVP w B = 1 wS = 1 0.1753 = 0.8247 = 82.47%

Stock/Bond Portfolios 18.0% 17.0% 16.0% 15.0% 14.0% 13.0% 12.0% Expected Return 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 0.0%

5.0%

10.0%

15.0% Standard Deviation

20.0%

25.0%

30.0%

2) If the correlation between these two securities is 0.0, what are the portfolio weights for the minimum variance portfolio created by combining these two securities? With a correlation of zero, the formula for the portfolio weights in the minimum variance portfolio simplifies to:
MVP wS = 2 B (0.11) 2 0.0121 = = = 21.53% 2 2 2 2 0.0441 + 0.0121 S + B (0.21) + (0.11)

MVP MVP w B = 1 wS = 1 0.2153 = 0.7847 = 78.47%

Stock/Bond Portfolios 18.0% 17.0% 16.0% 15.0% 14.0% 13.0% 12.0% Expected Return 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 0.0%

5.0%

10.0%

15.0% Standard Deviation

20.0%

25.0%

30.0%

3) If the correlation between these two securities is -1.0, what are the portfolio weights for the minimum variance portfolio created by combining these two securities? With a correlation of -1.0, the formula for the portfolio weights in the minimum variance portfolio simplifies to:
MVP wS =

B 0.11 = = 0.3438 = 34.38% S + B 0.21 + 0.11

MVP MVP w B = 1 wS = 1 0.3438 = 0.6562 = 65.62%

Note that this represents a perfect hedge portfolio. If you plug these weights into Rule 2*, you will find that the resulting standard deviation is zero.
Stock/Bond Portfolios 18.0% 17.0% 16.0% 15.0% 14.0% 13.0% 12.0% Expected Return 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 0.0%

5.0%

10.0%

15.0% Standard Deviation

20.0%

25.0%

30.0%

Appendix: Minimizing the Variance Function According to Rule 2*, the variance of a portfolio of two risky securities is given by:
2 2 = w12 12 + (1 w1 ) 2 2 + 2 w1 (1 w1 )COV12

or
2 2 2 2 = w12 12 + 2 2 w1 2 + w12 2 + 2 w1COV12 2w12 COV12

To minimize this function, take the first derivative with respect to w1 and set equal to zero, or: 2 2 2 = 0 = 2w1 12 2 2 + 2w1 2 + 2COV12 4w1 COV12 w1 rearranging gives :
2 2 0 = w1 [2 12 + 2 2 4COV12 ] 2 2 + 2COV12

or
2 2 COV12 2 12 + 2 2COV12

w1 =