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Lecture 2.5: Solution to the Portfolio Problem
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Outline
Solution to the Mean-Variance Portfolio Problem
1
Step 1: Determination of the optimal portfolio of risky assets
2
Step 2: Allocation of the complete portfolio to T-bills versus
the risky portfolio
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Step 1: Determination of the Optimal Risky Portfolio
The mean-variance frontier determines the risk-return opportunities
available to an investor
All portfolios that lie on the efcient frontier provide the best risk-return
combinations
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Determination of the Optimal Risky Portfolio contd.
We now search for the capital allocation line (CAL) with the highest
reward-to-variability ratio
everyone invests in the portfolio P of risky assets, regardless of their
risk preferences
Point P is the tangency point between the efcient frontier and a ray
passing through the point R
F
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Computation of the Optimal Risky Portfolio
The optimal portfolio of risky assets (the tangency portfolio) has the
highest Sharpe ratio.
to obtain the composition of this portfolio, we have to maximize the
Sharpe ratio:
max
X
1
,X
2
,...X
N
N

i =1
X
i
[E (R
i
) R
F
]

i =1
X
2
i

2
i
+
N

i =1
N

j =1
i =j
X
i
X
j

ij

1/2

subject to
N

i =1
X
i
= 1
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Today Optimal Risky Portfolio Optimal Overall Portfolio
Computation of the Optimal Risky Portfolio
The optimal portfolio of risky assets (the tangency portfolio) has the
highest Sharpe ratio.
to obtain the composition of this portfolio, we have to maximize the
Sharpe ratio:
max
X
1
,X
2
,...X
N
N

i =1
X
i
[E (R
i
) R
F
]

i =1
X
2
i

2
i
+
N

i =1
N

j =1
i =j
X
i
X
j

ij

1/2

subject to
N

i =1
X
i
= 1
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Computation of the Optimal Risky Portfolio contd
The rst order conditions are
1.

X
1
= 0
2.

X
2
= 0
.
.
.
N.

X
N
= 0
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Computation of the Optimal Risky Portfolio contd
Simplifying the N rst order conditions, we see that the solution involves
solving the following system of N simultaneous linear equations in N
unknowns:
1. E (R
1
) R
F
= Z
1

2
1
+Z
2

12
+Z
3

13
+ ... +Z
N

1N
2. E (R
2
) R
F
= Z
1

12
+Z
2

2
2
+Z
3

23
+ ... +Z
N

2N
.
.
.
N. E (R
N
) R
F
= Z
1

1N
+Z
2

2N
+Z
3

3N
+ ... +Z
N

2
N
solving the above system of equations gives (Z
1
, Z
2
, ..., Z
N
)
Finally, the optimum proportion to invest in asset i is obtained as
X
i
=
Z
i
N

i =1
Z
i
, i = 1, 2, ..., N
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Computation of the Optimal Risky Portfolio contd
Simplifying the N rst order conditions, we see that the solution involves
solving the following system of N simultaneous linear equations in N
unknowns:
1. E (R
1
) R
F
= Z
1

2
1
+Z
2

12
+Z
3

13
+ ... +Z
N

1N
2. E (R
2
) R
F
= Z
1

12
+Z
2

2
2
+Z
3

23
+ ... +Z
N

2N
.
.
.
N. E (R
N
) R
F
= Z
1

1N
+Z
2

2N
+Z
3

3N
+ ... +Z
N

2
N
solving the above system of equations gives (Z
1
, Z
2
, ..., Z
N
)
Finally, the optimum proportion to invest in asset i is obtained as
X
i
=
Z
i
N

i =1
Z
i
, i = 1, 2, ..., N
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Today Optimal Risky Portfolio Optimal Overall Portfolio
Computation of the Optimal Risky Portfolio contd
Simplifying the N rst order conditions, we see that the solution involves
solving the following system of N simultaneous linear equations in N
unknowns:
1. E (R
1
) R
F
= Z
1

2
1
+Z
2

12
+Z
3

13
+ ... +Z
N

1N
2. E (R
2
) R
F
= Z
1

12
+Z
2

2
2
+Z
3

23
+ ... +Z
N

2N
.
.
.
N. E (R
N
) R
F
= Z
1

1N
+Z
2

2N
+Z
3

3N
+ ... +Z
N

2
N
solving the above system of equations gives (Z
1
, Z
2
, ..., Z
N
)
Finally, the optimum proportion to invest in asset i is obtained as
X
i
=
Z
i
N

i =1
Z
i
, i = 1, 2, ..., N
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Step 2: Determination of the Optimal Overall Portfolio
All investors, regardless of their risk preferences, invest in the same
portfolio P of risky assets
Allocation of the overall portfolio to a safe asset (e.g. T-bills) versus the
risky portfolio P depends on investor preferences:
More risk averse investors put more in the risk-free asset
Less risk averse investors put more in P
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Today Optimal Risky Portfolio Optimal Overall Portfolio
Step 2: Determination of the Optimal Overall Portfolio
All investors, regardless of their risk preferences, invest in the same
portfolio P of risky assets
Allocation of the overall portfolio to a safe asset (e.g. T-bills) versus the
risky portfolio P depends on investor preferences:
More risk averse investors put more in the risk-free asset
Less risk averse investors put more in P
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Determination of the Optimal Overall Portfolio contd