25-08-2018

Module 4:Modern Portfolio Theory & Optimal risky portfolio

• The investment decision can be viewed as a top-down process: a) capital
allocation between risky portfolio and risk free assets, b) asset allocation
across broad asset classes (stocks, long term bonds, international stocks) &
c) security selection within each asset class.
• Diversification:
• Suppose your portfolio is composed of only 1 stock, say Dell computers,
what is the risk associated with this stock?
• A) Macro economic factors and B) Stock related risk
• None of the macro economic factors can be predicted with certainty but
they would affect the returns on the stock
• Now consider a naïve diversification strategy, in which you include
additional securities in your portfolio. For example, place half the funds in
Exxon Mobile and half in Dell. What would happen to portfolio risk if an
event like fall in OIL prices were to happen.
• To the extent of firm specific influences on the 2 stocks are different,
diversification would reduce portfolio risk.
• For example, when oil prices fall, hurting Exxon Mobile, computer prices
might rise, helping Dell (COP goes down, buying power increases leading to
more sales). The effects are offsetting and thereby stabilizing return.
1

Modern Portfolio Theory as given by Harry

Markowitz
• Publish an article in the Journal of Finance in March 1952 indicating the
importance of correlation among the different stock returns in the construction of
a stock portfolio.

• He showed that for a given level of expected return in a group of securities, one
security dominates the other.

• To find this out the knowledge of correlation coefficients becomes important.

• He also introduced the concept of diversification.

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Diversification
• Portfolio risk can be reduced by diversifying your investments into
different groups or types of securities and creating a portfolio of stocks.

• When different assets are added to the portfolio, the total risk tends to
decrease.

• In case of stocks, the diversification reduces the unsystematic risk or

unique risk.

Portfolio Risk and number of securities

Risk diversification

45

40

35

30
portfolio risk

25
Series1
20

15

10

0
0 200 400 600 800 1000 1200
number of securities

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Assumptions
• The individual investor estimates risk on the basis of the variability of returns
i.e. the variance of returns.

• For a given level of risk, investors prefer HIGHER return to lower return

• AND;

• For a given level of RETURN, investors prefer LOWER risk than higher risk.

• The PORTFOLIO that satisfies the above criteria are called as Efficient
portfolios

• An investor will plot a series of portfolios which are efficient as well as

inefficient

Modern Portfolio Theory

• This theory and subsequent theories stress upon the idea that, creation of portfolio depends
upon the relationship between the returns, expected returns represented by mean and the
variability of these returns represented by standard deviation.

• The Modern portfolio theory favors the concept of EFFICIENT FRONTIER.

• An EFFICIENT FRONTIER is nothing but a line representing or enveloping all efficient

portfolios plotted on a risk return graph/plane.

• It a the one which provides a better return for a given level of risk i.e. minimum risk for a
given level of returns compared to other portfolios OR it might provide maximum returns
for a given level of risk as compared to other portfolio.

• MPT believes that investor possess UTILITY curve with the help of which portfolio selection
can be done by tracing the efficient frontier.

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Modern Portfolio Theory

• Introduction
• Two-security case
• Minimum variance portfolio
• Correlation and risk reduction
• The n-security case
• Areas to cover: Markowitz diversification, the
efficient frontier, CAPM, the alpha-beta coefficients,
CML and SML.

MPT
• Portfolio’s performance is a result of the performance of its components

• Return realized on a portfolio is a linear function of the returns on

individual investments.

• Return assumed to be log-normally or normally distributed over the long

term.

• Normal Distribution of returns allow us to make use of standard deviation

and variance as a measure of risk.

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Expected returns for a portfolio

• Expected returns for a Single security is given
by E(r) = ∑ (Pi x Ri)
• However, the general tendency is to invest in
more than one security to create a portfolio
using weighted average and hence:

• E(R portfolio) = ∑ {Wi x E(Ri)}

Example
• A ltd B ltd.
Probability Possible ProbabilityPossible
rate of return rate of return
0.25 0.08 0.25 0.09
0.25 0.1 0.25 0.1
0.25 0.12 0.25 0.14
0.25 0.14 0.25 0.08
An investor is planning to invest 40% in A Ltd.
and balance in B ltd.
calculate the return on individual asset and portfolio

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• E (r ) A ltd.
px R
B ltd.

