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InvestmentInvestment AnalysisAnalysis && PortfolioPortfolio ManagementManagement ChapterChapter 77
InvestmentInvestment AnalysisAnalysis &&
PortfolioPortfolio ManagementManagement
ChapterChapter 77
OptimalOptimal RiskyRisky PortfoliosPortfolios
FIN 435 (Instructor- Saif Rahman)
MarketMarket riskrisk vs.vs. UniqueUnique riskrisk  Stand-alone risk = Market risk + Firm-specific risk 
MarketMarket riskrisk vs.vs. UniqueUnique riskrisk
 Stand-alone risk = Market risk + Firm-specific risk
 The risk that remains even after extensive diversification is called
market risk, risk that is attributable to market wide risk sources.
Such risk is also called systematic risk or nondiversifiable risk.
Measured by beta. (e.g. War, Inflation, High Interest Rates)
 In contrast, the risk that can be eliminated by diversification is
called unique risk, firm-specific risk, nonsystematic risk or
diversifiable risk.
FIN 435 (Instructor- Saif Rahman)
RiskRisk ReductionReduction withwith DiversificationDiversification s p (%) Company-Specific Risk 35 Stand-Alone Risk,
RiskRisk ReductionReduction withwith DiversificationDiversification
s p (%)
Company-Specific Risk
35
Stand-Alone Risk, s
p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
FIN 435 (Instructor- Saif Rahman)
2
TwoTwo--SecuritySecurity Portfolio:Portfolio: ReturnReturn r  w r  w r p D D E E
TwoTwo--SecuritySecurity Portfolio:Portfolio: ReturnReturn
r
w r
w r
p
D
D
E
E
r
Portfolio Return
P
w
Bond Weight
D
r
Bond Return
D
w
Equity Weight
E
r
Equity Return
E
E r
(
)
 w
E r
(
)
 w
E r
(
)
p
D
D
E
E
n
 w
 1
i
i  1
FIN 435 (Instructor- Saif Rahman)
TwoTwo--SecuritySecurity Portfolio:Portfolio: RiskRisk 2 2 2 2 2   w   w 
TwoTwo--SecuritySecurity Portfolio:Portfolio: RiskRisk
2
2
2
2
2
 w 
 w 
2
w 
Cov r
(
,
r
)
P
D
D
E
E
D
E
D
E
2
= Variance of Security D
D
2
= Variance of Security E
E
Cov r
(
,
r
)
D
E
= Covariance of returns for
Security D and Security E
FIN 435 (Instructor- Saif Rahman)
CovarianceCovariance andand CorrelationCorrelation Cov(r 1 r 2 ) =  1,2  1  2
CovarianceCovariance andand CorrelationCorrelation
Cov(r 1 r 2 ) =  1,2  1  2
 1,2 = Correlation coefficient of
returns
 1 = Standard deviation of returns for Security 1
 2 = Standard deviation of returns for Security 2
FIN 435 (Instructor- Saif Rahman)
CorrelationCorrelation Coefficients:Coefficients: PossiblePossible ValuesValues Range of values for  1,2 + 1.0 >
CorrelationCorrelation Coefficients:Coefficients: PossiblePossible ValuesValues
Range of values for  1,2
+ 1.0
>
r
>
-1.0
If r= 1.0, the securities would be perfectly
positively correlated
If r= - 1.0, the securities would be perfectly
negatively correlated
FIN 435 (Instructor- Saif Rahman)
ImportanceImportance ofof CorrelationCorrelation  Correlation is important because it affects the degree to which
ImportanceImportance ofof CorrelationCorrelation
 Correlation is important because it affects the
degree to which diversification can be achieved
using various assets.
 Theoretically, if two assets returns are perfectly
negatively correlated, it is possible to build a
riskless portfolio with a return that is greater than
the risk-free rate.
