Portfolio Management and Performance Evaluation: 4321

University of Minnesota November 2, 2019

Professor Erik Loualiche (eloualic@umn.edu) Handout 5b

Portfolio Management and Performance Evaluation

This document summarizes the essential concepts and techniques of fina 4321. It is more detailed than the
syllabus but more condensed than the lecture notes. Anything in this document may appear in the final
exam. Some notations of this section may be slightly different from the lecture notes. Please note that this
document is not meant to replace the lecture notes but rather give you some hints on where to put your
emphasis.

TOPIC 3: Mean Variance Portfolio Analysis: General

EXERCISE 3.1 (Computing the expected returns of a portfolio) On November 9, 2005 you
invested in the following stocks:

Stock Quantity Price Expected Return

Microsoft (MSFT) 300 $27.0 20%
IBM 600 $83.0 12%
Coca-Cola (KO) 1, 000 $42.1 15%

The expected return that you have estimated for each stock is given in the right-hand column. What is the
expected return for this portfolio?
Solution: First,we need to find out how much was invested:

W0 = 300 × $27 + 600 × $83 + 1, 000 × $42.1 = $100, 000

Then, we need to compute the security weights (Xi ) i.e. the proportion invested in each security:

300 × $27
XM SF T = = 0.081
$100, 000
600 × $83
XIBM = = 0.498
$100, 000
1, 000 × $41.1
XKO = = 0.421
$100, 000

note that the sum of the weight XM SF T + XIBM + XKO = 1.

Finally, to compute the expected return, we know that the expected return on any portfolio is the weighted
average of the expected return of the individual securities. Thus we just have to use the standard formula:
3
X
E[Rp ] = Xi E[Ri ] = 0.081 × 20% + 0.498 × 12% + 0.421 × 15% = 13.91%
i=1
2 Handout 5b: Portfolio Management and Performance Evaluation

EXERCISE 3.2 (Portfolio with two risky assets) Suppose you invest in two risky assets: asset a and
asset b. The expected return of each asset is E[Ra ] = 20% and E[Rb ] = 30%. The standard deviation of
asset a is σa = 25%, the standard deviation of asset b is σb = 75% and the correlation of the returns of
both assets is ρab = 0.3. Answer the following questions.
(a) Suppose you invest 50% of your initial wealth in each asset (so Xa = Xb = 0.5). Compute the expected
return, the variance and the standard deviation of the returns of this portfolio.
(b) Find the minimum variance portfolio of this two risky assets.
(c) Suppose there is a risky free asset in the market. Do you think a very risk averse investor should create
a portfolio that is composed of the risk-free asset and the minimum variance portfolio? If yes, why? if not,
why not? What investment strategy would you recommend to a very high risk averse investor? And what
investment strategy would you recommend to a low risk-averse investor?
Solution: The expected return is simply the weighted average of the expected returns of the individual
securities,
X2
E[Rp ] = Xi E[Ri ] = 0.5 × 20% + 0.5 × 30% = 25%
i=1

To compute the variance, just use the formula for the variance of a portfolio with two risky assets which is
given by (see formula sheet)

σ 2 (Rp ) = Xa2 × σa2 + Xb2 × σb2 + 2 × Xa × Xb × σa × σb × ρa,b

In our case, just plug in the numbers to get

σ 2 (Rp ) = 0.52 × (0.25)2 + 0.52 × (0.75)2 + 2 × 0.5 × 0.5 × 0.25 × 0.75 × 0.3
= 0.184375

