CHAPTER 7 Optimal Risky Portfolios 223

The expected rate of return on a portfolio: E(rp) = wD E(rD) + wE E(rE) KEY EQUATIONS
The variance of the return on a portfolio: ​​σ​ 2p​​​  2 2
= (wD σD) + (wE σE) + 2(wD σD)(wE σE) ρDE
E(rp) − rf
The Sharpe ratio of a portfolio: Sp = ​​  ________
 ​​
σp

Sharpe ratio maximizing portfolio weights with two risky assets (D and E) and a risk-free asset:
​[​​E(rD) − rf ​]​​​σ​  2E ​​  − [​ ​​E(rE) − rf ​]​​σD σE ρDE
wD = ​​  ________________________________________________________
      
       ​​
​[​​E(rD) − rf ​]​​​σ​  E ​​  + [​ ​​E(rE) − rf ​]​​​σ​  2D ​​  − [​ ​​E(rD) − rf + E(rE) − rf ​]​​σD σE ρDE
2

wE = 1 − wD

E(rp) − rf
Optimal capital allocation to the risky asset, y: ​​  ________  ​​
A​σ​  2p​​ 

1. Which of the following factors reflect pure market risk for a given corporation? PROBLEM SETS
a. Increased short-term interest rates.
b. Fire in the corporate warehouse.
c. Increased insurance costs.
d. Death of the CEO.
e. Increased labor costs.
2. When adding real estate to an asset allocation program that currently includes only stocks, bonds,
and cash, which of the properties of real estate returns affect portfolio risk? Explain.
a. Standard deviation.
b. Expected return.
c. Correlation with returns of the other asset classes.
3. Which of the following statements about the minimum-variance portfolio of all risky securities is
valid? (Assume short sales are allowed.) Explain.
a. Its variance must be lower than those of all other securities or portfolios.
b. Its expected return can be lower than the risk-free rate.
c. It may be the optimal risky portfolio.
d. It must include all individual securities.
The following data apply to Problems 4 through 10: A pension fund manager is considering three
mutual funds. The first is a stock fund, the second is a long-term government and corporate bond
fund, and the third is a T-bill money market fund that yields a rate of 8%. The probability distribution
of the risky funds is as follows:
Expected Return Standard Deviation

Stock fund (S) 20% 30%

Bond fund (B) 12 15
The correlation between the fund returns is .10.
4. What are the investment proportions in the minimum-variance portfolio of the two risky funds,
and what is the expected value and standard deviation of its rate of return?
5. Tabulate and draw the investment opportunity set of the two risky funds. Use investment propor-
tions for the stock fund of 0% to 100% in increments of 20%.
6. Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the
expected return and standard deviation of the optimal portfolio?
224 PART II Portfolio Theory and Practice

7. Solve numerically for the proportions of each asset and for the expected return and standard
deviation of the optimal risky portfolio.
8. What is the Sharpe ratio of the best feasible CAL?
9. You require that your portfolio yield an expected return of 14%, and that it be efficient, on the
best feasible CAL.
a. What is the standard deviation of your portfolio?
b. What is the proportion invested in the T-bill fund and each of the two risky funds?
10. If you were to use only the two risky funds, and still require an expected return of 14%, what
would be the investment proportions of your portfolio? Compare its standard deviation to that of
the optimized portfolio in Problem 9. What do you conclude?
11. Stocks offer an expected rate of return of 18%, with a standard deviation of 22%. Gold offers an
expected return of 10% with a standard deviation of 30%.
a. In light of the apparent inferiority of gold with respect to both mean return and volatility,
would anyone hold gold? If so, demonstrate graphically why one would do so.
b. Given the data above, reanswer (a) with the additional assumption that the correlation
coefficient between gold and stocks equals 1. Draw a graph illustrating why one would or
would not hold gold in one’s portfolio.
c. Could the set of assumptions in part (b) for expected returns, standard deviations, and
correlation represent an equilibrium for the security market?
12. Suppose that there are many stocks in the security market and that the characteristics of stocks
A and B are given as follows:
Stock Expected Return Standard Deviation

