MONASH

BUSINESS
SCHOOL

RISK AND RETURN: PORTFOLIO THEORY

Technical Notes for case: Partners Healthcare

Case instructor: Dr. Hannah Nguyen

Additional Reading (if required):

Bodie, Kane and Marcus (2011) Investments (9th edition), McGraw-
Hill/Irwin, New York, Chapters 5-7

BFX3999 Finance and Society

Semester 1, 2021 (Teaching Week One)
WHAT IS RETURN?

 Literal meaning “to give back” WITH PROFITS!

 Return for an individual security

𝑛𝑛
Σ𝑖𝑖=1 𝑅𝑅𝑖𝑖
𝐸𝐸 𝑅𝑅𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 𝐸𝐸 𝑅𝑅 =
𝑛𝑛

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WHAT IS RISK?

 Risk can be defined as the uncertainty of the future outcomes or the

chance of a financial loss (the variability of returns associated with
an asset).

 One of the best measures of risk is the variance or standard

deviation (SD) of expected returns. SD is a statistical measure of
the dispersion of returns from the mean. The higher the SD, the
higher the dispersion and vice versa.

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RISK FOR AN INDIVIDUAL SECURITY

 Given a history of past returns, the risk can be computed by finding

the square root of the variance which is computed as follows:
𝑛𝑛 2
Σ𝑖𝑖=1 𝑅𝑅𝑖𝑖 − 𝐸𝐸 𝑅𝑅
𝑉𝑉𝑉𝑉𝑉𝑉 𝑅𝑅 = 𝜎𝜎𝑅𝑅2 =
𝑛𝑛 − 1
 Standard deviation is the square root of the variance.

𝑛𝑛 2
Σ𝑖𝑖=1 𝑅𝑅𝑖𝑖 − 𝐸𝐸 𝑅𝑅
𝑆𝑆𝑆𝑆 = 𝜎𝜎 =
𝑛𝑛 − 1

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PORTFOLIO THEORY

 Portfolio theory was developed by Harry Markowitz in 1952 as an

approach to investment choice under certainty.

 The two important assumptions of portfolio theory are:

1) Investors perceive investment opportunities in terms of a probability distribution
defined by expected return and risk.

2) Investors’ expected utility is an increasing function of return and a decreasing

function of risk (risk aversion).

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PORTFOLIO THEORY: Expected return

 Measuring expected return of portfolio:

 Expected portfolio return 𝐸𝐸 𝑅𝑅𝑃𝑃 is a weighted average of all the expected
returns of the assets held in the portfolio.
𝑛𝑛
𝐸𝐸 𝑅𝑅𝑃𝑃 = Σ𝑗𝑗=1 𝑤𝑤𝑗𝑗 𝐸𝐸(𝑅𝑅𝑗𝑗 )

Where:

𝑤𝑤𝑗𝑗 = the proportion of the portfolio invested in asset 𝑗𝑗

𝑛𝑛 = the number of securities in the portfolio

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PORTFOLIO THEORY: Diversification

 For a diversified portfolio, the variance of the individual assets

contributes little to the risk of the portfolio.

 The risk depends largely on the covariance between the returns on

the assets.

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COVARIANCE AND CORRELATION

 Correlation coefficient describes the goodness of fit about a

linear relationship between two variables.
𝜎𝜎1,2
𝜌𝜌1,2 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅1 , 𝑅𝑅2 =
𝜎𝜎𝑅𝑅1 × 𝜎𝜎𝑅𝑅2
𝜎𝜎1,2 = 𝜌𝜌1,2 × 𝜎𝜎𝑅𝑅1 × 𝜎𝜎𝑅𝑅2

𝜎𝜎1,2 = Covariance between assets 1 and 2

𝜎𝜎𝑅𝑅1 = Standard deviation for asset 1

𝜎𝜎𝑅𝑅2 = Standard deviation for asset 2

𝜌𝜌1,2 = Correlation coefficient between assets 1 and 2

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 CORRELATION COEFFICIENT

expected
return B
ρ = -1.0

ρ = 1.0

ρ = 0.2
A

σ
Relationship depends on the correlation coefficient -1.0 < r < +1.0

 If r = +1.0, no risk reduction is possible.

