FINANCIAL ECONOMICS

Lecturer： Quyen Do Nguyen, PhD

Corporate Finance Department
Faculty of Banking and Finance
Foreign Trade University
Email： [email protected]

Course Materials: https://www.dropbox.com/sh/bhbsaz4t8ehyk50/AADaldsAfMk

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CHAPTER 5: OBJECT OF CHOICE:

MEAN-VARIANCE PORTFOLIO THEORY
 Main content

 Provide a framework where objects of choice are readily measurable

 mean-variance objects of choice.
 Measures of risk and return for a single asset
 Measures risk and return for a portfolio of many risky assets
 Decision rules: individuals choose optimal portfolio that maximize their
expected utility of wealth (with and without riskless borrowing and
lending)

Measuring risk and return for a single asset

 $I: Initial investment

 $W: final wealth
 R: Investor rate of return
 Properties

 Property 1: The expected value of a random variable 𝑋 plus a

constant a is equal to the expected value of the random variable plus
the constant:

 Property 2: The expected value of a random variable 𝑋 multiplied by

a constant a is equal to the constant multiplied by the expected value
of the random variable:

Properties

 Property 3: The variance of the random variable plus a constant is

equal to the variance of the random variable

 Property 4: The variance of a random variable multiplied by a

constant is equal to the constant squared times the variance of the
random variable:
 Measures of Location

 Measures of locations are intended to describe the most likely

outcome in set of events. The most often used measure of location is
the mean or expectation.

 Where: pi is the probability of a random event Xi; N is the total

number of possible events; and the tilde (~) is used to designate
randomness.

Measures of Location

 Mean: The expected outcome or the average

 Median: the outcome in the middle, often referred to as the 50th
percentile.
 Mode: the most frequent outcome, often used as a measure of location
for empirical distributions of security returns because security returns
are real numbers and consequently do not repeat themselves
frequently.
 5 measures of dispersion
 The range
 defined as the difference between the highest and the lowest outcomes
 The semi-interquartile range
 The difference between the observation of 75th percentile and 25th percentile
divided by 2
 The variance
 Most frequently used to measure the dispersion of distribution
 The semivariance
 A statistic that relates to just that risk. The expectation of the mean differences
below that mean squared.
 The mean absolute deviation
 The expectation of the absolute value of the difference from the mean

Measuring portfolio risk and return

 The normal distribution: by looking only at the mean and variance, we

assume that our sample is normally distributed.
 Bell-shaped probability distribution
 Can be completely describe by mean and variance

 The frequency of a return is measured along the vertical axis and the
returns are measured along the horizontal axis
 Perfectly symmetric
 Measuring portfolio risk and return

 The normal distribution: by looking only at the mean and variance, we

assume that our sample is normally distributed.

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Mean and variance of a two-asset portfolio

 The portfolio variance is the sum of the variances of the individual

securities multiplies by the square of their weights plus a third term,
which includes the covariance, COV(𝑋 , 𝑌)

 The covariance is a measure of the way in which the two random

variables move in relation to each other.
 Mean and variance of a two-asset portfolio

 If the covariance is positive, the variables move in the same direction.

If it is negative, they move in the opposite directions.

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EXAMPLE

 Example: Calculate the variance and the covariance of these assets:

 COVARIANCE

 Negative covariance implies that the returns on assets X and Y tend to

move in opposite directions.
 Invest in both securities at once, reduce risk of the portfolio.
 Suppose we invest half of our assets in X and half in Y:

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Correlation coefficient

 The correlation, 𝑟 , between two random variables is defined as the

covariance divided by the product of the standard deviations:

𝜌~
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The minimum variance opportunity set

 The minimum variance opportunity set is the locus of risk and return
combinations offered by portfolios of risky assets that yields the
minimum variance for a given rate of return
 The efficient set with two risky assets

 Optimal portfolio choice for a risk-averse investor and two risky assets

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The optimal portfolio

 Optimal portfolio = maximize our utility so that the marginal rate of

substitution between our preference for risk and return, represented
by our indifference curves must equal the marginal rate of
transformation offered by the minimum variance opportunity set.