A 10% 5%
B 15 10
Correlation = −1
Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the risk-
free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B.)
13. True or false: Assume that expected returns and standard deviations for all securities (including
the risk-free rate for borrowing and lending) are known. In this case, all investors will have the
same optimal risky portfolio.
14. True or false: The standard deviation of the portfolio is always equal to the weighted average of
the standard deviations of the assets in the portfolio.
15. Suppose you have a project that has a .7 chance of doubling your investment in a year and a .3
chance of halving your investment in a year. What is the standard deviation of the rate of return
on this investment?
16. Suppose that you have $1 million and the following two opportunities from which to construct
a portfolio:
a. Risk-free asset earning 12% per year.
b. Risky asset with expected return of 30% per year and standard deviation of 40%.
If you construct a portfolio with a standard deviation of 30%, what is its expected rate of return?
The following data are for Problems 17 through 19: The correlation coefficients between several
pairs of stocks are as follows: Corr(A, B) = .85; Corr(A, C) = .60; Corr(A, D) = .45. Each stock has
an expected return of 8% and a standard deviation of 20%.
17. If your entire portfolio is now composed of stock A and you can add some of only one stock to
your portfolio, would you choose (explain your choice):
a. B
b. C
c. D
d. Need more data
 CHAPTER 7 Optimal Risky Portfolios 225

18. Would the answer to Problem 17 change for more risk-averse or risk-tolerant investors? Explain.
19. Suppose that in addition to investing in one more stock you can invest in T-bills as well. Would
you change your answers to Problems 17 and 18 if the T-bill rate is 8%?
The following table of compound annual returns by decade applies to Problems 20 and 21.
1920s* 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s
Small-company stocks −3.72% 7.28% 20.63% 19.01% 13.72% 8.75% 12.46% 13.84% 6.70%
Large-company stocks 18.36 −1.25 9.11 19.41 7.84 5.90 17.60 18.20 −1.00
Long-term gov’t bonds 3.98 4.60 3.59 0.25 1.14 6.63 11.50 8.60 5.00
Treasury bills 3.56 0.30 0.37 1.87 3.89 6.29 9.00 5.02 2.70
Inflation −1.00 −2.04 5.36 2.22 2.52 7.36 5.10 2.93 2.50
*Based on the period 1926–1929.

20. Input the data from the table into a spreadsheet. Compute the serial correlation in decade returns
for each asset class and for inflation. Also find the correlation between the returns of various
asset classes. What do the data indicate?
21. Convert the asset returns by decade presented in the table into real rates. Repeat the analysis of
Problem 20 for the real rates of return.
The following information applies to Problems 22 through 27: Greta, an elderly investor, has a
degree of risk aversion of A = 3 when applied to return on wealth over a one-year horizon. She is
pondering two portfolios, the S&P 500 and a hedge fund, as well as a number of one-year strategies.
(All rates are annual and continuously compounded.) The S&P 500 risk premium is estimated at 5%
per year, with a SD of 20%. The hedge fund risk premium is estimated at 10% with a SD of 35%. The
returns on both of these portfolios in any particular year are uncorrelated with its own returns in other
years. They are also uncorrelated with the returns of the other portfolio in other years. The hedge
fund claims the correlation coefficient between the annual return on the S&P 500 and the hedge fund
return in the same year is zero, but Greta is not fully convinced by this claim.
22. Compute the estimated annual risk premiums, SDs, and Sharpe ratios for the two portfolios.
23. Assuming the correlation between the annual returns on the two portfolios is indeed zero, what
would be the optimal asset allocation?
24. What should be Greta’s capital allocation?
25. If the correlation coefficient between annual portfolio returns is actually .3, what is the covari-
ance between the returns?
26. Repeat Problem 23 using an annual correlation of .3.
27. Repeat Problem 24 using an annual correlation of .3.