 If r = –1.0, complete risk reduction is possible.
 If r = 0, no relationship exists.
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PORTFOLIO THEORY: risk

 Measuring risk of portfolio:

 Portfolio risk is NOT a weighted average. It is calculated considering the
relationships among returns of securities that make up the portfolio.
𝜎𝜎𝑃𝑃2 = 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 2𝑤𝑤1 𝑤𝑤2 𝜎𝜎1 𝜎𝜎2 𝜌𝜌1,2

Where:

𝑤𝑤1 = the proportion of the portfolio invested in asset 1

𝑤𝑤2 = the proportion of the portfolio invested in asset 2

𝜎𝜎1 = the risk (standard deviation) for risky asset 1

𝜎𝜎2 = the risk (standard deviation) for risky asset 2

𝜌𝜌 = the correlation coefficient between risky assets 1 and 2

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PORTFOLIO THEORY: risk (cont.)

2
𝜎𝜎𝑃𝑃2 = 𝐸𝐸 𝑅𝑅𝑃𝑃 − 𝐸𝐸 𝑅𝑅𝑃𝑃 2 = 𝐸𝐸 𝑤𝑤1 𝑅𝑅1 − 𝐸𝐸 𝑅𝑅1 + 𝑤𝑤2 𝑅𝑅2 − 𝐸𝐸 𝑅𝑅2
= 𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 2𝑤𝑤1 𝑤𝑤2 𝐸𝐸 (𝑅𝑅1 − 𝐸𝐸 𝑅𝑅1 )(𝑅𝑅2 − 𝐸𝐸 𝑅𝑅2 )

𝐸𝐸 (𝑅𝑅1 − 𝐸𝐸 𝑅𝑅1 )(𝑅𝑅2 − 𝐸𝐸 𝑅𝑅2 ) = 𝑐𝑐𝑐𝑐𝑐𝑐 𝑅𝑅1 , 𝑅𝑅2

𝑐𝑐𝑐𝑐𝑐𝑐 𝑅𝑅1 ,𝑅𝑅2

𝜌𝜌1,2 =
𝜎𝜎12 𝜎𝜎22

𝝈𝝈𝟐𝟐𝑷𝑷 = 𝒘𝒘𝟐𝟐𝟏𝟏 𝝈𝝈𝟐𝟐𝟏𝟏 + 𝒘𝒘𝟐𝟐𝟐𝟐 𝝈𝝈𝟐𝟐𝟐𝟐 + 𝟐𝟐𝒘𝒘𝟏𝟏 𝒘𝒘𝟐𝟐 𝝆𝝆𝟏𝟏,𝟐𝟐 𝝈𝝈𝟏𝟏 𝝈𝝈𝟐𝟐

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PORTFOLIO THEORY: ‘n’ asset case

𝑛𝑛
𝐸𝐸 𝑅𝑅𝑃𝑃 = Σ𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝐸𝐸 𝑅𝑅𝑖𝑖
𝑛𝑛 𝑛𝑛
𝜎𝜎𝑃𝑃2 = Σ𝑖𝑖=1 Σ𝑗𝑗=1 w𝑖𝑖 𝑤𝑤𝑗𝑗 𝜎𝜎𝑖𝑖 𝜎𝜎𝑗𝑗 𝜌𝜌𝑖𝑖𝑖𝑖

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PORTFOLIO RISK: The case of 3 risky assets