Thus the standard deviation is:

q √
σ(Rp ) = σ 2 (Rp ) = 0.184375 = 0.4294 = 42.94%

(b) To find the minimum variance portfolio, we just use the formula:
2
MV P σB − σA,B 0.752 − 0.25 × 0.75 × 0.3
XA = 2 + σ2 − 2 × σ = = 0.99
σA B A,B 0.252 + 0.752 − 2 × 0.25 × 0.75 × 0.3

so to obtain the Minimum Variance Portfolio, you should invest 99% on asset A and 1% in asset B. this
makes sense given that asset A is much less risky than asset B.
(c) If there is a risk-free asset in the market, the smart thing to do is to combine the risk-free asset with the
Mean Variance Efficient Portfolio (MVEP). It does not make any sense to combine the risk-free rate with
the minimum variance portfolio. As we discussed in class this does not depend on the preferences of the
investor. This is a simple an efficiency argument: portfolios that are a combination of the risk free asset and
the MVEP are efficient and thus for any given level of risk, they provide the highest expected return possible
from all the portfolios that you can form in the market. Thus everyone should do this independently of their
risk aversion. So the strategy that I would recommend to a very risk averse agent is exactly the same as the
strategy that I would recommend to a low-risk averse agent: they both should combine the risk-free asset
with the MVEP. The next step (not asked) is of course to specify how much to invest in the riskfree asset
and how much to invest in the MVEP. Now this step WILL depend on the risk aversion of the agents: more
risk averse investors will invest more on the risk free asset and less risk averse investors will invest more on
the MVEP.
Handout 5b: Portfolio Management and Performance Evaluation 3

EXERCISE 3.3 (Portfolio with two assets: one asset is risky and the other asset is risk free)
Suppose there are two assets in the market: asset f and asset b. Asset f is a Treasury-Bill, which you can
consider to be risk free and has a certain return of Rf = 4%. The expected return of asset b is E[Rb ] = 10%
and the standard deviation of its returns is σb = 18%. Answer the following questions.
(a) Suppose you invest 50% of your initial wealth in each asset (so Xf = Xb = 0.5). Compute the expected
return, the variance and the standard deviation of the returns of this portfolio.
(b) Suppose you have a risk aversion coefficient of A = 3. Find the optimal portfolio of these two assets.
Solution: (a) The expected return is simply the weighted average of the expected returns of the individual
securities,
2
X
E[Rp ] = Xi E[Ri ] = 0.5 × 4% + 0.5 × 10%
i=1
= 7%

To compute the variance, just use the formula for the variance of a portfolio which is given by (see formula
sheet)
σ 2 (Rp ) = Xf2 × σf2 + Xb2 × σb2 + 2 × Xf × Xb × σf × σb × ρf,b
Now, remember that a risk-free asset has zero variance (so σf2 = 0) and the correlation between a risk-free
asset with any other asset is zero (thus ρf,b = 0). Thus using the previous equation we have

σ 2 (Rp ) = Xb2 × 182

and the standard deviation is

q q
σ(Rp ) = σ 2 (Rp ) = Xb2 × 182 = |Xb | × 18

(b) Using the formula for the optimal portfolio of two securities when one security is risk-free, we have

E[Rb ] − Rf 10 − 4 6
Xb = 2 = 2
= = 0.618
0.01 × A × σb 0.01 × 3 × 18 9.72

So the optimal portfolio (i.e. the portfolio that gives you the highest level of utility) is obtained by investing
61.8% on asset b and the remaining 38.2% on the risk free asset.

EXERCISE 3.4 (The investment opportunity set with two assets: one asset is risky and the
other asset is risk-free) We want to draw the investment opportunity set i.e. all the risk and return
combinations of ALL possible portfolios of two assets for the case where one asset is risk-free (with return
Rf ) and the other asset is a risky stock (with returns Rs ) Denote Xf as the fraction of the wealth invested
in the risk free asset (Treasury Bill). Also, denote the expected return on the stock as E[Rs ] and the variance
of the stock as σs2 . Answer the following questions
(a) What is the fraction of wealth invested in the stock?
(b) What is the expected return on this portfolio as a function Xf ?
(c) What is the variance of the return on this portfolio?
(d) What is the standard deviation of the returns of this portfolio?
(e) Draw all possible combinations of risk and return in the mean-standard deviation diagram that these
two securities can achieve (assume 0 ≤ Xf ≤ 1) (i.e., give values to Xf from 0 to 1 and compute the E[Rp ]
and σp for each Xf ).
Solution: (a) Of course, since the weights always sum up to 1, the fraction of wealth invested in the stock
is Xs = (1 − Xf ).
4 Handout 5b: Portfolio Management and Performance Evaluation