The following data apply to CFA Problems 1 through 3: Hennessy & Associates manages a
$30 million equity portfolio for the multimanager Wilstead Pension Fund. Jason Jones, financial
vice president of Wilstead, noted that Hennessy had rather consistently achieved the best record
among the Wilstead’s six equity managers. Performance of the Hennessy portfolio had been clearly
superior to that of the S&P 500 in four of the past five years. In the one less-favorable year, the
shortfall was trivial.
Hennessy is a “bottom-up” manager. The firm largely avoids any attempt to “time the market.”
It also focuses on selection of individual stocks, rather than the weighting of favored industries.
There is no apparent conformity of style among Wilstead’s six equity managers. The five manag-
ers, other than Hennessy, manage portfolios aggregating $250 million made up of more than 150
individual issues.
Jones is convinced that Hennessy is able to apply superior skill to stock selection, but the
favorable returns are limited by the high degree of diversification in the portfolio. Over the years,
the portfolio generally held 40–50 stocks, with about 2%–3% of total funds committed to each issue.
226 PART II Portfolio Theory and Practice

The reason Hennessy seemed to do well most years was that the firm was able to identify each year
10 or 12 issues that registered particularly large gains.
On the basis of this overview, Jones outlined the following plan to the Wilstead pension
committee:
Let’s tell Hennessy to limit the portfolio to no more than 20 stocks. Hennessy will double the
commitments to the stocks that it really favors, and eliminate the remainder. Except for this
one new restriction, Hennessy should be free to manage the portfolio exactly as before.
All the members of the pension committee generally supported Jones’s proposal because all
agreed that Hennessy had seemed to demonstrate superior skill in selecting stocks. Yet the pro-
posal was a considerable departure from previous practice, and several committee members raised
questions. Respond to each of the following questions.
1. a. Will the limitation to 20 stocks likely increase or decrease the risk of the portfolio? Explain.
b. Is there any way Hennessy could reduce the number of issues from 40 to 20 without signifi-
cantly affecting risk? Explain.
2. One committee member was particularly enthusiastic concerning Jones’s proposal. He suggested
that Hennessy’s performance might benefit further from reduction in the number of issues to 10.
If the reduction to 20 could be expected to be advantageous, explain why reduction to 10 might
be less likely to be advantageous. (Assume that Wilstead will evaluate the Hennessy portfolio
independently of the other portfolios in the fund.)
3. Another committee member suggested that, rather than evaluate each managed portfolio indepen-
dently of other portfolios, it might be better to consider the effects of a change in the Hennessy
portfolio on the total fund. Explain how this broader point of view could affect the committee
decision to limit the holdings in the Hennessy portfolio to either 10 or 20 issues.
4. Which one of the following portfolios cannot lie on the efficient frontier as described by
Markowitz?

Portfolio Expected Return (%) Standard Deviation (%)

a. W 15 36
b. X 12 15
c. Z 5 7
d. Y 9 21

5. Which statement about portfolio diversification is correct?

a. Proper diversification can reduce or eliminate systematic risk.
b. Diversification reduces the portfolio’s expected return because it reduces a portfolio’s total
risk.
c. As more securities are added to a portfolio, total risk typically can be expected to fall at a
decreasing rate.
d. The risk-reducing benefits of diversification do not occur meaningfully until at least 30
individual securities are included in the portfolio.
6. The measure of risk for a security held in a diversified portfolio is:
a. Specific risk.
b. Standard deviation of returns.
c. Reinvestment risk.
d. Covariance.
7. Portfolio theory as described by Markowitz is most concerned with:
a. The elimination of systematic risk.
b. The effect of diversification on portfolio risk.
c. The identification of unsystematic risk.
d. Active portfolio management to enhance return.
 CHAPTER 7 Optimal Risky Portfolios 227

8. Assume that a risk-averse investor owning stock in Miller Corporation decides to add the stock
of either Mac or Green Corporation to her portfolio. All three stocks offer the same expected
return and total variability. The correlation of return between Miller and Mac is −.05 and
between Miller and Green is +.05. Portfolio risk is expected to:
a. Decline more when the investor buys Mac.
b. Decline more when the investor buys Green.
c. Increase when either Mac or Green is bought.
d. Decline or increase, depending on other factors.
9. Stocks A, B, and C have the same expected return and standard deviation. The following table
shows the correlations between the returns on these stocks.
Stock A Stock B Stock C

