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Two Fund Theorem

Two efficient funds or portfolios can be established so that any efficient portfolio can
be duplicated, in terms of mean and variance, as a combination of these two. All in-
vestors seeking efficient portfolios need only to invest in combinations of these two
funds. Hence two products can provide a complete investment service.
Proof:Consider a Markowitz MV Model

(M V ) min wT Ωw subject to eT w = 1, µT w = R

Suppose w∗ and w∗∗ are two efficient portfolios corresponding to the returns R1 and R2
respectively. Then eT w∗ = 1, µT w∗ = R1 and eT w∗∗ = 1, µT w∗∗ = R2

Consider convex combination wλ = λw∗ + (1 − λ)w∗∗ , 0 ≤ λ ≤ 1. Then

eT wλ = eT (λw∗ + (1 − λ)w∗∗ ) = eT λw∗ + (1 − λ)eT w∗∗ = λ + 1 − λ = 1

and µT (λw∗ + (1 − λ)w∗∗ ) = λR1 + (1 − λ)R2 . So wλ is a feasible portfolio of (M V )

with return Rλ say. Consider the (M V ) model with respect to return Rλ :

(M Vλ ) min wT Ωw s.to eT w = 1, µT w = Rλ

Next we show that wλ is an optimal solution of (Pλ ) for every λ.

(Pλ ) is a convex programming problem for each λ. KKT optimal conditions for (Pλ )
are both necessary and sufficient conditions for the existence of solution.
L(w, α, β) = wT Ωw + α(1 − eT w) + β(Rλ − µT w)
∇w L(w, α, β) = 2Ωwλ − αe − βµ
= 2Ω(λw∗ + (1 − λ)w∗∗ ) − α(λe + (1 − λ)e) − β(λµ + (1 − λ)µ)
= λ(2Ωw∗ − αe − βµ) + (1 − λ)(2Ωw∗∗ − αe − βµ) = 0, since w and w∗ are optimal
solution of P , so they satisfy KKT conditions for P .
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Hence wλ is an efficient portfolio whose

µ(wλ ) = λR1 + (1 − λ)R2

σ 2 (wλ ) = σ 2 (λw∗ + (1 − λ)w∗∗ )
= λ2 σw2 + (1 − λ)2 σw2

Example 0.0.1. Consider your model portfolio (20 asset set). As per your choice fix
returns R1 , R1 . Find the corresponding efficient portfolios w∗ and w∗∗ . Construct
different portfolios with different values of λ and trace Markowitz efficient frontier.

Fractional Programming and Capital Asset Pricing Model

• Let P be a portfolio which has n risky assets A1 , A2 , . . . , An and one risk free
asset Af , with return µ1 , µ2 , ..., µn and µf respectively.

• wj , j = 1, 2, ..., n is the proportion of investment in asset Aj and wf is the propor-

tion of investment in the risk free asset. nj=1 wj + wf = 1.
P

Pn
• Expected return of the portfolio =µP = j=1 w j µj + w f µf

• Let Pd be the portfolio with risky assets A1 , A2 , ..., An only and derived from the
original portfolio P . µd be the expected rate of return and σd2 be the variance of
the derived portfolio respectively.
Pn w1 w2
• Denote wr = j=1 wj , wd = ( w , , ..., wwnr )T = (w10 , w20 , ..., wn0 )T
r wr

Then

n
X
µP = w j µj + w f µf
j=1
n
X wj
= wr µj + wf µf = wr µd + wf µf
j=1
wr
= wr µd + (1 − wr )µf = wr (µd − µf ) + µf

σP
σP2 = wT Ωw + 0 = wr2 wdT Ωwd = wr2 σd2 or wr =
σd
 3

σP µP −µf µd −µf
Hence µP = σd
(µd − µf ) + µf that is, σP
= σd
. Since the w1 , w2 , ..., wn ; wf is
unknown so this relation for any portfolio can be expressed as

µ − µf µd − µf
=
σ σd

which is a line joining (0, µf ) and (σd , σf ). For various combination of (w1 , w2 , . . . , wn , wf ),

Figure 1:

this line takes different forms. Among these lines, the line which is tangent to the up-
per portion of Markowitz curve is known as CAPITAL MARKET LINE (CML)and the
point where CML is tangent to Markowitz curve is known as MARKET PORTFOLIO
with risk and return denoted by M = (σM , µM ).

