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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):
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 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
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=