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# Portfolio Optimization

## Unit 3: Mean-Variance Portfolio Selection

Duan LI & Xiangyu Cui
India Institute of Technology Kharagpur
May 26 - 30, 2014

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Return

## Asset: An investment instrument that can be bought and sold

Single (investment) period: An investor invests at the beginning of
the period and holds it until the end of the period
Total return of investing on an asset (for a single period):
amount received (later)
X1
R = total return =
=
amount invested (initially)
X0
Rate of return: r =

X1 X0
X0

Profit: p = X1 X0 = rX0
R =1+r
X1 = (1 + r)X0

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Short Sales

## Short selling or shorting: the process of borrowing an asset, selling

it, and returning the asset at a later date
Short selling is regarded very risky: the potential for loss is unlimited.
Suppose we receive X0 initially and pay X1 later. The total return of
the shorting is
R=
=

total return =
X1
X0

X1
X0

## amount received (later)

amount invested (initially)

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The rate of return is
r = rate of return =

X1 (X0 )
X1 X0
=
X0
X0

R =1+r
Profit p = X0 X1 = rX0
In practice, the short selling is supplemented by certain restrictions
and safeguards: To short a stock, you are required to deposit an
amount equal to the initial price X0 . At the end of the time period
(with stock price changing to X1 ), you recover your original position
(liquidate your position) and receive your profit from shorting equal
to X0 X1 .

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Example: John Goes Short

John short sold 100 shares of stock ABC at the price \$10/share. The
stock dropped to \$9/share after one year.
Question: Evaluate the return of this investment
Solution: X0 = 1000, X1 = 900
R=

900
1000

= 0.9

r = R 1 = 0.1
p = rX0 = 0.1 1000 = 100

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Portfolio Return

## A portfolio or a master asset: Allocation of the initial amount of X0

to available n different assets
= (X01 , X02 , , X0n ),
where X0i is the amount invested in the ith asset, with
n
X

X0i = X0

i=1

## Weight of asset i in the portfolio:

n

X
X0i

wi = 1.
wi =
X0
i=1

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Portfolio Return (Contd)

Let Ri and ri be the total return and rate of return of asset i. Then
The total return of the portfolio is
R=

Pn

X
i=1 Ri X0i
=
wi Ri
X0
i=1

## The rate of return of the portfolio is

r =R1=

n
X
i=1

wi ri

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Portfolio Mean and Variance
Consider n assets with random rate of return r1 , r2 , , rn , and a portfolio using the weights wi , i = 1, 2, , n. Let w = (w1 , , wn ) .
Let ri be the expected return of ri and ij be the covariance between
ri and rj . Let
r = (
r1 , , rn ) and = (ij )nn .
The mean rate of return of the portfolio is
r =

n
X

wi ri = w
r

i=1

## The variance of the return of the portfolio is

2 = var(r) =

n
X

i,j=1

wi wj ij = w w

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Example: A Two-Stock World

## Consider a market consisting of two stocks, with r1 = 0, 12, r2 = 0.15,

1 = 0.2, 2 = 0.18 and 12 = 0.01. Bill holds a portfolio with w1 =
0.25, w2 = 0.75 What are the mean return and variance of Bills portfolio?
Solution:
P2
r = i=1 wi ri = 0.1425
P
2 = 2i,j=1 wi wj ij = 0.024475 or = 0.1564
If 12 is instead 0.1. Then 2 = 0.095.
One seminal work of Prof. Harry Markowitzs is to use the variance of
the final wealth as a risk measure for investment.
Suitably constructing a portfolio can reduce investment risk.

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Diversification

Diversification: A process of including additional assets in the portfolio to reduce the variance of its return.
Consider n assets that are mutually uncorrelated. The rate of return
of each asset has mean m and variance 2 . Form a portfolio with
wi = n1 . Then
The mean rate of return of the portfolio is E(r) = m
The variance of the portfolio return is var(r) =

2
n

## The variance decreases as n increases while the mean return rate

remains the same.
In the case when some assets are correlated, there may be a lower
limit of variance that may be achieved by diversification.

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Diagram of Portfolios

## Mean-standard deviation diagram or r diagram: A two-dimensional

diagram, representing the return of assets or portfolios. The horizontal axis is for the standard deviation , and the vertical axis for the
mean rate of return r.
Assume that assets 1 and 2 are characterized by (
r1 , 1 ) and (
r2 , 2 ),
respectively, and their correlation coefficient is . Let the decision
variable be which is the percentage of wealth you invest in asset 2
You invest (1 ) of your wealth in asset 1.
The random return of the portfolio, (1 )r1 + r2 , has the following
mean and standard deviation,
r() =
()

(1 )
r1 +
r2
q
(1 )2 12 + 2(1 )1 2 + 2 22

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If = 1, then
()

=
=

q
(1 )2 12 + 2(1 )1 2 + 2 22
p
[(1 )1 + 2 ]2 = (1 )1 + 2 .

If = 1, then
()

=
=
=

q
(1 )2 12 2(1 )1 2 + 2 22
p
[(1 )1 2 ]2 =| (1 )1 2 |

1
(1 )1 2 if 1+
2
1
2 (1 )1 if 1 +2

## Portfolio diagram lemma. The curve in an r diagram defined

by portfolios made from two assets 1 and 2 lies within the triangular
region defined by the two original assets and the point on the vertical
r2 1
axis of height A = r1 21 +
+2 .