Stock A +1.0
Stock B +0.9 +1.0
Stock C +0.1 −0.4 +1.0
Given these correlations, the portfolio constructed from these stocks having the lowest risk is a
portfolio:
a. Equally invested in stocks A and B.
b. Equally invested in stocks A and C.
c. Equally invested in stocks B and C.
d. Totally invested in stock C.
10. Statistics for three stocks, A, B, and C, are shown in the following tables.
Standard Deviations of Returns

Stock: A B C

Standard deviation (%): 40 20 40

Correlations of Returns

Stock A B C

A 1.00 0.90 0.50

B 1.00 0.10
C 1.00
Using only the information provided in the tables, and given a choice between a portfolio made
up of equal amounts of stocks A and B or a portfolio made up of equal amounts of stocks B and
C, which portfolio would you recommend? Justify your choice.
11. George Stephenson’s current portfolio of $2 million is invested as follows:
Summary of Stephenson’s Current Portfolio

Percent of Expected Annual Annual Standard

Value Total Return Deviation

Short-term bonds $ 200,000 10% 4.6% 1.6%

Domestic large-cap equities 600,000 30 12.4 19.5
Domestic small-cap equities 1,200,000 60 16.0 29.9
Total portfolio $2,000,000 100% 13.8 23.1
Stephenson soon expects to receive an additional $2 million and plans to invest the entire
amount in an index fund that best complements the current portfolio. Stephanie Coppa, CFA, is
evaluating the four index funds shown in the following table for their ability to produce a portfo-
lio that will meet two criteria relative to the current portfolio: (1) maintain or enhance expected
return and (2) maintain or reduce volatility.
228 PART II Portfolio Theory and Practice

  Each fund is invested in an asset class that is not substantially represented in the current
portfolio.
Index Fund Characteristics

Expected Annual Correlation of Returns

Index Fund Expected Annual Return Standard Deviation with Current Portfolio

Fund A 15% 25% +0.80

Fund B 11 22 +0.60
Fund C 16 25 +0.90
Fund D 14 22 +0.65

Which fund should Coppa recommend to Stephenson? Justify your choice by describing how
your chosen fund best meets both of Stephenson’s criteria. No calculations are required.
12. Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC Com-
pany common stock worth $100,000. Her financial adviser provided her with the following
forecast information:
Risk and Return Characteristics

Expected Monthly Standard Deviation of

Returns Monthly Returns

Original Portfolio 0.67% 2.37%

ABC Company 1.25 2.95

The correlation coefficient of ABC stock returns with the original portfolio returns is .40.
a. The inheritance changes Grace’s overall portfolio, and she is deciding whether to keep the
ABC stock. Assuming Grace keeps the ABC stock, calculate the:
i. Expected return of her new portfolio, which includes the ABC stock.
ii. Covariance of ABC stock returns with the original portfolio returns.
iii. Standard deviation of her new portfolio, which includes the ABC stock.
b. If Grace sells the ABC stock, she will invest the proceeds in risk-free government securi-
ties yielding .42% monthly. Assuming Grace sells the ABC stock and replaces it with the
government securities, calculate the
i. Expected return of her new portfolio, which includes the government securities.
ii. Covariance of the government security returns with the original portfolio returns.
iii. Standard deviation of her new portfolio, which includes the government securities.
c. Determine whether the systematic risk of her new portfolio, which includes the government
securities, will be higher or lower than that of her original portfolio.
d. On the basis of conversations with her husband, Grace is considering selling the $100,000
of ABC stock and acquiring $100,000 of XYZ Company common stock instead. XYZ
stock has the same expected return and standard deviation as ABC stock. Her husband
comments, “It doesn’t matter whether you keep all of the ABC stock or replace it with
$100,000 of XYZ stock.” State whether her husband’s comment is correct or incorrect.
Justify your response.
e. In a recent discussion with her financial adviser, Grace commented, “If I just don’t lose
money in my portfolio, I will be satisfied.” She went on to say, “I am more afraid of losing
money than I am concerned about achieving high returns.”
i. Describe one weakness of using standard deviation of returns as a risk measure
for Grace.
ii. Identify an alternate risk measure that is more appropriate under the circumstances.
13. Dudley Trudy, CFA, recently met with one of his clients. Trudy typically invests in a master list
of 30 equities drawn from several industries. As the meeting concluded, the client made the fol-
lowing statement: “I trust your stock-picking ability and believe that you should invest my funds
in your five best ideas. Why invest in 30 companies when you obviously have stronger opinions
 CHAPTER 7 Optimal Risky Portfolios 229

on a few of them?” Trudy plans to respond to his client within the context of modern portfolio
theory.
a. Contrast the concepts of systematic risk and firm-specific risk, and give an example of each
type of risk.
b. Critique the client’s suggestion. Discuss how both systematic and firm-specific risk change
as the number of securities in a portfolio is increased.