(b) To compute the expected return on this portfolio. Use general formula:

E[Rp ] = Xf Rf + (1 − Xf )E[Rstock ]

(c) As before, to compute the variance of the portfolio just use the formula for the variance of a portfolio
which is given by (see formula sheet)

σ 2 (Rp ) = Xf2 × σf2 + Xs2 × σs2 + 2 × Xf × Xstock × σf × σs × ρf,s

Since a risk-free asset has zero variance (so σf2 = 0) and the correlation between a risk-free asset with the
stock is zero (thus ρf,s = 0). Thus using the previous equation we have
2
σ 2 (Rp ) = Xs2 × σs2 = (1 − Xf ) × σs2

(d) The standard deviation is given by:

σp = |1 − Xf | × σstock

(e) We did many similar exercises/example in class. The plot is just a straight line that goes from the
risk-free rate and passes through the stock. This line is the capital allocation line (CAL).

EXERCISE 3.5 (Efficient Portfolios) Suppose I tell you that the mean-variance efficient portfolio
(MVEP) has an expected return of E(RM V EP ) = 14.5% and a standard deviation σ(RM V EP ) = 16.5%
and there is a risk-free asset with Rf = 5%. Suppose you want to construct a portfolio that has the same
expected return of a certain asset (call it asset 1) but has the lowest standard deviation possible for this level of
expected return. The expected return on asset 1 is E(R1 ) = 10% and its standard deviation is σ(R1 ) = 15%.
What (efficient) portfolio p should you hold? What is the standard deviation of this portfolio?
Solution: The key thing that you need to realize is that the efficient portfolio will be located on the optimal
CAL, and thus it will be a combination of the riskfree asset and the MVEP. Our task is to find the optimal
combination of the risk-free asset and the MVEP for this particular case.
This agent wants to create a portfolio that has the same expected return of asset 1, i.e. E(R1 ) = 10%. Now,
recall that the expected return of a portfolio composed of the riskfree asset and the MVEP is given by the
standard formula:
E(Rp ) = Xf × Rf + (1 − Xf ) × E(RM V EP )
and since we want the expected return on this portfolio to be 10% we just need to solve the equation

10% = Xf × 5% + (1 − Xf ) × 14.5%
14.5 − 10
Xf = = 0.47
14.5 − 5

Thus the optimal portfolio that has a 10% expected return is constructed by investing 47% of your wealth
on the riskfree asset and the remaining (1 − 0.47) = 53% are invested on the MVE portfolio. To find the
standard deviation of the returns of this portfolio, recall that the standard deviation of a portfolio that
combines a riskfree asset and a risky asset (here the MVEP) is given by:

σ(Rp ) = |1 − Xf | × σ(RM V EP ) = 0.53 × 16.5% = 8.75%

Which is LOWER than the standard deviation of the returns on asset 1 (15%).
Handout 5b: Portfolio Management and Performance Evaluation 5

EXERCISE 3.6 (Efficient Portfolios) As in the previous question, suppose I tell you that the mean-
variance efficient portfolio (MVEP) has an expected return of E(RM V EP ) = 14.5% and a standard deviation
σ(RM V EP ) = 16.5% and there is a risk-free asset with Rf = 5%. Suppose you want to construct a portfolio
that has the same standard deviation of asset 1 but with the highest expected returns possible. The expected
return on asset 1 is E(R1 ) = 10% and its standard deviation is σ(R1 ) = 15%. What (efficient) portfolio p
should you hold? What is the expected return on this portfolio?
Solution: Again, the efficient portfolio will be located on the optimal CAL, and thus it will be a combination
of the riskfree asset and the MVEP. So we need to find the optimal combination. Now, we want to keep the
same standard deviation of asset 1. So using the formula for the standard deviation of a portfolio with a
riskfree rate we just need to solve