3 3
Portfolio variance = 𝜎𝜎𝑃𝑃2 = Σ𝑖𝑖=1 Σ𝑗𝑗=1 𝑤𝑤𝑖𝑖 𝑤𝑤𝑗𝑗 𝜌𝜌𝑖𝑖𝑖𝑖 𝜎𝜎𝑖𝑖 𝜎𝜎𝑗𝑗

Portfolio variance = 𝜎𝜎𝑃𝑃2 = 𝑤𝑤1 𝜎𝜎1 2 + 𝑤𝑤2 𝜎𝜎2 2 +

𝑤𝑤3 𝜎𝜎3 2 + 2𝑤𝑤1 𝑤𝑤2 𝜎𝜎1 𝜎𝜎2 𝜌𝜌1,2 + (2𝑤𝑤1 𝑤𝑤3 𝜎𝜎1 𝜎𝜎3 𝜌𝜌1,3 ) +
(2𝑤𝑤2 𝑤𝑤3 𝜎𝜎2 𝜎𝜎3 𝜌𝜌2,3 )

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Markowitz Portfolio Theory (1952) RECAP

 MPT is a theory of selecting an optimal combination of assets that

are expected to provide the highest possible expected return for a
given level of risk (or least risk for a given level of return).
 MPT quantifies risk.

 MPT derives the expected rate of return for a portfolio and an expected risk
measure.

 MPT shows that the variance of return is a meaningful measure of portfolio risk.

 MPT derives the formula for computing the variance of a portfolio, showing how
to effectively diversify a portfolio.

 MPT includes only risky assets.

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1. Calculating Portfolio Risk/Return – Two-Stock Case

 The risk and return for a portfolio made up of AGL and

FOA (𝑤𝑤𝐴𝐴𝐴𝐴𝐴𝐴 = proportion of stock AGL in portfolio) can be
calculated as:
Expected return:

𝐸𝐸 𝑅𝑅𝑃𝑃 = 𝑤𝑤𝐴𝐴𝐴𝐴𝐴𝐴 𝐸𝐸 𝑅𝑅𝐴𝐴𝐴𝐴𝐴𝐴 + 𝑤𝑤𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸 𝑅𝑅𝐹𝐹𝐹𝐹𝐹𝐹

Standard deviation:

2 2 2 2 1/2
𝜎𝜎𝑃𝑃 = 𝑤𝑤𝐴𝐴𝐴𝐴𝐴𝐴 𝜎𝜎𝐴𝐴𝐴𝐴𝐴𝐴 + 𝑤𝑤𝐹𝐹𝐹𝐹𝐹𝐹 𝜎𝜎𝐹𝐹𝐹𝐹𝐹𝐹 + 2𝑤𝑤𝐴𝐴𝐴𝐴𝐴𝐴 𝑤𝑤𝐹𝐹𝐹𝐹𝐹𝐹 𝜎𝜎𝐴𝐴𝐴𝐴𝐴𝐴,𝐹𝐹𝐹𝐹𝐹𝐹

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AGL, FOA risk/return

AGL FOA
Mean return, 𝐸𝐸(𝑅𝑅𝑖𝑖 ) 0.0016 0.0025
Standard deviation, 𝜎𝜎𝑖𝑖 0.0154 0.0187
Covariance, 𝜎𝜎𝐴𝐴𝐴𝐴𝐴𝐴,𝐹𝐹𝐹𝐹𝐹𝐹 0.00011

 To illustrate let us examine the mean and standard deviation of all

possible portfolios, assuming the weights range from 0 to 1 in
increments of 5% (using the formula from slide 15).

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Portfolio Proportion of portfolio in Mean Standard
Number AGL FOA Return Deviation

1 100% 0% 0.0016 0.01540

2 95% 5% 0.0016 0.01501
3 90% 10% 0.0017 0.01468
4 85% 15% 0.0017 0.01440
5 80% 20% 0.0018 0.01418
6 75% 25% 0.0018 0.01402
7 70% 30% 0.0019 0.01392
8 65% 35% 0.0019 0.01390
9 60% 40% 0.0020 0.01393
10 55% 45% 0.0020 0.01404
11 50% 50% 0.0021 0.01420
12 45% 55% 0.0021 0.01443
13 40% 60% 0.0021 0.01472
14 35% 65% 0.0022 0.01506
15 30% 70% 0.0022 0.01546
16 25% 75% 0.0023 0.01590
17 20% 80% 0.0023 0.01639
18 15% 85% 0.0024 0.01691
19 10% 90% 0.0024 0.01748
20 5% 95% 0.0025 0.01807
21 0% 100% 0.0025 0.01870
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 MINIMUM VARIANCE FRONTIER