E-INVESTMENTS EXERCISES
Go to the www.investopedia.com/articles/basics/03/050203.asp Web site to learn more about
diversification, the factors that influence investors’ risk preferences, and the types of invest-
ments that fit into each of the risk categories. Then check out www.investopedia.com/articles/
pf/05/061505.asp for asset allocation guidelines for various types of portfolios from conserva-
tive to very aggressive. What do you conclude about your own risk preferences and the best
portfolio type for you? What would you expect to happen to your attitude toward risk as you get
older? How might your portfolio composition change?

SOLUTIONS TO CONCEPT CHECKS

1. a. The first term will be w​  ​​ D​​ × ​w​  D​​ × ​σ​  2D ​​​  because this is the element in the top corner of the
matrix ​(​σ​  2D ​ ​  )​times the term on the column border (wD) times the term on the row border (wD).
Applying this rule to each term of the covariance matrix results in the sum
 ​​w​  2D ​ ​​  σ​  2D ​​  + ​w​  D​​ ​w​  E​​ Cov​​(​​​r​  E​​, ​r​  D)​​​ ​​​ + ​w​  E​​​w​  D​​ Cov​​(​​​r​  D​​, ​r​  E)​​​ ​​​ + ​w​  2E ​ ​​  σ​  2E ​​​ , which is the same as Equation 7.3,
because Cov(rE, rD) = Cov(rD, rE).
b. The bordered covariance matrix is

wX wY wZ
wX ​​σ​  2X​​​  Cov(rX, rY) Cov(rX, rZ)
wY Cov(rY, rX ) ​​σ​  2Y​​​  Cov(rY, rZ)
wZ Cov(rZ, rX ) Cov(rZ, rY ) ​​σ​  2Z​ ​​

There are nine terms in the covariance matrix. Portfolio variance is calculated from these nine
terms:
​​σ​  2P​​​  = ​​w​  2X​​ ​​​  σ​  2X​​​  + ​​w​  2Y​​ ​​​  σ​  2Y​​​  + ​​w​  2Z​​ ​​​  σ​  2Z​​​ 
+ wXwY Cov(rX, rY) + wY wX Cov(rY, rX)
+ wX wZ Cov(rX, rZ) + wZ wX Cov(rZ, rX)
+ wY wZ Cov(rY, rZ) + wZ wY Cov(rZ, rY)
= ​​w​  2X​​ ​​​  σ​  2X​​​  + ​​w​  2Y​​ ​​​  σ​  2Y​​​  + ​​w​  2Z​​ ​​​  σ​  2Z​​​ 
+ 2 wX wY Cov(rX, rY) + 2 wX wZ Cov(rX, rZ) + 2 wY wZ Cov(rY, rZ )
2. The parameters of the opportunity set are E(rD) = 8%, E(rE) = 13%, σD = 12%, σE = 20%,
and ρ(D,E) = .25. From the standard deviations and the correlation coefficient, we generate the
covariance matrix:

Fund D E

D 144 60
E 60 400
230 PART II Portfolio Theory and Practice

The global minimum-variance portfolio is constructed so that

​σ​  2E​​  − Cov(rD, rE)
wD = ____________________
​​   
    ​​
​σ​  2D​​  + ​σ​  2E​​  − 2 Cov(rD, rE)
400 − 60
= ___________________
  