σ(Rp ) = |1 − Xf | × σ(RM V EP ) = 15%

Xf = 0.09

And thus, since the sum of the weights is always one, the weight on the MVEP will be XM V EP = (1−0.09) =
0.91. In this case the expected return of this particular portfolio is

E(Rp ) = Xf × Rf + (1 − Xf ) × E(RM V EP )
= 0.09 × 5% + 0.91 × 14.5%
= 13.65%

Which is HIGHER than the expected returns on asset 1 (10%).

EXERCISE 3.7 (Investment opportunities with different borrowing and lending risk free rates)
Suppose that you can invest at the riskfree rate Rf but you can borrow only at a higher rate Rfb . Suppose
there are many assets available in the market.
(a) In class we showed that the optimal CAL in no longer a line. Sketch a minimum-variance frontier and
show what the new optimal CAL looks like when the risk free borrowing and lending rates are different.
Show on this graph the portfolio that will be selected by an defensive (high risk aversion) investors. Show
the portfolio that will be selected by agressive (low risk aversion) investors.
(b) What portfolio will be selected by investors who neither borrow nor lend?
Solution: (a) and (b) See picture.

EXERCISE 3.8 Assets A, B, and C have the following known characteristics:

E[RA ] = 2% , σA = 0
E[RB ] = 10% , σB = 18%
E[RC ] = 20% , σC = 30%

It is known that the MVEP portfolio composed of assets B and C has the following weights XB = 0.58 and
XC = 0.42 and has expected return of E[RM V EP ] = 14.2% and Sharpe ratio of SRM V EP = 0.83. Answer
the following questions:
(a) What is the riskfree asset? What is the standard deviation of the MVEP?
(b) Find the correlation coefficient between assets B and C.
(c) What is the expected return of an efficient portfolio that has a standard deviation of the returns equal
to 10%? (NOTE: this question does not require knowing the answers to the previous parts)
Solution:
6 Handout 5b: Portfolio Management and Performance Evaluation

(a) The riskfree asset is asset A because there is no uncertainty about its returns (σA = 0). We find the
standard deviation of the MVEP directly from the Sharpe ratio of the MVEP:
SRM V EP = 0.83
E[RM V EP ] − Rf
= 0.83
σM V EP
0.142 − 0.02
= 0.83
σM V EP
0.122
σM V EP = = 0.147 (14.7%)
0.83
(b) Knowing the variance of the MVEP portfolio and the weights of assets B and C in the MVEP we can
find the correlation between B and C using the formula for the variance of a portfolio

14.72 = σM
2 2 2 2 2
V EP = 0.58 × 18 + 0.42 × 30 + 2 × 0.58 × 0.42 × 18 × 30 × ρB,C
14.72 − 0.582 × 182 − 0.422 × 302 −51.7
ρA,B = = ≈ −0.2
2 × 0.58 × 0.42 × 18 × 30 263

(c) This efficient portfolio consists of the MVEP and the riskfree asset A. It is located on the capital allocation
line “pinned’ by the MVEP portfolio. Using the equation for this CAL we find:
E[R] = Rf + SRM V EP × σ ⇒ E[R] = 2% + 0.83 × 10% = 10.3%