0.02 0.0225
0.025 0.025
0.03 0.035
0.035 0.02
total 0.11 0.1025
Individual E(R) 11% 10.3%

E(Rportfolio) weights x E (r )
= 0.4 x 0.11 + 0.60 x 0.13
= 0.044 0.078
= 0.122
12.2 per cent

11

Expected return in a portfolio of assets

say 4 different assets with different E(R)
Weight E(Ri)

0.2 0.1
0.3 0.11
0.3 0.12
0.2 0.13

n
E(R por i )  WR
i 1
i i

where :
Wi  the percent of the portfolio in asset i
E(R i )  the expected rate of return for asset i
FIND E(Rp)

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Variance of portfolio
• Two basic concepts in statistics, covariance and
correlation, must be understood before we discuss
the formula for the variance of the rate of return of a
portfolio

• Understanding portfolio variance is the essence of

understanding the mathematics of diversification

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Covariance
• Covariance is a measure of the degree to which “TWO VARIABLES” move
together relative to their Individual Means over time.
• Covariance is a measure of the directional relationship between the returns on two
risky assets

• In portfolio analysis, we usually are concerned with the covariance of rates of

return rather than prices or some other variable.

• A positive variance means that the rates of return for two investments tend to
move in the same direction relative to their individual means.

• A Negative variance means that the rates of return for two investments tend to
move in DIFFERENT directions relative to their individual means.

• When Probability is given:

• Covariance = Cov (R1,R2) = [Pi * (r1-E(R1)*(r2-E(R2)......]

• When historical data is given:

• Covariance = Cov (R1,R2) = [(r1- r 1) * ( r2 – r2)......] / (N-1)

• In case of multiple probabilities for individual stocks we take average of

probabilities. 14

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Correlation
• Covariance is affected by the variability of the two individual return
series.

• A return might indicate a weak positive relationship if the two individual

series are volatile but would reflect a strong positive relationship if the
two series were very stable.

• We need to Standardize this covariance measure taking into consideration

the variability of the individual return series by studying the Correlation
between the securities.

• ρi j = Covij i.e. Covariance / Std. deviation

• σi σj

• Correlation = ρ 12= Cov (R1,R2)

• 1 * 2.
15

• Standardizing the covariance by the individual standard deviations yields the Correlation
coefficient (ρij), which can vary only in the range of +1 and -1.

• A value of +1 indicates a Perfect Positive linear relationship between Ri and Rj, meaning that
the TWO STOCKS move together in a completely linear manner i.e. both go up or both go
down together with the same magnitude.

• A value of -1 indicates a Perfect Negative Linear relationship between Ri and Rj, such that
when one stocks rate of return is above the mean, the other stocks rate of return will be
below its mean by a comparable amount i.e. returns move in opposite direction with the
same magnitude.

• A value of ZERO correlation would mean that the returns had no linear relationship that is,
they were uncorrelated statistically.

• For example: returns from beverages industry and building materials industry are NOT
correlated or Lowly Correlated.

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Example
•
Economic
Condition Probabil Rx Ry

Good 0.4 0.2 0.16

Fair 0.4 0.13 0.12
Poor 0.2 -0.05 0.03
Question:
Calculate E(R) of both the shares. Can a
portfolio effect be achieved by combining
the two shares.

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Solution:
2 2
E(R) of X E(R) of Y E(R) of X E(R) of Y Ri - E(Ri) {Ri - E(Ri)} Pi*{Ri - E(Ri)}
Pi x Ri Pi x Ri
Pi x Ri Pi x Ri for X
0.08 0.064
• 0.052
-0.01
0.048
0.006
0.08
0.052
0.064
0.048
0.078
0.008
0.006084
6.4E-05
0.0024336
0.0000256
0.122 0.118
-0.01 0.006 -0.172 0.029584 0.0059168
E(R)= pi*ri 0.122 0.118 -0.086 0.035732 0.008376
0.09152049
Covariance (X,Y) = ∑ { Pi (Rx-ErX) (Ry-ErY)} E(R)= pi*ri Risk is calculated using S.D.
Pi*{ [ Rx - E(Rx)]*[Ry - E(Ry)]}
SD = Sqrt of {Pi*[Ri - E(Ri)]}
FOR X = 9.15%
0.40*{ [ 0.2 - 0.122]*[0.16 - 0.118] } = 0.13104 Similarly do for Y SD of Y = 4.75% or 0.0475

