BMAN20072 Investment Analysis
Week 2-1: Optimal Risky Portfolios
BKM Ch. 7.1 – 7.3
Overview
• How to design an optimal portfolio?
– Capital allocation
• How to optimally allocate capital between risk-free
and risky assets? [week 1]
– Asset allocation
• How to optimally allocate budget across risky
assets? [this video]
• What you will do in the coursework “Portfolio
Choice Assignment” is Asset Allocation.
1
Key terms
• Diversification
• Optimal risky portfolio v. Optimal complete
portfolio
– Asset allocation v. Capital allocation
– Capital allocation line (CAL), Sharpe ratio
• Separation property
• Portfolio opportunity set
2
Portfolios of Two Risky Assets
Long-term debt security, D, and equity, E.
• The rate of return of this portfolio:
𝑟𝑃 = 𝑤𝐷 𝑟𝐷 + 𝑤𝐸 𝑟𝐸
𝑟𝐷 : return on the debt security
𝑟𝐸 : return on the equity
𝑤𝐷 : proportion invested in debt security
𝑤𝐸 : proportion invested in equity
• Expected return: 𝐸(𝑟𝑃 ) = 𝑤𝐷 𝐸 𝑟𝐷 + 𝑤𝐸 𝐸 𝑟𝐸
• Variance: 𝜎𝑃2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
3
Benefit of Diversification
• Covariance:
𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸 = 𝐸 𝑟𝐷 − 𝐸 𝑟𝐷 𝑟𝐸 − 𝐸 𝑟𝐸
= 𝐸 𝑟𝐷 𝑟𝐸 − 𝐸 𝑟𝐷 𝐸 𝑟𝐸
It is closely related to the correlation coefficient,
𝜌𝐷𝐸 :
𝐶𝑜𝑣 𝑟𝐷 ,𝑟𝐸
𝜌𝐷𝐸 = , −1 ≤ 𝜌𝐷𝐸 ≤ 1
𝜎𝐷 𝜎𝐸
𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 ) = 𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
4
Benefit of Diversification
• Variance:
𝜎𝑃2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝜎𝐷 𝜎𝐸 𝜌𝐷𝐸
• If 𝜌𝐷𝐸 = 1,
𝜎𝑃2 = 𝑤𝐷 𝜎𝐷 + 𝑤𝐸 𝜎𝐸 2 or 𝜎𝑃 = 𝑤𝐷 𝜎𝐷 + 𝑤𝐸 𝜎𝐸
• If 𝜌𝐷𝐸 = −1,
𝜎𝑃2 = 𝑤𝐷 𝜎𝐷 − 𝑤𝐸 𝜎𝐸 2
or 𝜎𝑃 = 𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 (𝑤𝐷 𝜎𝐷 − 𝑤𝐸 𝜎𝐸 )
• If −1 < 𝜌𝐷𝐸 < 1,
𝜎𝑃2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝜎𝐷 𝜎𝐸 × 𝜌𝐷𝐸
< 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝜎𝐷 𝜎𝐸 × 1
5
Benefit of Diversification
• Portfolios of less than perfectly correlated assets
always offer some degree of diversification
benefit.
6
Optimal Risky Portfolio
• What is an optimal risky portfolio?
• Optimal complete portfolio for an investor
maximizes her utility level. [Capital allocation;
Week 1 video]
– It depends on risk averse coefficient, A.
• Risk averse level does NOT matter for optimal
risky portfolio construction.
– Separation Property
7
Optimal Risky Portfolio
• A risky portfolio is optimal when:
– It offers the highest reward to risk (or reward
to volatility) ratio among the feasible
portfolios.
– The Sharpe ratio is maximized.
• Sharpe ratio:
𝐸 𝑟𝑃 − 𝑟𝑓
𝑆𝑃 =
𝜎𝑃
8
Separation Property
• All clients use same optimal risky portfolio as
their investment vehicle regardless of their risk
aversion level.
• More risk averse client will invest more in the
risk-free asset and less in risky asset.
• Optimal complete portfolio reflects clients’ risk
aversion level, but optimal risky portfolio does
not.