EXERCISE 3.9 You have $1 million currently invested entirely in portfolio A. You are considering
switching into a combination of Treasury-Bills (the risk-free asset) and a portfolio B for next year. This
portfolio B has 50% invested in the stock ABC and 50% invested in the stock XYZ. The risk-free rate is
5%.You have come up with the following assessments of the return of portfolio A along with the returns of
the stock ABC and XYZ for next year
E[RA ] = 10% σA = 20%
E[RABC ] = 10% σABC = 20%
E[RXY Z ] = 18% σXY Z = 30% ρABC,XY Z = 0.5
Using just the Treasury-Bill and portfolio B, create a new portfolio that is better than your current portfolio
A. You must explain clearly why the new portfolio is better.
Solution:
To solve this problem, we first need the expected return and the standard deviation of the return of portfolio
B. The expected return is:
E[RB ] = 0.5 × E[RABC ] + 0.5 × E[RXY Z ]
= 0.5 × 10% + 0.5 × 18%
= 14%
The variance of the portfolio B is, using the standard formula for the variance of a portfolio (see formula
sheet)
σ 2 (RB ) = XABC
2 2
× σABC 2
+ XXY 2
Z × σXY Z + 2 × XABC × XXY Z × σABC × σXY Z × ρABC,XY Z

Plug in the numbers, you get

σ 2 (RB ) = 0.52 × 202 + 0.52 × 302 + 2 × 0.5 × 0.5 × 20 × 30 × 0.5
= 475
Handout 5b: Portfolio Management and Performance Evaluation 7

Hence, the standard deviation is σ(RB ) = 21.8%.

Now there are two ways of creating a better portfolio than portfolio A. (1) Create a portfolio with the same
expected return as portfolio A but with a lower level of risk or (2) Create a portfolio with the same level of
risk of portfolio A but with higher expected return. Let’s do both.
Option 1: Let’s find a portfolio P ∗ composed of the risk-free asset and portfolio B that has the same return
of portfolio A. Let XB be the weight invested in portfolio B (naturally, the weight invested in the risk-free
asset is Xf = 1 − XB . Then we need:

E[Rp∗ ] = 10%
XB × E[RB ] + (1 − XB ) × Rf = 10%
XB × 14% + (1 − XB ) × 5% = 10%
5
XB =
9
The standard deviation of this portfolio P ∗ is σP ∗ = 59 × σ(RB ) = 95 × 21.8% = 12.1%. This portfolio has
the same expected return of portfolio A, but lower standard deviation (so it’s better than portfolio A).
Option 2: Alternatively, we could try to find a portfolio P∗ with the same standard deviation as that of
portfolio A but with higher expected return. In this case, since we want to have the same standard deviation,
we set:

σ (RP ∗ ) = 20%
XB × σ(RB ) = 20%
XB × 21.8% = 20%
XB = 0.917

And the expected return of this portfolio P∗ is

E[Rp∗ ] = XB × E[RB ] + (1 − XB ) × Rf
= 0.917 × 14% + (1 − 0.917) × 5%
= 13.25%

This portfolio is also better than portfolio A: it has the same level of risk, but higher expected return.

EXERCISE 3.10 (Factor Model) Suppose the market model for the returns of stocks A and B is
estimated with the following results

RA = 5% − 0.2 × RM + eA
RB = −10% + 1.5 × RM + eB
σM = 20%, σA = 5%, σB = 40%

where σM is the standard deviation of the returns on the market, σA is the standard deviation of the returns
on stock A and σB is the standard deviation of the returns on stock B. Answer the following questions:
(a) Find the covariance and the correlation coefficient between the two stocks.
(b) Suppose that for next year, you expect the market return to be 3%. Find the expected return of each
stock for next year.
Solution:
(a) Using the formula sheet, we know that the covariance between the two stocks is
2
σA,B = βA × βB × σm = (−0.2) × 1.5 × 202 = −120
8 Handout 5b: Portfolio Management and Performance Evaluation

Now, to get the correlation coefficient, recall the formula for correlation which is
σA,B −120
ρA,B = = = −0.6
σA × σB 5 × 40
(b) Taking expectations and using the fact that E[ei ] = 0 we have

E[RA ] = 5% − .2 × E [RM ] + E [eA ] = 5% − 0.2 × 3% = 4.4%

E[RB ] = −10% + 1.5 × E [RM ] + E [eB ] = −10% + 1.5 × 3% = −5.5%