0.40*{ [0.13 - 0.122]*[0.12 - 0.118] } = 0.064 Conclusion:

0.20*{ [-0.05-01220]*[0.03-0.118]} = 0.30272 Rule: if ratio of correlation coefficient is less
than the ratio of smaller SD to larger SD
Total = 0.13104+0.064+0.30272 = 0.004344
(4.75: 9.15 = 0.52), then only portfolio effect
for risk minimization can be achieved.
Correlation = Cov (x,y) divided by SD of X and SD of Y
Here ratio is about 0.52 and value of
Corre = +0.004344 / (0.0915 * 0.0475 = +0.999 approx correlation is +1, hence portfolio effect
+1 cannot be achieved by combining these two
stocks. 18

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Portfolio Risk
• Variance of individual risky asset:
• σi = √ ∑ pi [(ri – E(r) ]2

• Variance of Portfolio of 2 securities as derived

by H. Markowitz is given by:

• σp = √ Wi2. σ2i + 2WiWj Cov(Ri Rj)

• σp = √ W12. σ21 + W22. σ22 + 2W1W2 Cov(R1 R2)

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Variance of portfolio
• Variance of individual risky asset:
• σi = √ ∑ pi [(ri – E(r) ]2

• Variance of Portfolio of multiple assets as derived by

Markowitz is given by:
• σp = √ Wi2. σ2i + WiWj Cov(Ri Rj)
• Where i runs from 1 to n.

• σp = √ Wi2. σ2i + WiWj Correl i,j * SDi * SDj

• This formula indicates that the standard deviation for a portfolio of

assets is a function of the weighted average of the individual variances,
plus weighted covariance's between all the assets in the portfolio.

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Portfolio Risk
• It must be noted that in case of two securities
we have 1 covariance.
• As the number of securities in the portfolio
increases, the number of terms on the right
hand side increases as number of covariance's
increase.
• For example in case of three securities we
have three co-variance while in case of 5
securities we have 10 covariance`s. And so on.

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Adding securities to eliminate risk

• Another version of the general formula
• σp = √Wi2 * σ2 (Ri) + WiWj Cov(RiRj)
• Consider a special case, where securities have
zero correlation with each other
– covariance terms are also zero and the last term
goes to zero.
– Because: (Correl coeff) ρij = Cov ij / σiσj
• Expression simplifies to;
• σp =√ Wi2 *σ2 (Ri)
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Example

• Consider a case of Equal returns for 2 stocks:

• E(r1) = 0.20 and E(r2) = 0.20.
• σ1= 0.10 and σ2 = 0.10. Weights are equal (0.50 each)

• We know: ρij = Cov12 / σ1 σ2.=> Covij = ρij * σi* σj

• For different correlation coeff we get:

• If ρ 12= 1.00 then Cov12 = 1.00 x 0.10 x 0.10 = 0.010

• If ρ 12= 0.50 then Cov12 = 0.50 x 0.10 x 0.10 = 0.005
• If ρ 12= 0.00 then Cov12 = 0.00 x 0.10 x 0.10 = 0.000
• If ρ 12= - 0.50 then Cov12 = 0.50 x 0.10 x 0.10 = -0.005
• If ρ 12= - 1.00 then Cov12 = 1.00 x 0.10 x 0.10 = -0.010

• Lets see what happens to Risk (σ)of portfolio under these 5 situations.

• We know, σp = √Wi2. σi2 + WiWj Cov(RiRj)] therefore for 2 securities it would be:
• σp = √W12. σ12 + W22. σ22 + 2w1w2 Cov(r1r2)]
• σp = √(0.50)2(0.10) 2 +. (0.50) 2(0.10)2 + 2(0.50)(0.50) (0.010) = 0.10

• Solve for others………..

• When σp = 0 = this is RISK FREE portfolio.