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Feasible Set
Suppose there are n basic assets.
Feasible set or feasible region: The set of points that corresponding
to all possible portfolios forming from the n basic assets
The feasible region must be convex to the left.
Minimum-variance set: The left boundary of a feasible set
Minimum-variance point (MVP): The point on the minimum-variance
set that has minimum variance
Risk-averse investor: An investor who, under the same rate of return,
prefers the portfolio with the smallest standard deviation

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Risky Assets

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## Mean-Variance Formulation in Portfolio

Selection

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Feasible Set (Contd)

## Risk-seeking or risk-preferring investor: An investor who, under the

same rate of return, chooses the portfolio other than the one of minimum standard deviation
Non-satiation investor: An investor who, under the same level of
standard deviation, selects the portfolio with the largest mean rate of
return
Efficient frontier: The upper portion of the minimum-variance set
Efficient frontier provides the best trade off between return and risk

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Formulation of Markowitzs Model
Suppose there are n basic assets with mean rates of return ri (i =
1, 2, , n) and covariances ij (i, j = 1, 2, , n). Given a value r, the
objective of a Markowitzs mean-variance portfolio selection problem is
Minimize 12 w w
subject to w
r = r
1 w = 1,
where 1 = (1 1) .
This classical Markowitzs Model is a convex quadratic optimization
problem.

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Solution to Markowitzs Mean-Variance Model
Introduce the Lagrangian
1
L = w w (w
r r) (1 w 1)
2
where and are two Lagrangian multipliers.
Equations for Efficient Set. The portfolio weights wi (i = 1, 2, , n)
and the two Lagrange multipliers and for an efficient portfolio (with
shorting allowed) having mean rate of return r satisfy
w
r 1 = 0

r w = r
1 w = 1,
where 0 = (0 0) .

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Linearity of Efficient Equations
Let {w1 , 1 , 1 }, and {w2 , 2 , 2 } be two efficient portfolios corresponding to r1 and r2 , respectively.
wj
r 1 = 0

r wj = rj
1 wj = 1, j = 1, 2
Then {w = w1 + (1 )w2 , 1 + (1 )2 , 1 + (1 )2 }
satisfies
w
r 1 = 0

r w =
r 1 + (1 )
r2
1 w = 1

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Two-Fund Theorem
Two efficient funds (portfolios) can be established so that any efficient
portfolio can be duplicated, in terms of mean and variance, as a combination
of these two. In other words, all investors seeking efficient portfolios need
only invest in combinations of these two funds.
Implications:
Two mutual funds could provide a complete investment service.
Individuals do not need to purchase individual stocks separately.
Note the underlying assumptions:
Mean-variance framework
Everyone has the same assessment of means, variances and covariances.
Single period

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Computational Implication

## Find two particular solutions!

Take (a) = 0 and (b) = 0
The constraint 1 w = 1 may be violated, so one needs to normalize.
The solution to (a) is the minimum-variance point.

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Example

n = 2;
r=




0.151
0.125

0.023 0.0093
0.0093 0.014

 
0.0093
1
v=

0.014
1

;=

0.023
Let = 0.
0.0093




0.2554
19.9562
1
and w =
v=
Normalization = 78.1278
0.7446
58.1716




0.023 0.0093
0.151
Let = 0.
v=

0.0093 0.014
0.125




4.04
0.393
1
v=
Normalization = 10.28
and w =
6.24
0.607
All efficient solutions can be expressed as




0.393
0.2554

+ (1 )
,
0.607
0.7446

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M-V Selection: No Shorting

## A modified Markowitzs mean-variance selection problem with shorting

prohibited:
Minimize 21 w w
subject to w
r = r
1 w = 1
wi 0, i = 1, 2, , n.
This problem is still a convex quadratic optimization problem and can
be solved by quadratic programming algorithms.

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Inclusion of Riskless Asset

## Riskless or risk-free asset: An asset that has a deterministic return

When riskless borrowing and lending are available, the efficient set
becomes a single straight line.
This line is tangent to the original feasible set of risky assets from the
riskless point.
Tangent portfolio: The portfolio that corresponds to the point F in
the original feasible set that is on the line segment defining the efficient
set.
The One-Fund Theorem. There is a single fund F of risky assets
such that any efficient portfolio can be constructed as a combination
of the fund F and the risk-free asset.

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Calculation of Tangent Fund

## Let the tangent point be (p , rp ). To identify the tangent point is

equivalent to solving
rp rf
w
r rf
max tan =
Fractional programming
=
p
(w w)1/2
From the theory of fractional programming, the above problem can be solved
by considering the following auxiliary problem:
max w (
r 1rf ) w w
where is a parameter to be determined.

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## Tangent Portfolio and One Fund Theorem

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Calculation of Tangent Fund (Cont)

## Algorithm to find tangent portfolio wF :

1. Solve
v =
r rf 1
2. Normalize
v
wF =
1v

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Example

0.151
0.023 0.0093
;=
; rf = 0.08.
0.125
0.0093 0.014



 

0.023
0.0093
0.151
0.08

v=

0.0093
0.014
0.08


 0.125


2.444
2.444
0.6057
v=
w=
/(2.444 + 1.591) =
1.591
1.591
0.3943




0.6057
All efficient solutions can be expressed by
(1 )
0.3943
with 1.
n = 2;
r=