Professional Documents
Culture Documents
Portfolio Theory
Road Map
Main Issues
Returns of Portfolios
Diversication
Fall 2006
c J. Wang 15.401 Lecture Notes
7-2 Portfolio Theory Chapter 7
2 Portfolio Returns
A portfolio is simply a collections of assets, characterized by the
mean, variances/covariances of their returns, r1, r2, . . . , rn:
Mean returns:
Asset 1 2 n
Mean Return r1 r2 rn
r1 12
12 1n
r2 21 2 2
2n
.. .. .. . . . ..
. . . .
rn n1 n2 n 2
V = V1 + V2 .
Then, w1 + w2 = 1.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-4 Portfolio Theory Chapter 7
rp = w1 r1 + w2r2 .
rp = w1 r1 + w2r2 .
rp rp = w1 (
r1
r1) + w2 (
r2
r2).
w1 r1 22
w1 w1 w2 12
1
w2 r2 w1 w2 12 22
w2 2
Fall 2006
c J. Wang 15.401 Lecture Notes
7-6 Portfolio Theory Chapter 7
(2)(0.5)2 (0.002095)
= 0.003888
p = 6.23%.
w1 + w2 + w3 = 1.
w1 r1 w2 r2 w3 r3
w1 r1 22
w1 w1 w2 12 w1 w3 13
1
w2 r2 w1 w2 12 22
w2 w2 w3 23
2
w3 r3 w1 w3 13 w2 w3 23 22
w3 3
Fall 2006
c J. Wang 15.401 Lecture Notes
7-8 Portfolio Theory Chapter 7
What are the variance and StD of a portfolio with 1/3 invested
in each stock (the equally weighted portfolio)?
p = 5.59%.
IBM = 8.81%
Merck = 5.99%
Intel = 9.89%.
where ii = i2.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-10 Portfolio Theory Chapter 7
w1 r1 w2 r2 w n rn
w1 r1 22
w1 w1 w2 12 w1 wn 1n
1
w2 r2 w2 w1 21 22
w2 w2 wn 2n
2
.. .. ... ..
. . .
wn rn wn w1 n1 wn w2 n2 22
wn n
3 Diversification
Lesson 1: Diversication reduces risk.
1. Two assets:
Diversification with two assets
1.5
correlation = 0.1
0.5
excess return
0.5
... n=1
n=2
1.5
0 10 20 30 40 50 60
time
2. Multiple assets:
Diversification with many assets
2
average correlation = 0.1
1.5
1
excess return
0.5
0.5
... n=1
n=10
__ n=infinity
1
0 10 20 30 40 50 60
time
Fall 2006
c J. Wang 15.401 Lecture Notes
7-12 Portfolio Theory Chapter 7
Example. Given two assets with the same annual return StD,
1 = 2 = 35%, consider a portfolio p with weight w in asset 1
and 1w in asset 2.
p = w2 12 + (1w)2 22 + 2w(1w)12 .
From the plot below, the StD of the portfolio return is less than
the StD of each individual asset.
0.45
0.40
0.35
0.30
Portfolio StD
0.25
0.20
0.15
0.10
0.05
0.00
-0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2
Weight in asset 1
Risk eliminated
by diversification
Undiversifiable
or market risk
Diversiable risk.
Non-diversiable risk.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-14 Portfolio Theory Chapter 7
w1 r1 wn rn
w1 r1 w2 2 w1 wn 1n
1 1
.. .. ... ..
. . .
wn rn wn w1 n1 22
wn n
1
2
A typical variance term: n
ii.
Total number of variance terms: n.
2
A typical covariance term: n1 ij (i =
j ).