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Recap: Two security case –variance

• For a two-security portfolio containing Stock A
and Stock B, the variance is:
• σp = √ w2i σ2i + w2j σ2j + 2wiwjρij σi σj

Since Correlation (ij)= Cov (Ri, Rj) /i, j.

Therefore,

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Example with N=3 securities

• P = [  i=1to 3  j=1to 3 Xi.Xj.  ij.]1/2.

» P= [ X .X . .+ X .X . .+ X .X . . ] .
j=1to 3
1 j 1j j=1to 3
2 j 2j j=1to 3
3 j 3j
1/2

»  =[(X .X  + X .X  +X .X  )+(X .X  +X .X 
P 1 1 11 1 2 12 1 3 13 2 1 21 2 2 22 +

X .X  )+(X .X  + X .X  + X .X  )] .
2 3 23 3 1 31 3 2 32 3 3 33
1/2

• Both variances and covariances generated

in the expansion.

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Example for 3 securities

Asset class E(r) Stdev Weights

Stocks (s) 0.12 0.2 0.6
Bonds (b) 0.08 0.1 0.3
Cash equi (c) 0.04 0.03 0.1
Correlation R s,b 0.25
R s, c -0.08 R b,c 0.15
E(Rp) = (0.60)(0.12)+ (0.30)(0.08)+ (0.10)(0.04)
E(Rp) = 0.10

Risk of portfolio for 3 assets is given by :

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Risk of 3 securities portfolio

• σ p = √Wi2. σi2 + WiWj ρIJ * σi * σj

• σp = √ W2sσ2s + W2bσ2b + W2cσ2c + [2WsWbσsσbRsb+ 2WsWcσsσcRsc +

2WbWcσbσcRbc.

• Using the given data:

• σp = √(0.60)2(0.20)2+(0.30)2(0.10)2+ (0.10)2(0.03)2 +
{[2 (0.6)(0.30)(0.20)(0.10)(0.25)] + [2(0.6)(0.10)(0.20)(0.03)(-0.08)
+[2(0.30)(0.10)(0.10)(0.03)(0.15)]}
• σp = 0.1306 = 13.06%
• Similarly we can solve for N securities…

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• Change in portfolio proportions can change portfolio risk.

• By skillfully balancing of investment proportions in difference securities,

the portfolio risk can be brought down to zero.

• The proportion to be invested in each security can be found by:

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Analysis of weights when Correlations are given

•
If the correlation between A and B is perfect (+1), above equation is:
Portfolio risk is simply a weighted average of risks
p2 = (WA.A + WB.B)2.
p = WA.A + WB.B.
How low can portfolio risk get?
If correlation is -1
p2 = (WA.A - WB.B)2.
p = absolute value of WA.A - WB.B.
Note: the sum of weights will always be equal to 1 (100%) where WB = 1-WA.
Weights can drive the SD to zero
0 = WA.A - WB.B. Replace WB by 1- WA in the equation
0 = WA.A – (1-WA).B.
0= WA.A – B + B WA
WA = B/(A+B)
WB = A/(A+B) where WB = 1-WA.
Or WA = 1-WB

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Minimum Variance
• The minimum variance portfolio is a
particular combination of securities that will
result in the least possible variance

• Solving for the minimum variance portfolio

requires basic calculus

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Minimum Variance Portfolio

• Investors are risk averse. A risk averse investor
will always like to reduce his risk exposure and
attain higher returns.

• So he may be interested in knowing the

combination of two securities such that portfolio
variance is minimum.

• Minimum variance portfolio is also the optimal

portfolio for an investor who wants minimum
exposure to risk
31

Minimum Portfolio variance

• We can use the following formula for
estimating the weights of two securities in a
minimum variance portoflio.