​​     ​​ = .8019
(144 + 400) − (2 × 60)
wE = 1 − wD = .1981
Its expected return and standard deviation are
E(rP) = (.8019 × 8) + (.1981 × 13) = 8.99%
σP = ​​[​​​​​w​  2D​​ ​​​  σ​  2D​​​  + ​​w​  2E​​ ​​​  σ​  2E​​​  + 2 wD wE Cov(rD, rE)​​]1/2
​​​
= ​​[​​​(.80192 × 144) + (.19812 × 400) + (2 × .8019 × .1981 × 60)​​]1/2
​​​
= 11.29%
For the other points we simply increase wD from .10 to .90 in increments of .10; accordingly, wE ranges
from .90 to .10 in the same increments. We substitute these portfolio proportions in the formulas for
expected return and standard deviation. Note that when wE = 1.0, the portfolio parameters equal
those of the stock fund; when wD = 1, the portfolio parameters equal those of the debt fund.
We thus generate the following table:
wE wD E (r ) σ

0.0 1.0 8.0 12.00

0.1 0.9 8.5 11.46
0.2 0.8 9.0 11.29
0.3 0.7 9.5 11.48
0.4 0.6 10.0 12.03
0.5 0.5 10.5 12.88
0.6 0.4 11.0 13.99
0.7 0.3 11.5 15.30
0.8 0.2 12.0 16.76
0.9 0.1 12.5 18.34
1.0 0.0 13.0 20.00
0.1981 0.8019 8.99 11.29 minimum variance portfolio
You can now draw your graph.
3. a. The computations of the opportunity set of the stock and risky bond funds are like those of
Question 2 and will not be shown here. You should perform these computations, however, in
order to give a graphical solution to part a. Note that the covariance between the funds is
Cov(rA, rB) = ρ(A, B) × σA × σB
= −.2 × 20 × 60 = −240
b. The proportions in the optimal risky portfolio are given by
(10 − 5)602 − (30 − 5)(−240)
wA = ________________________________
​​     
     ​​
(10 − 5)602 + (30 − 5)202 − 30(−240)
= .6818
wB = 1 − wA = .3182
The expected return and standard deviation of the optimal risky portfolio are
E(rP) = (.6818 × 10) + (.3182 × 30) = 16.36%
σP = ​​{(.68182 × 202) + (.31822 × 602) + [​ ​​2 × .6818 × .3182( − 240)​]​​}1/2
​​
= 21.13%
 CHAPTER 7 Optimal Risky Portfolios 231

Note that portfolio P is not the global minimum-variance portfolio. The proportions of the
latter are given by
602 − (−240)
__________________
wA =   
​​      ​​ = .8571
602 + 202 − 2(−240)
wB = 1 − wA = .1429
With these proportions, the standard deviation of the minimum-variance portfolio is
σ(min) = (.85712 × 202) + (.14292 × 602) + [​​ ​​​2 × .8571 × .1429 × (−240)​​]​​​1/2
= 17.75%
which is less than that of the optimal risky portfolio.
c. The CAL is the line from the risk-free rate through the optimal risky portfolio. This line
represents all efficient portfolios that combine T-bills with the optimal risky portfolio.
The slope of the CAL is
E(rP) − rf _________
16.36 − 5
S = ​​ ________
 ​​ = ​​   ​​ = .5376
σP 21.13
d. Given a degree of risk aversion, A, an investor will choose the following proportion, y, in the
optimal risky portfolio (remember to express returns as decimals when using A):
E(rP) − rf __________ .1636 − .05
y = ​​ ________  ​​ = ​​   ​​ = .5089
A ​σ​  2P​​  5 × .21132
This means that the optimal risky portfolio, with the given data, is attractive enough for an investor
with A = 5 to invest 50.89% of his or her wealth in it. Because stock A makes up 68.18% of the
risky portfolio and stock B makes up 31.82%, the investment proportions for this investor are
Stock A: .5089 × 68.18 = 34.70%
Stock B: .5089 × 31.82 = 16.19%
Total          50.89%
4. Efficient frontiers derived by portfolio managers depend on forecasts of the rates of return on
various securities and estimates of risk, that is, the covariance matrix. The forecasts themselves
do not control outcomes. Thus preferring managers with rosier forecasts (northwesterly frontiers)
is tantamount to rewarding the bearers of good news and punishing the bearers of bad news.
What we should do is reward bearers of accurate news. Thus, if you get a glimpse of the frontiers
(forecasts) of portfolio managers on a regular basis, what you want to do is develop the track
record of their forecasting accuracy and steer your advisees toward the more accurate forecaster.
Their portfolio choices will, in the long run, outperform the field.
5. The parameters are E(r) = 15, σ = 60, and the correlation between any pair of stocks is ρ = .5.
a. The portfolio expected return is invariant to the size of the portfolio because all stocks have
identical expected returns. The standard deviation of a portfolio with n = 25 stocks is
σP = ​​[​​​σ2 / n + ρ × σ2(n − 1) / n​​]1/2
​​​
= [602 / 25 + .5 × 602 × 24 / 25]1/2 = 43.27%

