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Investment Analysis and Portfolio Management: Gareth Myles

This document discusses the efficient frontier for portfolio analysis. It defines an efficient portfolio as one with the maximum return for a given level of risk, or minimum risk for a given return. The efficient frontier is the set of portfolios that cannot be dominated by another portfolio with higher return and equal or lower risk. The document examines the efficient frontier for two-asset portfolios under different assumptions about the assets' correlation and whether short sales are allowed. It shows that the frontier is a straight line for perfectly positively or negatively correlated assets, and curved otherwise. Introducing a risk-free borrowing and lending option extends the frontier to a new straight line.

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70 views26 pages

Investment Analysis and Portfolio Management: Gareth Myles

This document discusses the efficient frontier for portfolio analysis. It defines an efficient portfolio as one with the maximum return for a given level of risk, or minimum risk for a given return. The efficient frontier is the set of portfolios that cannot be dominated by another portfolio with higher return and equal or lower risk. The document examines the efficient frontier for two-asset portfolios under different assumptions about the assets' correlation and whether short sales are allowed. It shows that the frontier is a straight line for perfectly positively or negatively correlated assets, and curved otherwise. Introducing a risk-free borrowing and lending option extends the frontier to a new straight line.

Uploaded by

hoalongkiem
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Investment Analysis and

Portfolio Management
Lecture 4
Gareth Myles
Efficiency
 An efficient investor will choose the portfolio
with the maximum return for a given level of
risk
 Or the minimum risk for a given return
 Any other choice is inefficient
 To explore this idea it is necessary to
determine the frontier of efficient portfolios
 The set of portfolios with maximum return for given
risk
Two-Asset Portfolios
 Consider a portfolio composed of two assets A
and B
 The expected return on the portfolio is
rp  X ArA  X B rB
 The standard deviation of return is


 p  X   X   2 X A X B  AB A B
2
A
2
A
2
B
2
B 
12

 The relationship between return and standard


deviation is now derived
No Short Sales
 Assume initially that there are no short sales
 The holdings of both assets must be non-
negative
 This implies the asset proportions satisfy
X A  0, X B  0, X A  X B  1
 Now consider the standard deviation for
various values of the correlation coefficient
 1   AB  1
Perfect Positive Correlation
 Case 1: Perfect positive correlation
 AB  1
 The standard deviation becomes


 p  X   X   2 X A X B A B
2
A
2
A
2
B
2
B 12

 The term in the bracket is a perfect square


No Short Sales

 Taking the square root


 p  X A A  X B B
 The return is
rp  X A rA  X B rB
 This pair of equations determine a linear
relation between expected return and standard
deviation
 The trade-off between risk and return is
described by a straight line
Perfect Positive Correlation
 An example
Expected return % Standard
deviation %
Allied Motors 14 6
Brown Engineers 8 3
 This gives the linear relations
 p  X A 6  X B 3  X A 6  1  X A 3  3  3 X A
rp  X A14  X B 8  X A14  1  X A 8  8  6 X A
Perfect Positive Correlation
rP
A (XA = 1, XB = 0)
14

8
B (XA = 0, XB = 1)

3 6 P
Perfect Negative Correlation
 Case 2: Perfect negative correlation  AB  1

 p  X   X   2 X A X B A B
2
A
2
A
2
B
2
B 
12

 This equation has two solutions


1.  p  X A A  X B B
2.  p   X A A  X B B
 For the example
rp  8  6 X A
 p  6 X A  31  X A , p  6 X A  31  X A 
Perfect Negative Correlation
1
 Notice that at X A  ,  p  0
3
 The existence of a portfolio with zero risk is a
general property when
 AB  1
 Notice also that
 p  0  X A A  1  X A  B  0
 So B
XA 
A B
Perfect Negative Correlation
Efficient
rP
A (XA = 1, XB = 0)
14

8
B (XA = 0, XB = 1)

Inefficient

3 6 P
Intermediate Values
 Case 3: 1   AB  1

 In the intermediate case the frontier must lie


between that for the two extremes
 It must be curved with no straight segments
Intermediate Values
Efficient
rP
A (XA = 1, XB = 0)
14