• WminA =(σ2B – CovAB) / (σ2A + σ2B – 2*CovAB)

• CovAB = ρAB* σ A* σB

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Example
• Construct the minimum variance portfolio of securities A and B from the following
information. Calculate the portfolios return as well as risk. Covariance between the
returns of A and B = -10.
Stock A B
ER (%) 15 9
SD (%) 5.3 2

• Solution: WminA = (2)(2) – (-10) / {(5.3)(5.3)+(2)(2) – 2(-10) = 0.27

• WminB = 1 – WminA = 1 – 0.27 = 0.73

• Hence minimum variance portoflio is one which has 27% of security A and 73% of portfolio B
• The risk of portfolio as given by SDp

• Sqrt 0.27*0.27*5.3*5.3 +0.73*0.73*2*2 + 2*0.27*0.73*(-10) = 0.25

• SDp = 0.5%
• Thus, the minimum variance portfolio comprises of 27% of Security A, 73% of security B and
minimum portfolio risk is very low at 0.5%.
• Any other combination will give higer portfolio risk

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Example: Two security case

Stock A Stock B

Expected return .015 .020

Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50

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Return calculation

n
E ( R p )    xi E ( Ri ) 
i 1

  xA E ( R A )   xB E ( R B ) 
  0.4(0.015)   0.6(0.020)
 0.018  1.80%

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Variance

 2p  xA2 A2  xB2 B2  2xA xB  AB A B

 (.4)2 (.05)  (.6)2 (.06)  2(.4)(.6)(.5)(.224)(.245)
 .0080  .0216  .0132
 .0428

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Coefficient of Correlation and Diversification

• Don’t put all your eggs in one basket. This is the basic idea behind diversification.
• Every investor would like to invest his total funds in not just one type of security; rather
he will like to hold combination of securities.
• The reason being that diversification helps reduce variability of returns and thereby
reduces risk of total investment.

• Diversification works because returns and prices of all securities do not move together.
In a diversified portfolio securities are less than perfectly positively correlated. It implies
that when the COEFFICIENT of CORRELATION is less than 1, an investor can have the
benefits of diversification.

• For diversification the lower the Coefficient of Correlation the better it is. Hence a
portfolio, of securities which has 0.3 as Coefficient of correlation will be more
diversified than a portfolio which has Correl = 0.7.

• When Correlation coefficient is +1:

• In such cases security returns are perfectly positively correlated. It implies that an
increase (decrease) in one security is accompanied by exactly same proportionate
increase (decrease) in another security.
• Hence the returns move in tandem.
• In other words, there is no difference in the pattern of these 2 securities. In such a case
we do NOT have any DIVERSIFICATION benefit. We only have Risk averaging.
• SDp = W1*SD1 + W2*SD2 + 0 {this is called NAÏVE diversification}

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When Correlation is less than 1 but greater than 0

• When Correlation is less than 1, then

although the returns of the securities move in
the same direction but they are not increasing
or decreasing in the same proportion.

• Hence, if we include these securities in a

portfolio we get the benefit of diversification.

• We will be able to diversify away the

unsystematic risk. The corresponding portfolio
risk will be lower.
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When correlation is Zero

• When it is ZERO, the returns are unrelated.
There is no relationship between the returns
of the two securities.
• This is even better for diversification.
• When we include securities which are not
related with each other, we get higher degree
of diversification and hence lower portfolio
risk

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When Correlation is -1
• This is a case of perfectly negative coefficient
of correlation.
• In such a case it is possible to completely
eliminate risk.
• Hence when the coefficient of correlation is -
1, we can have a portfolio which has Zero
portfolio risk.
• But these are difficult to find.

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Zero Risk or Zero variance portfolio

• We can have a Zero risk portfolio if:
• Coefficient of Correlation is -1
• In this case, point of minimum risk becomes -> W1 = σ 2 / (σ 1+ σ2)
• For example, assume that 2 securities A and B have expected returns of
12% and 18% and σ as 20% and 30% respectively. The correlation is -1.
• Solution:
• Wa = 30 / (20+30) = 0.60, therefore Wb = 1- 0.60 = 0.40
• Hence the portfolio which invests 60% of total funds in security A and 40%
in security B will have ZERO risk. This can be seen below:

• σp = sqrt {(0.60) 2 x (20)2 + (0.40) 2 x (30)2 + 2*0.6*0.4*(-1)*20*30

• = 0
• This shows the relationship between coefficient of correlation,
diversification and portfolio risk

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Example: Lets assume: Risk and Return

with different correlations
Proportion of Proportion of Rp SD under different Correlation Co-
asset A in asset B in Correlation Co-efficients
portfolio (X) portfolio (1 - X) 1 -1 0 0.5
1 0 5.00% 4.00% 4.00% 4.00% 4.00%
0.75 0.25 5.75%
0.5 0.5 6.50%
0.25 0.75 7.25%
0 1 8.00% 10.00% 10.00% 10.00% 10.00%
For calculating SD, use the formula for risk from Module 3.

