Mean Variance Theory

September 24th, 2012

Mean Variance Theory

Mean & Variance of a Portfolio

Let r1 , . . . , rN be R.V.s representing random future return rates of
N assets. The portfolio return rate is
r=

N
X

w n rn

n=1

and is also random. Denote rn = Ern and r = Er ,

r = E

N
X

wn rn =

n=1
2

(r ) = var (r ) = cov

N
X

wn rn ,

n=1
N
X

w n rn ,

n=1

N
X
m,n=1

N
X
n=1

wn wm cov (rn , rm ) .
| {z }
=cnm

Mean Variance Theory

!
w n rn

Covariance Matrix
C is the covariance matrix of (r1 , . . . , rN ),

c11 c12 c13 . . .

c21 c22 c23 . . .

C = c31 c32 c33 . . .

..
..
.
.
cN1 cN2 cN3 . . .

c1N
c2N

c3N

cNN

C is a symmetric matrix (C T = C ) and is positive semi-definite

N
X

xm xn cnm 0

for all x RN .

m,n=1

Mean Variance Theory

Example: Two Assets

r1 = .12, 1 = .18, w1 = .25

r1 = .15, 2 = .20, w2 = .75 and cov (r1 , r2 ) = .01.

r = .25(.12) + .75(.15) = .1425

2 = var (w1 r1 + w2 r2 ) = cov (w1 r1 + w2 r2 , w1 r1 + w2 r2 )
= w12 var (r1 ) + w22 var (r2 ) + 2w1 w2 cov (r1 , r2 )
= (.25)2 (.18)2 + (.75)2 (.2)2 + 2(.25)(.75)(.01)
= .028275 ,
and so = .1681. Have compromised on the expected return, but
have lowered the overall variation of the outcome.

Mean Variance Theory

Diversification (Uncorrelated Assets)

For N mutually uncorrelated assets with mean return m and

variance 3 , portfolio with equal weights wi = N1 is less risky:
r

r =

var (r ) =

N
1 X
ri ,
N

1
N

n=1
N
X

N
1 X
Eri =
m=m,
N

n=1
N
X

1
N2

n=1

n=1

2 =

2
0
N

as N .

Mean Variance Theory

Diversification (Correlated Assets)

Suppose now that cov (ri , rj ) = .3 2 . Then

! N
N
X
X
1
var (r ) = 2 E
(ri r ) (rj r )
N
i=1

j=1

N
X
X
X
1
1
2 +
cov (ri , rj )
cov (ri , rj ) = 2
= 2
N
N
i,j=1

i=j

i6=j

1
2
2
2
N
+
N(N

1).3
=
.7
+ .3 2 .3 2 .
N2
N

Mean Variance Theory

Diversification in General

Assets all with equal expected returns is unrealistic.

In general: diversification may reduce overall expected return
while reducing the variance.
Mean-Variance approach developed by Markowitz make
explicit the trade-off between mean and variance.

Mean Variance Theory

Lets Develop a Finanical Model for Measuring Risk

From N-many assets with returns r1 , r2 , . . . , rN , well construct

portfolios based on our
concerns regarding volatility,
and our natural liking for higher returns.
It turns out that a simple 2-D relationship can be formed.

Mean Variance Theory

Simple Example

Two Assets: with expected return rates r1 , r2 , variance 1 ,

2 , and covariance c12 (each asset is a point in the
mean-standard deviation diagram)
form a portfolio of this two assets with weights w1 = and
w2 = (1 ),
r = r1 + (1 )r2
2 = 2 12 + 2(1 )c12 + (1 )2 22
is a new point in the diagram (, r ) (is a new asset)
different portfolio for different

Mean Variance Theory

Portfolio Diagram (No Shortselling)

Figure: For no short selling: the lines labeled = 1 are the lower
bounds on . The upper bound is the line labeled = 1. The set of
points (, r ) for [0, 1] are the curved line.
Mean Variance Theory

Variance Bounds

For each define

q
.
() = (1 )2 12 + 2(1 )1 2 + 2 22 .
For [0, 1] (no short selling), the most variance occurs when
= 1,
q
() (1 )2 12 + 2(1 )1 2 + 2 22
=

((1 )1 + 2 )2 = (1 )1 + 2

(this is the dotted line in Figure 1).

Mean Variance Theory

Variance Bounds

Similarly for [0, 1] (no short selling), the minimum variance

occurs when = 1,
q
() (1 )2 12 2(1 )1 2 + 2 22
q
= ((1 )1 2 )2 = |(1 )1 2 |
(this makes up the two straight lines originating on left in Figure
1).

Mean Variance Theory

Variance Bounds

In Figure 1, the point where the two lines meet on the y-axis is
r (0 ) where 0 is s.t. (0 ) = 0 when = 1, i.e.
(1 )1 0 2 = 0
1
,
1 + 2


1
1
and so r (0 ) = 1+

r
+
1

r2 .
1
1 +2
2
0 =

Mean Variance Theory

Variance Bounds (with short selling)

Same bounds for [0, 1], but for

/ [0, 1] we have
() |(1 )1 2 |

case = 1

() |(1 )1 + 2 |

case = 1

(See Figure 2).

Mean Variance Theory

Portfolio Diagram (With Shortselling)

Figure: With shortselling. Solid line is |(1 )1 2 | and dotted is

|(1 )1 + 2 |.

Mean Variance Theory

For 3 Assets

Add a third asset with expected return r3 and std. dev. 3 . Let
1 equal the total allocation in assets 1 and 2, then repeat
analysis from before.
Results in more options for allocation (hyper place of R3
instead of the lower dimensional hyper lane of R2
There is a region of possible (, r ) points rather than just a
curve (See Figure 3).
In general, can find feasible sets of points (, r ) for N-many
assets, and it gives us a good idea of a portfolios
mean-variance trade-off.

Mean Variance Theory

Feasible Region

Figure: Assets 1 and 2 are the same as from slide 4, and for the new
asset we have r3 = .11 and 3 = .1.

Mean Variance Theory

Minimum Variance and the Efficient Frontier

For a portfolio allocation w RN to be optimal, we would like it

to minimize variance will still maintaining a certain level of
expected return. This optimization problem is formulate as
!
N
N
X
X
min var
wn rn =
wn wm cnm = w T Cw
w RN

n=1

n,m=1

P
P
subject to the constraints nn=1 wn = 1 and N
rn = r ,
n=1 wn
where r is our desiredP
level of return.
We say portfolio r = N
n=1 wn rn is efficient if there exists no other
portfolio r such that Er Er and (r ) < (r ).

Mean Variance Theory

Minimum Variance Set

Figure: The side-ways parabola shows the minimum variance set,

minw w T Cw s.t. w1 + w2 = 1 and w1r1 + w2r2 = r . This is the same
number from slide 4, and the dot on the frontier is the allocation from
slide 4 (its in fact efficient).
Mean Variance Theory

Solving with Matlab

A good way to find optimal mean-variance allocation is using

Matlabs fmincon (see Matlab code on Blackboard).

Mean Variance Theory