b. Because the stocks are identical, efficient portfolios are equally weighted. To obtain a standard
deviation of 43%, we need to solve for n:
602 602(n − 1)
432 = ___
​​   ​​ + .5 × _________
​​   ​​
n n
1,849n = 3,600 + 1,800n − 1,800
1,800
n = _____
​​   ​​ = 36.73
49
Thus we need 37 stocks and will come in with volatility slightly under the target.
232 PART II Portfolio Theory and Practice

c. As n gets very large, the variance of an efficient (equally weighted) portfolio diminishes,
leaving only the variance that comes from the covariances among stocks. Therefore,
______ _______
Systematic standard deviation = √
​​ ρ × σ2 ​​ = √
​​ .5 × 602 ​​ = 42.43%
Note that with 25 stocks we came within .84% of the systematic risk, that is, the standard
deviation of a portfolio of 25 stocks is only .84% higher than 42.43%. With 37 stocks, the
standard deviation is 43.01%, which is only .58% greater than 42.43%.
d. If the risk-free is 10%, then the risk premium on any size portfolio is 15 − 10 = 5%.
The standard deviation of a well-diversified portfolio is (practically) 42.43%; hence the slope
of the CAL is
S = 5 / 42.43 = .1178

APPENDIX A: A Spreadsheet Model for Efficient Diversification

Several software packages can be used to generate the efficient frontier. We will dem-
onstrate the method using Microsoft Excel. Excel is far from the best program for this
purpose and is limited in the number of assets it can handle, but working through a simple
portfolio optimizer in Excel can illustrate concretely the nature of the calculations used in
more sophisticated “black-box” programs. You will find that even in Excel, the computa-
tion of the efficient frontier is not difficult.
We apply the Markowitz portfolio optimization program to the problem of interna-
tional diversification. We take the perspective of a portfolio manager serving U.S. clients,
who wishes to construct for the next year an optimal risky portfolio of large stocks in the
U.S. and six developed capital markets (Japan, Germany, the U.K., France, Canada, and
Australia). First we describe the input list: forecasts of risk premiums and the covariance
matrix. Next, we describe Excel’s Solver, and finally we show the solution to the man-
ager’s problem.

The Input List

The manager needs to compile an input list of expected returns, variances, and covariances
to compute an efficient frontier and the optimal risky portfolio. Spreadsheet 7A.1 shows
the calculations.
Panel A lays out the expected excess return for each country index. While these esti-
mates may be guided by historical experience, as we discussed in Chapter 5, using simple
historical averages would yield extremely noisy estimates of expected risk premiums
because returns are so variable over time. Average returns fluctuate enormously across
subperiods, making historical averages highly unreliable estimators. Here, we simply
assume the manager has arrived at some reasonable estimates of each country’s risk pre-
mium through scenario analysis informed by historical experience. These values are pre-
sented in column B.
Panel B is the bordered covariance matrix corresponding to Table 7.2 earlier in the
chapter. The covariances in this table might reasonably be estimated from a sample of
historical returns, as empirically based variance and covariance estimates are far more
precise than corresponding estimates of mean returns. It would be common to estimate
Panel B using perhaps five years of monthly returns. The Excel function COVARIANCE
would compute the covariance between the time series of returns for any pair of coun-
tries. We assume the manager has already collected historical returns on each index,
plugged each pair of returns into the COVARIANCE function, and obtained the entries
that appear in Panel B. The elements on the diagonal of the covariance matrix in Panel B