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Conclusion
Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15
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Ramana Sonti
Preliminaries
Conclusion
Agenda
1 Preliminaries
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Preliminaries
Conclusion
available choices?
Basic assumptions:
Investors care about
Average return: Expected return, E(r)
Risk: Variance of return, 2 (r), or Standard deviation (r)
Investors are greedy: like more return with less risk
Investors are risk averse: as the risk level increases, the extra return
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Preliminaries
Conclusion
p2
n
X
i=1
w2i i2
i=1
n X
n
X
wi wj i,j
i=1 j=1
i,j
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Preliminaries
Conclusion
portfolio of X and Y ?
Portfolio expected return: E(rp ) = w(0.10) + (1 w)(0.20)
Portfolio variance:
p2 = w2 (0.0049) + (1 w)2 (0.01) + 2w(1 w)(0.07)(0.10)
For a given value of , we can trace out the expected return and
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Conclusion
0.2
0.18
0.16
0.14
=-1.0
=-0.5
=0
=0.5
=1.0
0.12
0.1
X
0
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0.02
0.04
0.06
Portfolio standard deviation
0.08
0.1
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Ramana Sonti
Preliminaries
Conclusion
diagram is linear
When correlation is between the two extremes, the mean-standard
have portfolios which have lesser risk for the same expected return
As we change the correlation, only portfolio variance (standard
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Conclusion
0.10
0.20
0.15
0.0049
0.0007
0
0.0007
0.01
0.0108
0
0.0108
0.0144
three assets
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0.2
0.15
Z
MVP
0.1
X
0.05
0
0.05
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0.06
0.07
0.08
0.09
0.1
Portfolio standard deviation
0.11
0.12
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Ramana Sonti
Preliminaries
Conclusion
w p2 = w0 w
n
X
subject to E(rp ) = w0 = m and
wi = 1
i=1
w E(rp ) = w0
n
X
subject to p2 = w0 w = s and
wi = 1
i=1
Ramana Sonti
Preliminaries
Conclusion
portfolio as
wX = 13 (0.54) + 32 (0.2625) = 0.355
wY = 13 (0.74) + 23 (1.6625) = 1.355
wZ = 13 (0.28) + 23 (0.925) = 0.71
Step 3: The mean and std. devn. of this portfolio are 20% and 0.0783
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Conclusion
Efficient Frontier
0.22
Portfolio expected return
EP 2: 0.2625,1.6625,-0.925
0.2
EP 3: 0.355,1.355,-0.71
0.18
0.16
EP 1: 0.54,0.74,-0.28
0.14
MVP
0.06
0.07
0.08
Portfolio standard deviation
0.09
0.1
Ramana Sonti
Preliminaries
Conclusion
Constraints on investment
Say we want to solve a constrained version of the problem, e.g., no
Unconstrained frontier
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Constrained frontier
0.16
0.14
0.12
0.1
0.06
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0.07
0.08
Portfolio standard deviation
0.09
0.1
Ramana Sonti
Preliminaries
Conclusion
0.2
More assets
0.15
0.1
0.05
0
0.04
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0.06
0.08
Portfolio standard deviation
0.1
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Ramana Sonti
Preliminaries
Conclusion
n
X
w2i i2 +
i=1
n X
n
X
i=1
wi wj i,j
j=1
i,j
covariance c
This means p2 = n 12 v + n(n 1) 12 c = n1 v + n1
c
n
n
n
As n , 1n 0, and n1
1, which implies p2 c
n
Ramana Sonti
Preliminaries
Conclusion
Portfolio variance
Diversifiable risk
Systematic risk
20
40
60
80
100
No. of stocks
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Conclusion
portfolio of X and Y pivoting about the risk-free asset until the CAL
which passes through the risk-free asset and the portfolio labelled
MVE
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Conclusion
0.2
MVE
0.15
CAL Y
0.1
X
CAL X
0.05
0
0
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0.02
0.04
0.06
Portfolio standard deviation
0.08
0.1
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Ramana Sonti
Preliminaries
Conclusion
max
w
E(rp ) rf
p
where E(rp )
and p
wE(rX ) + (1 w)E(rY )
h
i1
w2 X2 + (1 w)2 Y2 + 2w(1 w)X ,Y 2
wX
h
i
h
i
E(rX ) rf Y2 E(rY ) rf X ,Y
h
i
h
i
h
i
E(rX ) rf Y2 + E(rY ) rf X2 E(rX ) rf + E(rY ) rf X ,Y
wY
1 wX
Ramana Sonti
Preliminaries
Conclusion
X , Y and Z
Now, Sharpe ratio is maximized at the point where the CAL is
MVE
H0.2274, 1.7793,-1.0067L
0.2
0.15
CAL
0.1
0.05
0
0
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0.02
0.04
0.06
Portfolio standard deviation
0.08
0.1
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Ramana Sonti
Preliminaries
Conclusion
wX
wY
wZ
4.8186
= 0.2274,
21.1876
37.6984
= 1.7793,
21.1876
21.3294
= 1.0067,
21.1876
Ramana Sonti
Preliminaries
Conclusion
E(rX ) rf
E(rY ) rf
E(rZ ) rf
=
=
Cov(rX , rMVE ) Cov(rY , rMVE ) Cov(rZ , rMVE )
Intuition: In the MVE portfolio, the marginal reward-to-risk ratio is
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Conclusion
invested at rf )
to make sure the portfolio variance does not change due to the
modifications we made with X and Y
But since we started with the MVE portfolio, we must have
X (X rf ) Y (Y rf ) = 0, otherwise Portfolio T must not have been
MVE to begin with
Combining the last two equations, we get the desired property
E(rX )rf
Cov(rX ,rT )
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E(rY )rf
Cov(rY ,rT )
Ramana Sonti
Preliminaries
Conclusion
aversion A = 15, and another with A = 40. How will their money be
allocated among the risk-free asset and the three risky assets?
Key insight 1: Risk aversion does not play any role in determining
be on the CAL with the highest slope. In other words, all investors
hold portfolios of the risk-free asset and the MVE portfolio. This is
two-fund separation in the presence of a risk-free asset
In summary, all investors follow a two step process
Step 1: Come up with the MVE portfolio (common to all) the
investment decision
Step 2: Decide on the split of their money between T-bills and the MVE
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Preliminaries
Conclusion
Investor with A = 15
The MVE portfolio consists of
wX = 0.2274, wY = 1.7793, wZ = 1.0067. The expected return and
standard deviation of this portfolio are 0.2276 and 0.0916
respectively
Recall that the relative split between the risk-free asset and the MVE
w =
E(rMVE )rf
2
AMVE
0.22760.05
15(0.0916)2
= 141.25%
$412,500 (at the risk-free rate), and invest the total, i.e. $1.4125 M in
the MVE portfolio, i.e. split this amount among X , Y , and Z according
to the proportions wX = 0.2274, wY = 1.7793, wZ = 1.0067
Exercise: Work out the allocation for an investor with A = 40, and
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Preliminaries
Conclusion
CAL
0.4
0.35
A=15
0.3
0.25
MVE
0.2
0.15
A=40
0.1
0.05
0
0
T-bills
0.04
0.08
0.12
0.16
Portfolio standard deviation
0.2
0.24
0.28
Both investors choose portfolios of the same two assets: T-bills and the MVE
Locate on the CAL according to their risk aversion
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Conclusion
Final thoughts
Final thoughts
Markowitz optimization is elegant and easy to implement if we are
willing to assume that all investors care about are the mean and
variance of risky assets
This is strictly true if (a) all investors really have quadratic utility
We have still not talked about the inputs for this optimization, i.e.,
Ramana Sonti