 The utility-maximizing choice equates the marginal rate of substitution

and transformation
 The optimal portfolio
 Endowment with a portfolio at point A
 At point A, the MRT b/t return & risk along the minimum
variance opportunity set is equal to the slope of the
line DAF.
 The slope of the line CAB at point A indicates our
subjective trade-off b/t return and risk, MRS.
 At point A, relatively high level of risk  willing to give
up a lot of return in order to get rid of a little risk.
 We can move along the opportunity set towards
point E w/o any cost.
 At this point, we attain the highest possible expected
utility on indifference curve U2.
 The MRT=MRS (slope of the line HEG)

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Efficient set

 The efficient set is the set of mean-

variance choices from the investment
opportunity set where for a given
variance (or standard deviation) no
other investment opportunity offers a
higher mean return.
 Efficient set

 Point B and F offer the same s.d but B is

on the efficient set because it offers a
higher return for the same risk.
 Point B is stochastically dominant over
point F.
 Who is more risk averse investor? I or II
or III?

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Minimum variance opportunity set vs. Efficient set

 Minimum variance opportunity set:

 Efficient set:

 With a greater length:

 Correlation between assets

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The efficient set with one risky & one risk-free asset

 If one of the two assets, 𝑅 , has zero variance, then the mean and
variance of the portfolio become:
 The efficient set with one risky & one risk-free asset

 Assumptions:
 Borrowing = lending rate

 Rate of return on the risk-free asset is equal

to then borrowing and lending rate

 Frictionless economy: all assets are infinitely

divisible. Transaction cost = 0.

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The efficient set with one risky & one risk-free asset

 The change in expected return with

respect to the percentage invested in X:
( )
=E X −𝑅
 The slope of the line is:

 a: % of portfolio invested in risky asset

 a>1: 𝐸(𝑅 )= aE X + 1 − a 𝑅 ; 𝞼(𝑅 )=𝑎𝞼
 a<1: 𝐸(𝑅 )= 1 − a 𝑅 + aE X ; 𝞼(𝑅 )= 𝑎 𝞼
 Optimal portfolio choice: Many assets

 Portfolio Mean:

 Portfolio Variance:

 Portfolio covariance:

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The opportunity set with N risky assets

 The efficiency set with N risky assets
and one risk-free asset

 The straight line

represents the
efficient set for all
investors ~ aka. the
Capital Market Line
– representing the
linear relationship
between portfolio
risk and return

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A description of Equilibrium
 Assumptions:
 Borrowing = lending rate @ risk-free rate (unlimited amount)
 Frictionless capital markets

 Investors are homogeneous, no information asymmetry

If Vi is the market value of ith asset, then the % of wealth in each asset is:
 Two-fund separation

 Each investor will have a utility-maximizing portfolio that is the

combination of the risk-free asset and a portfolio (or fund) of risky
assets that is determined by the line drawn from the risk-free rate of
return tangent to the investor’s efficient set of risky assets.

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Capital Market Line (CML)

 If investors have homogeneous beliefs, then they all have the same
linear efficient set called the Capital Market Line.
 The equation for CML:
 Mean-variance opportunity set vs. CML
 2 choices avail:
move along the
mean-variance
opportunity set (by
changing our
portfolio of risky
assets) or move
along the CML (by
borrowing or
lending)

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Mean-variance opportunity set vs. CML

 At point A: the trade-off between risk and return is
better along the opp set than the CML  move to
point B. At point B: MRT b/t risk and return = MRS
 In the absence of capital markets: E(U) is
maximized at point B (U1U2).
 With the existence of capital markets: BM, then
borrow to reach C (U2U3)
 Everyone is better off.
 Two-fund separation is obtained.
 MRS b/t risk and return is the same for all,
regardless of their subjective attitude toward risk.
 Practice exercise 1
Assume a current share price is $50/share. Following are hypothetical
end-of-period share prices:

Pi 0.15 0.10 0.30 0.20 0.25

End-of-period price per share 35 42 50 55 60

Calculate the rate of return for each probability. What is the expected
return? The variance of end-of-period returns? The range? The semi-
interquartile range?

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Practice exercise 2
Assume a current share price is $50/share. Following are hypothetical end-of-
period share prices:

Pi 0.10 0.05 0.07 0.02 0.10 0.30 0.20 0.15 0.05 0.05
End-of-period price 0 35 38.57 40 42 50 55 57 60 69
per share

a) Calculate the expected return, the range of returns, the semi-interquartile

range of returns, the semi-variance of end-of-period returns?
b) Why might some investors be concerned with semi-variance as a measure of
risk?
 Practice exercise 3
Two random variables x and y are as follows:

Probability of State State of Nature Variable X Variable Y

of Nature
0.2 I 18 0
0.2 II 5 -3
0.2 II 12 15
0.2 IV 4 12
0.2 V 6 1

Calculate the mean and variance of each of these variables and the covariance
between them.

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