FIN 435 (Instructor- Saif Rahman)
7
ThreeThree--SecuritySecurity PortfolioPortfolio = W 1 r 1 + W 2 r 2 + W 3
ThreeThree--SecuritySecurity PortfolioPortfolio
= W 1 r 1 + W 2 r 2 + W 3 r 3
r p
 2 p = W 1 2  1 2 + W 2 2  1 2
+ W 3 2  3 2
+ 2W 1 W 2 Cov(r 1 r 2 )
+ 2W
Cov(r 1 r 3 )
1
W 3
+ 2W
W
Cov(r r
)
2
3
2
3
 p 2 = w 1 2  1 2 + w 2 2  2 2 + 2W 1 W 2 1 2 r 12
FIN 435 (Instructor- Saif Rahman)
InIn General,General, ForFor anan nn--SecuritySecurity PortfolioPortfolio r p = Weighted average of the n securities
InIn General,General, ForFor anan nn--SecuritySecurity PortfolioPortfolio
r p = Weighted average of the n
securities
 p 2 = (Consider all pair-wise
covariance measures)
FIN 435 (Instructor- Saif Rahman)
TwoTwo--SecuritySecurity PortfoliosPortfolios withwith DifferentDifferent CorrelationsCorrelations  p 2 = w 1 2  1
TwoTwo--SecuritySecurity PortfoliosPortfolios withwith DifferentDifferent CorrelationsCorrelations
 p 2 = w 1 2  1 2 + w 2 2  2 2 + 2W 1 W 2 1 2 r 12
E(r)
13
%
 = -1
 = .3
 = -1
 = 1
St. Dev
12%
20%
FIN 435 (Instructor- Saif Rahman)
%
8
PortfolioPortfolio Risk/ReturnRisk/Return TwoTwo Securities:Securities: CorrelationCorrelation EffectsEffects  The
PortfolioPortfolio Risk/ReturnRisk/Return TwoTwo Securities:Securities:
CorrelationCorrelation EffectsEffects
 The relationship depends on correlation coefficient.
-1.0 <  < +1.0
 The smaller the correlation, the greater the risk reduction
potential .
 If r = +1.0, no risk reduction is possible.
FIN 435 (Instructor- Saif Rahman)
WhatWhat isis thethe minimumminimum levellevel toto whichwhich portfolioportfolio standardstandard deviationdeviation
WhatWhat isis thethe minimumminimum levellevel toto whichwhich portfolioportfolio
standardstandard deviationdeviation cancan bebe held?held?
2
 cov(
r
,
r
)
E
D
E
w
(
D
)
min
2
2
  
 2cov(
r
,
r
)
D
E
D
E
EE
xx ee
tt ndinndin
gg
CC
oo
nn
cepcep ss
tt
tt
oo
AllAll SS
ecuecu
ritiriti
eses
 The optimal combinations result in lowest level
of risk for a given return.
 The optimal trade-off is described as the efficient
frontier.
 These portfolios are dominant.
FIN 435 (Instructor- Saif Rahman)
MarkowitzMarkowitz PortfolioPortfolio SelectionSelection ModelModel  Security Selection  First step is to
MarkowitzMarkowitz PortfolioPortfolio SelectionSelection ModelModel
 Security Selection
 First step is to determine the risk-return
opportunities available
 All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations
FIN 435 (Instructor- Saif Rahman)
TheThe MinimumMinimum--VarianceVariance FrontierFrontier ofof RiskyRisky AssetsAssets E(r) Efficient frontier
TheThe MinimumMinimum--VarianceVariance FrontierFrontier
ofof RiskyRisky AssetsAssets
E(r)
Efficient
frontier
Individual
Global
assets
minimum
variance
portfolio
Minimum
variance
frontier
St. Dev.
FIN 435 (Instructor- Saif Rahman)
AlternativeAlternative CALsCALs (CAL(CAL withwith thethe highesthighest rewardreward--toto-- variabilityvariability
AlternativeAlternative CALsCALs (CAL(CAL withwith thethe highesthighest rewardreward--toto--
variabilityvariability ratio)ratio)
CAL (A)
E(r)
CAL (P)
M
M
P
P
CAL (Global
minimum variance)
A
A
G
F
P
P&F
M
A&F
FIN 435 (Instructor- Saif Rahman)
CapitalCapital AllocationAllocation andand thethe SeparationSeparation PropertyProperty  The most striking conclusion
CapitalCapital AllocationAllocation andand thethe SeparationSeparation PropertyProperty
 The most striking conclusion is that a portfolio manager will offer the same
risky portfolio, P, to all clients regardless of their degree of risk aversion
 The result is called a separation property, it tells us that the portfolio choice
problem may be separated into two independent tasks:
1)
First determine the optimal risky portfolio
2)
Then choose the allocation of the complete portfolio to risk-free
assets
 An example of a situation when there is more than one optimal risky
portfolio: Risk-free lending only
FIN 435 (Instructor- Saif Rahman)
PortfolioPortfolio SelectionSelection && RiskRisk AversionAversion U’’ U’ U’’’ E(r) Efficient f
PortfolioPortfolio SelectionSelection && RiskRisk AversionAversion
U’’
U’
U’’’
E(r)
Efficient
f
ron
ti
er o
S
f
risky assets
P
Q
Less
risk-averse
investor
More
risk-averse
investor
St. Dev
FIN 435 (Instructor- Saif Rahman)