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Prepared by Francisco Oteiza for Pedro Bordalos Fall 2014 EC3314 Course. Errors
abound, Im sure.
1 Notation
For simplicity, lets call Ei E[ri ] for i = {p, s, b} and Cov(s, b) Cov(rs , rb ).
b2 Cov(s, b)
s2 + b2 2Cov(s, b)
In the first step above I first distributed the square (1 w)2 before applying the
differentiation. I then proceeded normally and used the chain rule for the term with the
covariance.
P = wp S + (1 wp ) B
As discussed in class, here we shall be looking at the Sharpe ratio, that is, how much
a portfolio pays (in terms of the risk premium) for every unit of risk we expose ourselves
to. So lets first calculate the Sharpe ratio of a portfolio composed of these two risky
assets (our old friends S and B):
Sp =
Sp =
Ep rf
p
(w2 s2
wEs + (1 w)Eb rf
+ (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2
And now we will proceed as before but this time we will look for the combination of
S and B that maximizes the portfolios Sharpe ratio.
max Sp =
(w2 s2
wEs + (1 w)Eb rf
+ (1 w)2 b2 + 2 Cov(s, b) w (1 w))1/2
We will have to apply the quotient rule, so the first thing we will do is define the
terms. Recall that the quotient rule states the following:
g(x)
h(x)
g 0 (x)h(x) g(x)h0 (x)
then f 0 (x) =
h(x)2
if f (x) =
h0 (w) =
h0 (w) =
h0 (w) =
In the last step above, for simplicity we have expressed the denominator as h(w) = p ,
but we will get back to this later. In the same way, we will for now write h(w)2 = p2 .
Now get ready, here comes a tricky part:
f 0 (w) =
Now we can set the FOC for the maximization, that states that S
w = 0 and this will
make our life much easier, since we can quickly remove the denominator of the expression
above.
And this is the expression we had to arrive at (check in the PS solutions). Success!
3