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Example: Lets assume: Risk and Return

with different correlations
Proportion of Proportion of Rp SD under different Correlation Co-efficients
asset A in asset B in Correlation Co-efficients
portfolio (X) portfolio (1 - X) 1 -1 0 0.5
1 0 5 4.00% 4.00% 4.00% 4.00%
0.75 0.25 5.75 5.50% 0.50% 3.91% 4.77%
0.5 0.5 6.5 7.00% 3.00% 5.39% 6.24%
0.25 0.75 7.25 8.50% 6.50% 7.57% 8.05%
0 1 8 10.00% 10.00% 10.00% 10.00%
For calculating SD, use the formula for risk from Module 3.

43

When r = +1 and -1
r = +1 • r = -1
Return and Risk at R=1 Return and Risk at R= -1
9.00% 9.00%

8.00% 8.00%
7.00%
7.00%
Returns
Return

6.00%
6.00%
5.00%
5.00%
4.00%
4.00%
3.00%
3.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00%12.00%
4.00% 5.50% 7.00% 8.50% 10.00% Risk
Risk

Line is flatter, Risk is lower

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• r=0 • r = +0.5
Return and Risk at R= 0 Return and Risk at R= 0.5
9.00% 9.00%

8.00% 8.00%

7.00% 7.00%
Returns

Returns
6.00% 6.00%

5.00% 5.00%

4.00% 4.00%

3.00% 3.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00%12.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00%12.00%
Risk Risk

Long Line is steeper

45

Combined Risk Return Frontiers

9.00%

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%
0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%
R=1 R = -1 R=0 R=0.5

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Example 2: Risk-return portfolio trade-off varying portfolio weights

Panel A
Expected return Standard Dev Correlations
Stock A 15% 24% +1.0,0.0,+0.5
Stock B 12% 18%

Portfolio Weighting
Stock A (% Wt) 0 20 40 60 80 100
Stock B (% Wt) 100 80 60 40 20 0
Expected Return 12 12.6 13.2 13.8 14.4 15
Standard Deviation
Corr =1.0 18 19.2 20.4 21.6 22.8 24
Corr =0.5 18 17.3 17.7 19 22 24
Corr =0.0 18 15.2 14.4 16.1 19.5 24

47

All the graphs show the portfolio risks under varying levels of co-relation
co-efficients. All the figures can be assembled together and placed in a
single figure as below for e.g .2

• Risk and Return

15
Corr=1
14.8
Corr=0.5
14.6
Corr=0
14.4
Corr=-0.5
14.2 corr=-1
14

13.8

13.6

13.4

13.2

13

12.8

12.6

12.4

12.2

12
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

R i sk ( %)

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Efficient Frontier
• The Efficient Frontier represents that set of portfolios that has the
maximum rate of return for every given level of risk, or the minimum risk
for every given level of return.

• We have to impose the utility function on the Efficient frontier and identify
the relevant portfolios based on the clients/customers needs.

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Markowitz Efficient frontier

• The risk and return of all portfolios plotted in the risk return space would be
dominated by efficient portfolios.
• All possible combinations of expected return and risk compose the attainable
set.
• Recollect the Utility function:

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Markowitz Portfolio construction process

• Step 1: Making probabilistic estimates of

future performance of securities
• Step 2: Creating a set of efficient portfolios for
constructing the Efficient frontier.
• Step 3: identifying the utility curve and
tangency portfolio on the utility curve

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Bordered Variance/Covariance matrix

Markowitz 3 security model

A B C
A A2 CovAB CovAC

B CovBA  B2 CovBC

C CovCA CovCB C2

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Approach used to build minimum

variance set

E(RP)

Risk

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Efficient Frontier
• Excel Simulation

• Stock Portfolio and Global index portfolio

• Download 4 stocks prices

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