• Risky portfolio managers can design their
optimal portfolio without considering clients’ risk
aversion level. 9
Optimal Risky Portfolio
• Solve the maximization problem:
𝐸 𝑟𝑃 − 𝑟𝑓
max 𝑆𝑃 =
𝑤𝐷 𝜎𝑃
subject to 𝑤𝐷 + 𝑤𝐸 = 1.
• Solution for two risky assets case:
2
∗
𝐸 𝑅𝐷 𝐸 − 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝜎
𝑤𝐷 =
𝐸 𝑅𝐷 𝜎𝐸2 + 𝐸 𝑅𝐸 𝜎𝐷2 − 𝐸 𝑅𝐷 + 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐸∗ = 1 − 𝑤𝐷∗
where R is excess return.
10
Two risky assets
11
Expected Return and Weights
12
Standard Deviation and Weights
13
Portfolio Opportunity Set
14
Optimal Risky Portfolio
• Optimal Sharpe ratio
∗
∗
𝐸 𝑟𝑃 − 𝑟𝑓
𝑆𝑃 =
𝜎𝑃 ∗
where 𝐸 𝑟𝑃 ∗ = 𝑤𝐷∗ 𝐸 𝑟𝐷 + 𝑤𝐸∗ 𝐸 𝑟𝐸
𝜎𝑃 ∗ = 𝑤𝐷∗2 𝜎𝐷2 + 𝑤𝐸∗2 𝜎𝐸2 + 2𝑤𝐷∗ 𝑤𝐸∗ 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
• Markowitz procedure is the generalised version
of this process. 15
Optimal CAL
• Optimal Capital Allocation Line (CAL)
𝜎𝐶
𝐸 𝑟𝐶 = 𝑟𝑓 + ∗ 𝐸(𝑟𝑃 )∗ − 𝑟𝑓
𝜎𝑃
= 𝑟𝑓 + 𝑆𝑃∗ 𝜎𝐶
• In Capital Allocation, we implicitly assumed that
the Asset Allocation is already done, and we are
working with this optimal CAL.
16
Optimal Complete Portfolio
1. Specify the return characteristics of all securities
(expected returns, variances, covariances).
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio.
b. Calculate the properties of risky portfolio using the
weights determined in step a.
3. Allocate funds between the risky portfolio and the risk-
free asset (capital allocation):
a. Calculate the fraction of the complete portfolio
allocated to risky portfolio and to risk-free asset.
b. Calculate the share of the complete portfolio
invested in each risky asset and in risk free asset.
17
Optimal Risky Portfolio
18
Optimal Risky Portfolio
19
Optimal Risky Portfolio and
Optimal Complete Portfolio
20
Optimal Risky Portfolio and
Optimal Complete Portfolio
21
Optimal Complete Portfolio
60% to Stocks
40% to Bonds
Risk aversion: A = 4
22
Key terms and formulas
• Capital Allocation Line (CAL)
𝜎𝐶
𝐸 𝑟𝐶 = 𝑟𝑓 + 𝐸(𝑟𝑃 ) − 𝑟𝑓
𝜎𝑃
= 𝑟𝑓 + 𝑆𝑃 𝜎𝐶
• Sharpe ratio
𝐸 𝑟𝑃 − 𝑟𝑓
𝑆𝑃 =
𝜎𝑃
• Two assets risky portfolio:
– Expected return: 𝐸(𝑟𝑃 ) = 𝑤𝐷 𝐸 𝑟𝐷 + 𝑤𝐸 𝐸 𝑟𝐸
– Variance: 𝜎𝑃2 = 𝑤𝐷2 𝜎𝐷2 + 𝑤𝐸2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
– Covariance: 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 ) = 𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
23
Key terms and formulas
• Optimum asset allocation for two risky assets case:
𝐸 𝑅𝐷 𝜎𝐸2 − 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐷 =
𝐸 𝑅𝐷 𝜎𝐸2 + 𝐸 𝑅𝐸 𝜎𝐷2 − 𝐸 𝑅𝐷 + 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐸 = 1 − 𝑤𝐷
• Diversification
• Separation property
• Portfolio opportunity set
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