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You are on page 1of 29

Duan LI & Xiangyu Cui

India Institute of Technology Kharagpur

May 26 - 30, 2014

2

Return

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

3

Short Sales

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 invested (initially)

4

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 .

5

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

6

Portfolio Return

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

n

X

X0i

wi = 1.

wi =

X0

i=1

7

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

r =R1=

n

X

i=1

wi ri

8

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

2 = var(r) =

n

X

i,j=1

wi wj ij = w w

9

Example: A Two-Stock World

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.

10

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

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.

11

Diagram of Portfolios

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

12

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

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 .

13

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

14

Risky Assets

17

15

18

16

Selection

20

17

Feasible Set (Contd)

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

18

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.

19

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) .

20

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

21

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

22

Computational Implication

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.

23

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

24

M-V Selection: No 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.

25

Inclusion of Riskless Asset

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.

26

Calculation of Tangent Fund

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.

27

30

28

Calculation of Tangent Fund (Cont)

1. Solve

v =

r rf 1

2. Normalize

v

wF =

1v

29

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=

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