FINC3017 Investments and Portfolio Management Tutorial 3 Optimal Portfolios

1.

Refer to the spreadsheet from Tutorial 1. Use the Solver optimisation tool in Excel to calculate the weights in the minimum-variance portfolio, for the three-security portfolio (excl the index). How does it compare to the equal-weighted portfolio from Tutorial 1?

2.

What are the minimum variance weightings for a two-asset portfolio where both assets have the same variance?

3.

In estimating the opportunity set, does the assumption that the expected returns, variances and covariances are known with certainty matter?

The expected returns may be estimated with error and the error may not be consistent across securities. For example the level of information varies across securities and so the precision of the estimates will also vary across securities. If estimates are prone to error the opportunity set may concentrate on those securities with greatest error rather than those companies which best meet the needs of the investor. This result is often termed error maximisation and can result in a portfolio that concentrates on a fairly small subset of the available securities. These are the securities with greatest expected returns and/or least variance and covariance effect, often the most likely to suffer from data entry errors and errors in analysis. The key point to note is the importance of accurate measures of expected return, variance and covariance and the possibility that a number of approximately optimal portfolios may exist in practice.

4.

The ABC company wants to invest in two risky assets over the next 12 months. Analysts predict that the expected return on asset A is 5% per annum and on asset B it is 7% per annum. The standard deviation of the returns for asset A is 8% and for asset B it is 9%. The correlation between the two assets in 0.4 and the risk-free rate is 5.5% per annum. What combination of the two assets will give returns that exceed the riskfree rate?

The question requires an estimate of the weights in the risky assets that produces a portfolio return that exceeds the return on the risk-free asset. We can solve as follows: wa E(Ra) + (1wa) E(Rb) > 5.5% wa 5 + (1wa)7 > 5.5% 5 wa + 7 7 wa > 5.5% 2 wa > 1.5 wa < 0.75 Therefore, all portfolios that have a weight of less than 75% in asset A will have a return that exceeds the risk-free rate. Note that the standard deviation and correlation do not affect the weights.

5.

The correlation coefficients between pairs of stocks are as follows: Corr(A,B) = 0.85, Corr(A,C) = 0.60, Corr(A,D) = 0.45. Each stock has an expected return of 8% and a standard deviation of 20%. If your entire portfolio is now composed of stock A and you can add some of only one stock to your portfolio, would you choose: a) B b) C c) D d) Need more data.

The correct choice is c. Intuitively, we note that since all stocks have the same expected rate of return and standard deviation, we choose the stock that will result in lowest risk. This is the stock that has the lowest correlation with Stock A. More formally, we note that when all stocks have the same expected rate of return, the optimal portfolio for any risk-averse investor is the global minimum variance portfolio (G). When the portfolio is restricted to Stock A and one additional stock, the objective is to find G for any pair that includes Stock A, and then select the combination with the lowest variance. With two stocks, I and J, the formula for the weights in G is:

w Min (I)

2 J Cov( rI , rJ ) 2 I 2 J 2Cov( rI , rJ )

w Min (J) 1 w Min (I)

Since all standard deviations are equal to 20%:
Cov(rI , rJ ) I J 400 and wMin ( I ) wMin ( J ) 0.5

This intuitive result is an implication of a property of any efficient frontier, namely, that the covariances of the global minimum variance portfolio with all other assets on the frontier are identical and equal to its own variance. (Otherwise, additional diversification would further reduce the variance.) In this case, the standard deviation of G(I, J) reduces to:

Min (G ) [200 (1 IJ )]1/ 2

This leads to the intuitive result that the desired addition would be the stock with the lowest correlation with Stock A, which is Stock D. The optimal portfolio is equally invested in Stock A

and Stock D, and the standard deviation is 17.03%.