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Returns generating assets a1, a2, a3, .... are projected to yield uncertain
returns y1, y2, y3, ..... the uncertainty in returns is modeled with a
gaussian distribution with expected value = k1, k2, k3, .... and standard
deviation = s1, s2, s3, ...
The question
If we combine assets a1, a2, a3, ... with relative dollar amounts invested in
each asset given by the weight vector w1, w2, w3, ...and form a portfolio p
then what will the returns distribution of p look like? i.e., what are values
of kp and sp?
Computation of kp and sp
This expression is not linear but quadratic. To see what these curves will
look like let us first define
rij=sij/(si*sj)
where rij is the correlation coefficient between ai returns and aj returns
and rewrite the spp equation as
spp = sumi(sumj(wi*wj*s1*sj*rij))
for two assets 1 and 2 this equation simplifies to
spp = w1*w1*s11 + w2*w2*s22 + 2*w1*w2*s1*s2*r12
Consider the following cases for the two asset equation
These curve shapes will not change when the number of assets in the
portfolio is increased.