Minimum
rMVP variance
portfolio
8
B (XA = 0, XB = 1)

Inefficient

 MVP 3 6 P
Minimum Variance Portfolio
 Note that for every value of  AB there is a
portfolio with minimum variance
 This is the one furthest to the left.
 It is found be choosing X A to minimize

 p  X   1  X A    2 X A 1  X A   AB A B
2 2
A A
2 2
B 
12

 Taking the first-order condition and solving


gives
 B   A B  AB
2
XA  2
 A   B2  2 A B  AB
An Example
Tesco Sainsbury
Price Return Price Return
410.8 0.005655 328.9 -0.00303
408.49 0.022247 329.9 0.015077
399.6 0.063049 325 0.023622
375.9 0.023275 317.5 0.014377
367.35 0.038886 313 0.008864
353.6 -0.03097 310.25 -0.06127
364.9 0.082147 330.5 0.055911
337.2 0.011398 313 -0.00714
333.4 0.0006 315.25 -0.0533
333.2 -0.06979 333 0.013699
358.2 -0.005 328.5 0.144599
360 0.219099 287 0.015929
295.3 -0.12994 282.5 -0.18822
339.4 -0.12436 348 0.000719
387.6 0.01599 347.75 0.102219
381.5 0.058546 315.5 -0.00864
360.4 -0.0241 318.25 -0.0868
369.3 -0.10819 348.5 -0.09126
414.1 -0.03473 383.5 0.118076
429 343

rbt 0.000727 rbs 0.000707


sigmat 0.080556 sigmas 0.077441
corr 0.392065
An Example
_
rp

p
The Efficient Frontier
 The efficient frontier is the set of portfolios that
have a higher return than the minimum
variance portfolio
 With additional assets the frontier is traced out
be considering all possible portfolios
 Any portfolio below the frontier is dominated
by one on the frontier
 There are no portfolios that allow risk/return
combinations above the efficient frontier
 The frontier is always concave
The Efficient Frontier
rP Efficient

A
14

rMVP
C

8
B

Inefficient

 MVP 3 6 P
Allowing Short Sales
 With short sales, no restrictions are placed on
the proportions X A and X B except that
XA  XB 1
 Allowing short selling introduces negative
proportions
 This extends the frontier at both ends
 It extends indefinitely
Allowing Short Sales

XA > 1, XB < 0
rP
XA = 1, XB = 0
14

rMVP

8 XA = 0, XB = 1

XA < 0, XB > 1

 MVP 3 6 P
Riskfree Borrowing and Lending
 Consider combining a portfolio, A, and the
riskfree asset in proportions X and 1 - X
 This gives expected return
rp  1  X  rf  XrA
 And standard deviation

 p  1  X    X   2 X 1  X  A f  Af
2 2
f
2 2
A 
12

 But  2f  0 and  f  0 so
 p  X A
Riskfree Borrowing and Lending

 Hence
 p p
rp  1   rf  rA
 A A
 Giving
 rA  rf 
rp  rf    p
 A 
 The attainable risk and return combinations lie
on a straight line
Risk-free Borrowing and Lending
rP

c
d

b
a

P
 Hence the efficient frontier is a straight line
 It is tangential to the frontier without the risk-
free asset
Risk-free Borrowing and Lending
Efficient frontier

rP
Xf < 0, XT > 1
14

Xf = 0, XT = 1 Portfolio T:
a mix of A and B
8
rf
Xf = 1, XT = 0

3 6 P
Borrowing and Lending Rates
 The above has assumed the interest rate for
borrowing = interest rate for saving
 In practice the borrowing rate is higher
 Explained by asymmetric information
 Borrowers other than governments cannot be
treated as risk-free
 Risky borrowers must pay a higher rate of interest
 Borrowing rate rb > lending rate rf
Borrowing and Lending Rates
 Efficient frontier now in three sections
Efficient frontier
rP
XA > 1, XB < 0
14
XA = 1, XB = 0

rb

8 XA = 0, XB = 1

rf
XA < 0, XB > 1

3 6 P

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