Mean (Return) Portfolio 21

0.0027
(100% in FOA)

0.0025
Portfolio 8
Minimum Variance
0.0023
Portfolio

0.0021

0.0019
Portfolio 1
(100% in AGL)
0.0017

0.0015
0.01300 0.01400 0.01500 0.01600 0.01700 0.01800 0.01900
Standard Deviation (Risk)

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2. The efficient set for many securities

𝐸𝐸 𝑅𝑅

Individual Assets/Portfolios

𝜎𝜎
 Consider a world with many risky assets; we can still
identify the opportunity set of risk-return combinations
of various portfolios much like we did in the case of 2
risky assets.

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2. The efficient set for many securities (cont.)
𝐸𝐸 𝑅𝑅

minimum
variance
portfolio

Individual Assets/Portfolios

𝜎𝜎

 Given the opportunity set we can identify the minimum

variance portfolio.

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CONSTRUCTION OF A PORTFOLIO

 The efficient frontier

 Given risk-aversion, each investor will try to secure a portfolio
on the efficient frontier. The efficient frontier is determined on
the basis of dominance.

 Dominance implies that a portfolio is efficient if:

 No other portfolio has a higher return for the same risk, or

 No other portfolio has a lower risk for the same return.

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2. The efficient set for many securities (cont.)
𝐸𝐸 𝑅𝑅

minimum
variance
portfolio

Individual Assets/Portfolios

𝜎𝜎

 The section of the opportunity set above the minimum

variance portfolio is the efficient frontier.

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3. THE CAPITAL MARKET LINE

 Introducing a risk-free asset, the opportunity set for

investors is expanded and results in a new efficient
frontier: the Capital Market Line (CML).

 The CML represents the efficient set of all portfolios that

provides the investor with the best possible investment
opportunities when a risk-free asset is available.

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Riskless borrowing and lending
𝐸𝐸 𝑅𝑅

𝑹𝑹𝒇𝒇

𝜎𝜎

 Now investors can allocate their money across the risk

free and risky assets.

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 THREE IMPORTANT FACTS

 Risk free asset (𝑅𝑅𝑓𝑓 ) has a 𝐸𝐸 𝑅𝑅

standard deviation of zero.
D
 The minimum variance portfolio
(MVP) lies on the boundary of the O
feasible set at a point where the
variance is at a minimum. MVP

 The optimal (market) portfolio (O) 𝑹𝑹𝒇𝒇

lies on the feasible set and on a
tangent from the risk-free asset.

𝜎𝜎

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RISK – RETURN POSSIBILITIES WITH LEVERAGE

To attain a higher expected return than is available at point

O (the tradeoff is an exchange for accepting higher risk)

Either

1) Invest along the efficient frontier beyond point O, such

as point D, or
2) Add leverage to the portfolio by borrowing money at the
risk-free rate and investing in the risky portfolio at point
O

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Portfolio possibilities combining the risk-free asset and risky portfolios
on the efficient frontier

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IMPLICATIONS OF THE MARKET PORTFOLIO

 Because portfolio O lies at the point of tangency, it has

the highest portfolio possibility line.

 Everybody will want to invest in Portfolio O and borrow

or lend to be somewhere on the CML.

 Therefore this portfolio must include ALL RISKY

ASSETS and is called the market portfolio.

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SUMMARY

 We have examined the theory of portfolio diversification.

 We have seen how the efficient frontier is constructed.
 We have seen that portfolio diversification reduces risk
to the non-diversifiable component.

Please refer to the excel spreadsheet on Moodle which

demonstrates how Solver may be used as a tool for
identifying an optimal portfolio.

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