Total number of covariance terms: n2 n.
n
n n
n
n
1 2 1 2
p2 = wi wj ij = ii + ij
n n
i=1 j=1 i=1 i=1 j=i
n
n
n
1 1 n2 n 1
= i2 + ij
n n n2 n2 n
i=1 i=1 j=i
1 n2 n
= (average variance) + (average covariance).
n n2
r
6
maximizing
6return
minimizing
risk
-
Fall 2006
c J. Wang 15.401 Lecture Notes
7-16 Portfolio Theory Chapter 7
Frontier with
six assets
5.00
Intel
4.00
Return (%, per month)
3.00
2.00
GE
IBM
JP Morgan
Merck
1.00
AT&T
0.00
0.0 2.0 4.0 6.0 8.0 10.0 12.0
Standard Deviation (%, per month)
Then
rp = w
r1 + (1 w)
r2
rp r2
w= .
r1 r2
r 2 r r
r2 2 2
rp p r1 2 p r2 p r1
p = 1 + 2 + 2 12 .
r1 r2 r2
r1 r1
r2 r2
r1
Fall 2006
c J. Wang 15.401 Lecture Notes
7-18 Portfolio Theory Chapter 7
r1 rp r2.
1.8
1.6
IBM
1.4
R eturn (%, per m onth)
1.2
1 Merck
0.8
0.6
0.4
0.2
0
0 2 4 6 8 10 12
StandardDeviation (%, per m onth)
Example. (Continued.)
1.6
IBM
1.4
1.2
R eturn (%, per m onth)
Merck
1
0.8
0.6
0.4
0.2
0
0 2 4 6 8 10 12
StandardDeviation (%, per m onth)
Fall 2006
c J. Wang 15.401 Lecture Notes
7-20 Portfolio Theory Chapter 7
1. 1 = 0: Asset 1 is risk-free.
Portfolio Frontier with A Risk-Free Asset
1.8
1.7
1.6
1.5
R eturn (%, per m onth)
1.4
1.3
1.2
1.1
0.9
0.8
0 2 4 6 8 10 12
StandardDeviation (%, per m onth)
1.8
1.7
1.6
1.5
R eturn (%, per m onth)
1.4
1.3
1.2
1.1
0.9
0.8
0 2 4 6 8 10 12
StandardDeviation (%, per m onth)
Frontier with
six assets
5.00
Intel
4.00
R eturn (%, per m onth)
3.00
2.00
GE
IBM
JP Morgan
Merck
1.00
AT&T
0.00
0.0 2.0 4.0 6.0 8.0 10.0 12.0
StandardDeviation (%, per m onth)
Intuition: Since one can choose to ignore the new assets, including
them cannot make one worse o.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-22 Portfolio Theory Chapter 7
w2 = 30% in Merck.
rp = (1x)rF + x
rq
rp = (1x)rF + x
rq
p2 = x2 q2 .
4.50
Efficiency frontier
4.00
3.50
R eturn (%, per m onth)
3.00 T
2.50 q
2.00
1.50
1.00
0.50
0.00
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
StandardDeviation (%, per m onth)
rp rF
Frontier portfolios have the highest Sharpe ratio: p
.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-24 Portfolio Theory Chapter 7
6 Summary
Main points of modern portfolio theory:
Fall 2006
c J. Wang 15.401 Lecture Notes
7-26 Portfolio Theory Chapter 7
We now outline the steps involved in obtaining the optimal portfolio using the
Solver.
Step 3 Open Solver (from the Tools menu). If Solver is not installed, you
can try and install it from the Add-ins choice under Tools. If this does
not work, then you will need to get professional help.
In the target cell, choose $H$26 and select Min.
Step 4 Click on Solve and the optimal portfolio weights should appear in
cells C26 and D26.
Step 5 You can repeat this process for other values of portfolio expected return
(as in B27, B28, . . . and redoing Steps 2-4 with the appropriate changes).
Step 6 Plotting the points in columns H and I (using x-y plots) will give the
portfolio frontier.
Fall 2006
c J. Wang 15.401 Lecture Notes
7-28 Portfolio Theory Chapter 7
8 Homework
Readings:
Assignment:
Problem Set 4.