• CML results from the combination of the market portfolio and the risk-free asset.

µM −µf
• Slope of CML ( σM
)is known as sharp ratio of the market portfolio, which is
µ−µf µd −µf
the maximum slope of the line σ
= σd
.

• Equation of capital market line for a portfolio P with n - risky assets and one risk
free asset is
µM − µf
µ= σ + µf
σM

0.0.1 How to find Market portfolio?

Recall the notations:

Pn
• P = (w1 , w2 , ..., wn : wf ), wr = j=1 wj .
4

Capital
𝜇 Market Market line
Portfolio
𝑀(𝜎𝑀 , 𝜇𝑀 )

𝜇𝑓

𝜎
Figure 2: Efficient frontier

0 0 0 0 wj
• Derived portfolio is Pd = (w1 , w2 , ..., wn ), where wj = wr
is the investment in
risky asset Aj of the derived portfolio.

• Denote m = (µ1 , µ2 , ..., µn )T is the expected rate of return vector for the derived
portfolio Pd .

• Expected rate of return of the derived portfolio is µd = wdT m and variance risk of
the derived portfolio is σd2 = wdT Ωwd

Market portfolio is the point on the capital market line when return is maximum, that is,
µ−µf µd −µf
Market portfolio is a point on the efficient frontier where slope of the line σ
= σd

is maximum. Hence we need to solve the following fractional optimization problem.

µd − µf
max
σd
s.t. eT wd = 1

µd − µf mT wd − µf
= p T
σd wd Ωwd

This is a concave programming problem.

T
m w −µ
L(wd , λ) = √ Td f + λ(1 − eT wd ).
wd Ωwd
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KKT optimality conditions for this optimization problem are:

∇w L(wd , λ) = 0, λ ∈ R, eT wd = 1

∇w L(wd , λ) = 0
m mT w − µf
≡ p T − T Ωwd = λe
wd Ωwd (wd Ωwd )3/2
m µd − µf
≡ − Ωwd = λe
σd σd3
≡ mσd2 − (µd − µf )Ωwd = λeσd3

≡ wdT (mσd2 ) − (µd − µf )wdT Ωwd = λσd3 wdT e = λσd3

≡ µd σd2 − µd σd2 + µf σd2 = λσd3

µf
≡ λ=
σd

Put (??) in (??)

µf 3
mσd2 − (µd − µf )Ωwd = eσ
σd d
σd2 (m − µf e) =(µd − µf )Ωwd

σd2 Ω−1 (m − µf e) =(µd − µf )wd

σd2 eT {Ω−1 (m − µf e)} =(µd − µf )eT wd = (µd − µf )

wdT Ωwd eT Ω−1 (m − µf e) =wdT m − µf = wdT (m − µf e)

Ωwd eT Ω−1 (m − µf e) =(m − µf e)

Ω−1 (m − µf e)
wd =
eT Ω−1 (m − µf e)
m, Ω → Return, Covariance of derived portfolio.
, , ..., wwnr )T , ni=1 w
w1 w2
P w1
wd = ( wr wr r
+ wf = 1 i.e wdT e = 1 − wf Equation of capital market
6

line for a portfolio P is

µm − µf
µ= σ + µf
σm
σ
= (µm − µf ) + µf (0.0.1)
σm
=wP µm + (1 − wp )µf (0.0.2)

i.e. if the investment is willing to accept risk σ then he has to invest wp in market
portfolio and (1 − wp ) in risk free assets.

Equation of Security Market line:

(Relation between individual asset and market portfolio) Prove that if M (σm , µm ) is the
market portfolio and A(σ, µ) is an individual asset then

µ = β(µm − µf ) + µf ,

Cov(A,M )
where β = µm
.

