1

Portfolio Theory
Slide 2
Premise of Portfolio Theory
Any asset can go up or down depending on the
market conditions.
When these assets are put together to form a
portfolio, their interaction reduces overall
volatility which then contributes to the stability
of the portfolio.
Any portfolio is designed with returns in mind.
One can then choose an expected return and
then seek to minimize the risk.
Slide 3
Assumptions of Portfolio Theory
Asset returns are normal distributed.
Correlations between the asset returns (not raw
prices) are fixed and constant over a period of
time.
Investors seek to maximize their overall return.
All players in the market are rational and risk
averse
Common information is available to all players in
the market
Many other assumptions .
Slide 4
Topics
Two risky assets
- with specified expected return
- global minimum variance portfolio
One risky asset & one risk-free asset
Two risky assets & one risk-free asset
Matrix Formulation
Slide 5
Motivation
Suppose investment in a certain stock offers an
expected return of 12% while the expected
return on a certain bond is only 8%. Would you
put all your money in the stock ?
If not, what is the optimal combination of these
two assets ?
Slide 6
Data Set for Demonstration
The following data will be repeatedly used to illustrate the
techniques :

A

B

A
2

B
2

A

B

AB

AB

0.175 0.055 0.067 0.013 0.258 0.115 -0.004875 -0.164
Slide 7
Portfolio with 2 Risky Assets
Suppose a percentage of w
A
of the capital is invested in
security A and w
B
in security B.

Thus w
A
+ w
B
= 1 with w
A
, w
B
0

Rate of return
r
p
= w
A
r
A
+ w
B
r
B

Expected return of portfolio
E(r
p
) = w
A
E(r
A
) + w
B
E(r
B
)

Slide 8
Portfolio with 2 Risky Assets
(contd)

Variance of rate of return of portfolio

p
2
= var(r
p
)
= var(w
A
r
A
+ w
B
r
B
)
= w
A
2
var(r
A
) + w
B
2
var(r
B
) + 2w
A
w
B
cov(r
A
, r
B
)
= w
A
2

A
2
+w
B
2

B
2
+2w
A
w
B

AB

B
where
AB
is the correlation coefficient between r
A
and r
B
.

Portfolio with 2 Risky Assets
Example 1
Consider a portfolio with w
A
= w
B
= 0.5.

P
= (0.5)(0.175) + (0.5)(0.055) = 0.115

p
2
= (0.5)
2
(0.067) + (0.5)
2
(0.013) + 2(0.5)(0.5)(-0.004875)
= 0.01751

p
= 0.1323

The portfolio expected return is the average of the
expected returns of assets A and B
The portfolio s.d. is less than the average of the asset s.d.
This shows diversification reduces risk.


Slide 9
Portfolio with 2 RiskyAssets
Example 2
Consider a long-short portfolio with w
A
= 1.5 and w
B
= -0.5.

P
= E(r
p
) = (1.5)(0.175) + (-0.5)(0.055) = 0.235

p
2
= (1.5)
2
(0.067) + (-0.5)
2
(0.013) + 2(1.5)(-0.5)(-0.004875)
= 0.1604

p
= 0.4005

This portfolio has a higher expected return and a higher
s.d. than both asset A and asset B.


Slide 10
Slide 11
Shape of Portfolio Frontier : 1




( )
( ) ( )
( ) ( ) ( )
2 2 2 2 2
2
2 2 2
2 2 2 2 2
2
1 2 1
2 2 2
P A A B B A B A B
P A A B B A B A B
A A A B A A A B
A B A B A B A B A B
w w w
w w w w
w w w w
w w




= + = +
= + +
= + +
= + + + +
Portfolio lies on the quadratic curve joining A and B.
Slide 12
Shape of Portfolio Frontier : = 1





2 2 2 2 2 2

2 ( )

P A A B B
P A A B B A B A B A A B B
P A A B B
w w
w w w w w w
w w



= +
= + + = +
= +
Portfolio lies on the line joining A and B.
Slide 13
Shape of Portfolio Frontier : = -1








The portfolio is riskless when :
( )
( )
( )
( )
( )
2
2 2 2 2 2

2
0
1

+
= + =
+
+
+
+
+


=
= =

A B A B
P A A B B A B A B A A B B
P A A B B A B A B
B
A B A B A
A B
B
A B A B A
A B
P
w
w w w w w w
w w w
w w
w w
if
if
, 1
B
A B A
A B
w w w

= =
+
Slide 14
Portfolio Frontier : = -1 Example






The portfolio is riskless when :

115
373
115
373
0
1
0.12
0.373
0.373

=
A A
A A
B A
B
B
P
P
w
w w
w w
if
if
115 258
,
373 373
= =
A B
w w

A

B

A

B

0.175 0.055 0.258 0.115
Slide 15
Portfolio Frontier : = -1 Example
(contd)






The portfolio is riskless when :

258
373
258
373
0
1
0.12
0.373
0.373

=
A
A A
A
A B
B
B
P
P
w
w w
w w
if
if
258 115
,
373 373
= =
A B
w w

A

B

A

B

0.055 0.175 0.115 0.258
Shape of Portfolio Frontiers for Various
Efficient Portfolio & Efficient Frontier
Portfolios with the highest expected return for a
given level of risk are called efficient portfolios.
The curve passing through a collection of
efficient portfolios is called the efficient frontier
(EF).
Slide 17
Efficient Portfolios & EF with 2 Risky
Assets : 1
Slide 18
Efficient portfolios in green
Inefficient portfolios in red
Global Minimum Variance Portfolio
Slide 19
This portfolio has the smallest variance among all efficient portfolios
Global Minimum Variance Portfolio
To find this portfolio, one has to solve the
constrained minimization problem



It can be shown that
Slide 20
2 2 2 2 2
,
2
s.t. 1
min
A B
P A A B B A B AB
w w
A B
w w w w
w w
= + +
+ =
2
min
2 2
min min

2
1
B AB
A
A B AB
B A
w
w w

=
+
=
Global Minimum Variance Portfolio -
Example
Using the data, we have



The expected return, variance and s.d. of this
portfolio are



Slide 21
min min
0.013 ( 0.004875)
0.1992 0.8008
0.067 0.013 2( 0.004875)
A B
w w

= = =
+
2 2 2
(0.1992)(0.175) (0.8008)(0.055) 0.0789
(0.1992) (0.067) (0.8008) (0.013)
2(0.1992)(0.8008)( 0.004875) 0.00944
0.00944 0.09716
P
P
P

= + =
= +
+ =
= =