Proof:
Consider one risky asset Ai whose expected return is µi and S.D. σi , M is the market
2
portfolio with expected return µm and variance σm . Suppose the investor comprises of
asset Ai with weight w and market portfolio with weight (1 − w). Then expected return
of the investor portfolio is

µ =wµi + (1 − w)µm

σ 2 (w) =w2 σi2 + (1 − w)2 σm

2
+ 2ρw(1 − w)σi σm (0.0.3)

ρ = correlation between the returns of asset Ai and market portfolio.

If w varies then σ 2 (w) traces a non linear curve in µ − σ space. At w = 0, σ =

σm , µ = µm , which corresponds to the capital market point M . At w = 1, σ = σi , µ =
µi , which correspond to the portfolio A
 7

Figure 3: Efficient frontier

dµ
|w=0 =µi − µm
dw
dσ 1
2wσi2 − 2(1 − w)σm 2


|w=0 = + 2ρσi σm − 4wρσi σm w=0
dw 2σ |w=0
2 2
−2σm + 2ρσi σm ρσi σm − σm
= =
2σ(at w = 0) σ
2
σim − σm σim
= , ρ=
σm σi σm
(0.0.4)

d2 σ σi2
|w=0 = (1 − ρ2 ) ≥ 0
dw2 σm
Hence σ 2 (w) passes through capital market point M at w = 0 and Capital Market Line
is tangent to this curve at M .
Slope of the tangent to the curve σ 2 (w) at w = 0 is
 
dµ dµ dw µi − µm
|w=0 = |w=0 = 2
σm
dσ dw dσ σim − σm

Slope of capital market line = Slope of tangent to σ 2 (w) at w = 0. Hence

 
µm − µf µi − µm
= 2
σm
σm σim − σm
8

µm − µf 2
µi − µm = 2
(σim − σm )
σm
 
σim
=(µm − µf ) −1
σi2
 
σim
µi =µm + − 1 (µm − µf )
σi2
σim
µ
µi = m + (µm − µf ) −  µ
m + µf
σi2
σim
µi = 2 (µm − µf ) + µf
σi

σim
Beta ratio(βi ) = σm2 =Risk of ith asset in relation to market risk. In general for any
individual asset A = (σ, µ), this linear equation can be expressed as

µ = β(µm − µf ) + µf

This equation is known as security market line.

 9

OM F − 2018 : T U T ORIAL − −T EST − 1 − −24/08/2018(OP EN BOOK)

**************************************************************************
Class Serial No:
Roll N0:
Name:

Instruction: Questions are fill up the blank type. You have to write code in PYTHON/R/MATLAB/EXC
SOLVER to solve the question. Final out put should be mentioned in the blank space.
Your code will be checked for evaluation. Send your code to [email protected]
before 10 AM today with file name OMFT1yourrollno. Codes received after 10 will not
be evaluated.
Full Mark-10, Time 9-9.40 AM

**************************************************************************
Fill up the asset names in your data set below
Time : From————————–to———————-(monthwise/daywise put tick)
A1 A11
A2 A12
A3 A13
A4 A14
A5 A15
A6 A16
A7 A17
A8 A18
A9 A19
A10 A20
Use this data set to answer the following questions.
Q.1 The variance risk corresponding to the efficient portfolio if total expected return as
10

2%, short selling allowed, is ————————–.

Q.2 Efficient portfolio in Q.2 is——————-. (Fill up this table)
Asset efficient portfolio Asset efficient portfolio
A1 A11
A2 A12
A3 A13
A4 A14
A5 A15
A6 A16
A7 A17
A8 A18
A9 A19
A10 A20

Q3. Trace Markowitz curve and indicate the portfolio point for Q.2(will be evaluated in
soft copy)
Q.4. Suppose you have invested Rs 10000/ according to the efficient portfolio of Q.2 on
01/07/2018. Your profit or loss today is —————————-.
State shortcut calculation process here: