Lecture 2: Delineating efficient

portfolios, the shape of the mean-

variance frontier, techniques for
calculating the efficient frontier
Prof. Massimo Guidolin

Portfolio Management
Spring 2016
Overview
The two-asset case
o Perfectly correlated assets
o Perfectly negatively correlated assets
o The case of -1 < < +1 (and = 0, uncorrelated assets)
The shape of the mean-variance frontier
The efficient frontier in the general N-asset case
The efficient frontier with unrestricted borrowing and
lending and the riskless rate
The tangency portfolio and the separation theorem
One practical issue in the construction of the efficient
frontier: parameter uncertainty

Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 2

The two-asset case
Call XA the fraction of a portfolio held in asset A and XB the fraction
held in asset B
o However these may as well be portfolio and not individual assets
We require the investor to be fully invested, XA + XB = 1 and XB = 1
XA, so that:
Such a simple, weighted way of combining is not necessarily true of
the risk (standard deviation of the return) of the portfolio:

Using the equation for means returns and , we obtain

In order to learn more about this relationship, we study specific

cases involving different degrees of co-movement btw. securities
Case 1: Perfect Positive Correlation ( = +1), the securities move in
unison

Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 3

The two-asset case: = +1
When = +1, there is a linear relationship btw. expected ptf.
returns and ptf. standard deviation

o This derives from the presence of a perfect square inside brackets

o C and S refer to an example (see above)
o The expected return on the portfolio is
o Thus with = + l, risk and return are linear combinations of the risk
and return of each security and because
XC = (E[RP] - E[RS])/(E[RC] - E[RS]), we have

When = +1, there is a linear relationship

btw. expected ptf. returns and std. dev. 4
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin
The two-asset case: = -1
o E.g., with our inputs for Colonel Motors and Separated Edison,
substituting this expression for XC into the equation for E[RP] and
rearranging yields:
In the case of perfectly correlated assets, there is no reduction in
risk from purchasing both assets
o In the plot, any combinations of the two assets lie along a straight line
connecting the two assets
Case 2: Perfect Negative Correlation ( = -1), the securities move
perfectly together but in exactly opposite directions
In this case the standard deviation of the portfolio is:

The term in the brackets is equivalent to either of the following:

or
Ptf. volatility is (*)or (**)
o Since we took the square root and the square root of a negative
number is imaginary, the equations hold only when right-hand side >0
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 5
The two-asset case: = -1
If two securities are perfectly negatively correlated, it is always
possible to find some combination that has zero risk
o Since one is always positive when the other is negative (except when
both equations equal zero), each also plots as a straight line when
expected return is plotted against volatility
o In fact, the value of P in this case is always smaller than the value of
P for the case where = + 1, for all values of
XC between 0 and 1
We can go one step further: If two
securities are perfectly negatively
correlated, it should always be
possible to find some combination
that has zero risk
By setting either (*) or (**) equal to 0,
we find that a portfolio with

will have zero risk

Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 6
The two-asset case: -1 < < +1
o Because S + C > C this implies that 0 < XC < 1 the zero risk ptf. will
always involve positive investment in both securities
o In our example, zero risk obtains for a simple 1/3-2/3 portfolio
because 3/(3 + 6) = 1/3
o Two equations relating mean and standard deviation, and for each
selection of XC the appropriate one is the one that guarantees P 0

Case 3: Uncorrelated assets ( = 0), in this case

shows for any value for XC between 0 and 1 the lower the
correlation the lower is the standard deviation of the ptf.
Ptf. standard deviation reaches its lowest value for = -1 (curve
SBC) and its highest value for = + 1 (curve SAC)
These two curves represent the limits within which all portfolios of
these two securities must lie for intermediate values of
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 7
The two-asset case: = 0

GMVP

o E.g., when = 0, noting that the covariance term drops out, the
expression for standard deviation becomes

There is one point on this figure that is worth special attention: the
portfolio that has minimum risk, the global minimum variance ptf.
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 8
The two-asset case: -1 < < +1
In the case -1 < < +1, the global minimum variance ptf. is the set
of weights that minimizes the resulting ptf.risk
o This portfolio can be found by looking at the equation for risk

and minimizing by taking the FOC w.r.t. XC and solving:

(***)
=0

o Continuing with our example, the value of XC that minimizes risk is

The correlation between any two actual stocks is almost always

greater than 0 and considerably less than 1
o E.g., in the case of = 0.5, the ptf. risk equation becomes

o In our example, minimum risk is obtained at a value of XC = 0 or 100%

in Separated Edison
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 9
The critical coefficient in the two-asset case
There is some critical value of such that ptf. risk cannot be made
less than the risk of the least risky asset without selling short
o Analytically,

In this example (i.e., = 0.5) there is no combination of the two

securities that is less risky than the least risky asset by itself,
though combinations are still less risky than under = +1
The particular value of the correlation coefficient for which no
combination of two securities is less risky than the least risky
security depends on the characteristics of the assets in question
For all assets there is some critical value of such that the risk on
the portfolio can no longer be made less than the risk of the least
risky asset in the portfolio without selling short
Setting XC equal to zero in (***) above and solving for * gives * =
S/C so that when is equal to or higher than *, the least risky
combination involves short selling the most risky security and may
be impossible 10
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin
The shape of the mean-variance frontier
Note that the portion of the portfolio possibility curve (aka mean-
variance frontier) that lies above the MVP is concave while that
which lies below the minimum variance portfolio is convex
This is a general characteristic of all portfolio problems

o The three figures represent three hypothesized shapes for

combinations of Colonel Motors and the MV portfolio
Shape (b) is impossible because combinations of assets cannot
have more risk than on a straight line connecting two assets
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 11
The shape of the mean-variance frontier
The (efficient) segment of the mean-variance frontier above the
GMVP must have a concave shape
In (c) all portfolios have less risk than the straight line connecting
Colonel Motors and the MVP, but this shape is impossible
o Examine the portfolios labeled U and V, combinations of the minimum
variance portfolio and Colonel Motors
o Since U and V are portfolios, all combinations of U and V must lie
either on a straight line connecting U and V or above such a line
The only legitimate shape is that shown in (a), which is concave
o Analogous reasoning can be used to show that if we consider
combinations of the MVP and a security or portfolio with higher
variance and lower return, the curve must be convex
What if the number of assets is some general N >> 2?
In theory we could plot all conceivable risky assets and their
combinations in a diagram in return standard deviation space
In theory," not because there is a problem, but because there are
an infinite number of possibilities that must be considered
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 12
The efficient frontier in the general N-asset case
Mean-variance dominance criteria simplify the opportunity set
If we were to plot all possibilities in risk-return space, we would get
Examine the diagram and see if
we can eliminate any part of it from
consideration by the investor
A rational investor would prefer
a higher mean return to less and
would prefer less risk to more
Thus, if we can find a set of ptfs
that (i) offered a bigger mean
return for the same risk, or (ii)
offered a lower risk for the same
mean return, we have the choice set
o E.g., ptf. B would be preferred by all investors to ptf. A because it
offers a higher return with the same level of risk
o Ptf. C would be preferable to portfolio A because it offers less risk for
the same level of return
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 13
The efficient frontier in the general N-asset case
However, we can find no portfolio that dominates portfolio C or
portfolio B
For this reason, an efficient set of
ptfs. cannot include interior ptfs.
Moreover, for any point in risk-
return space we want to move as
far as possible in the direction of
increasing mean return and as far
as possible in the direction of
decreasing risk
o Therefore we can eliminate D since
portfolio E exists, which has higher
mean return for the same risk
o This is true for every other portfolio as we move up the outer shell
from D to point C
o Point C cannot be eliminated because it is the GMVP
o Ptf. F is on the outer shell, but E has less risk for the same return
o As we move up the outer shell from point F, all ptfs are dominated
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 14
The efficient frontier in the general N-asset case
The efficient frontier consists of the envelope curve of all portfolios
that lie between the global MVP and the maximum return portfolio
o This until we come to B that cannot be eliminated for there is no ptf.
that has same return and less risk
or the same risk and more return
o Point B represents that ptf. (usually
a single security) that offers the
highest expected return of all ptfs.
The efficient set consists of the
envelope curve of all portfolios
that lie between the global
minimum variance portfolio
and the maximum return portfolio
See a graph of the efficient frontier
Based on our earlier proof, it is
a concave function
Only linear segments may exist
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 15
The efficient frontier with short selling
The portfolio problem, then, is to find all portfolios along this
frontier, which we shall examine later
So far, one could only combine long positions in existing assets
In many capital markets, an investor can often sell a security that he
or she does not own, a process called short selling
o In practice, this amounts to borrowing
an asset under the promise to the lender
that she will be no worse off lending it
and with a commitment to return it at
same date (say, end-of day)
o This requires re-funding any cash flows
(e.g., dividends or coupons that the
asset may pay out over time)
Short selling allows us to leverage up
the return of best performing securities
but also increases risks
With short sales, ptfs. exist that give infinite expected returns
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 16
Unrestricted Borrowing and Lending
Up to this point we have dealt with portfolios of risky assets only
The introduction of a riskless asset, that yields RF, into the
investment opportunity set considerably simplifies the analysis
o Because the return is certain, the standard deviation of the return on
the riskless asset must be zero
Of course such a step requires assuming that a risk-free asset exists
Borrowing can be considered as selling such a security short, so
that also borrowing can take place at the riskless rate
The investor is interested in placing part of the funds in some
portfolio A and either lending or borrowing
Call X the fraction of original funds that the investor places in ptf A
o X may exceed 1 because we are assuming that investors can borrow at
the riskless rate and invest more than his initial funds in ptf. A
The expected return on the combination of riskless asset and risky
portfolio is given by
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 17
Unrestricted Borrowing and Lending
The risk on the combination is (C stands for combination)

Since we have already argued that F is zero,

Solving this expression for X yields X = C/A and substituting this
expression into the expression for expected return and re-
arranging, yields

This is the equation of a straight line with

slope = Sharpe ratio of ptf. A:
The line passes through point (A, E[RA])
To the left of point A we have
combinations of lending and portfolio A,
whereas to the right of point A we have
combinations of borrowing and ptf. A
Problem: ptf. A we selected has no special properties; we could
have combined portfolio B with riskless lending and borrowing
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 18
The tangency portfolio
All investors facing the same efficient frontier ABGH will select the
same tangency portfolio G
Combinations along the ray RFB are superior to combinations along
RFA since they offer greater expected return for the same risk
We would like to rotate the straight line
passing through RF as far as we can in a
counterclockwise direction
The furthest we can rotate it is through G
Point G is the tangency point between the
efficient frontier and a ray through RF
Cannot rotate the ray further because by
definition there are no ptfs lying above
the line passing through RF and G
All investors who believed they faced the efficient frontier and
riskless lending and borrowing rates shown in the figure would
hold the same ptf. of risky asset: G
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 19
The tangency portfolio and the separation theorem
According to the separation theorem, all investors facing the same
efficient frontier select the tangency ptf. of risky assets regardless
of their preferences towards risk
o Investors who are very risk-averse select a ptf along the segment RFG
and place some money in a riskless asset and some in risky ptf G
o Others who were much more tolerant of risk would hold portfolios
along the segment G-H, borrowing funds and placing their original
capital plus the borrowed funds in portfolio G
Yet all of these investors would hold the tangency portfolio G.
Thus, for the case of riskless lending and borrowing, identification
of portfolio G constitutes a solution to the problem
The ability to determine the optimal ptf. of risky assets without
knowing anything about an investor is the separation theorem
Our our assumptions realistic? While there is no question about the
ability of investors to lend at the risk-free rate (buy government
securities), they could possibly not borrow at this rate
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 20
The effects of frictions on the separation theorem
Whe borrowing at the riskless rate is impossible, the efficient
frontier becomes RFGH
Certain investors will hold portfolios of
risky assets located between G and H
However, any investor who held some
riskless asset would place all remaining
funds in the tangency portfolio G
The separation theorem fails: different
investors may select different risky ptfs
A possibility is that investors can lend
at one rate (RF) but must pay a different
and higher rate to borrow (RF)
The efficient frontier becomew RFGHI
There is a small range of risky ptfs that
is optional for investors to hold and
two different tangency ptfs, G and H
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 21
One practical issue in portfolio choice
Also in this case the separation theorem fails
Reliable inputs on means, variances, and covariances are crucial to
the proper use of mean-variance optimization
Common to use historical risk, return, and correlation as a starting
point in obtaining inputs for calculating the efficient frontier
If return characteristics do not change through time, then the
longer the data are available the more accurate are the estimates
o E.g., the formula for the standard error of the mean of a sequence of
independent random variables is 2/N where N is the sample size
o This effect may be first-order: imagine an investor choosing between
two investments, each with identical sample means and variances
o The standard approach would view the two investments as equivalent
o If you consider the additional information that the first sample mean
was based on 1 year of data and the second on 10 years of data,
common sense would suggest that the second alternative is less risky:

Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 22

One practical issue in portfolio choice
There is a trade-off between using a long time frame to improve
the estimates and having potentially inaccurate estimates from the
longer time period because the characteristics have changed
o The first part of the expression captures the inherent risk in the
return; the second term captures the uncertainty that comes from lack
of knowledge about the true mean return
Characteristics of asset returns usually change over time
There is a trade-off between using a long time frame to improve the
estimates and having potentially inaccurate estimates from the
longer time period because the characteristics have changed
Because of this, most analysts modify historical estimates to reflect
beliefs about how current conditions differ from past conditions
The choice of the time period is more complicated when a relatively
new asset class is added to the mix, and the available data for the
new asset is much less than for other assets
For example, consider the case of CDS or CDOs as asset classes
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 23
One practical issue in portfolio choice
o An analyst who wishes to use historical data could use all available
data or use shorter data only from the common period of observation
Consider the IFC emerging markets index example in the table

o Differences may be substantial: e.g., statistics over the longer term are
consistent with an equilibrium in which a higher investor risk is
compensated by higher investor expected return
o Statistics over the period of common observation, beginning in 1985,
are inconsistent with this argument
Also correlations
are very different
and will affect the
frontier 24
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin
The stock-bond choice again (shorting allowed)
Consider again the allocation between equity and debt
The estimated historical inputs are:

The minimum variance portfolio is given by

Unsurprisingly, it implies selling the index short (write futures?)

The associated st. dev. is 4.75%,
which is slightly less than the
one associated with 100% in (tangency)
bonds, so were slightly below
the critical
This is the efficient frontier with
short sales allowed (it continues
to the right) 25
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin
The stock-bond choice again (no short sales)
The tangency portfolio is T and we will see how it is calculated soon
Assuming a 5% T-bill rate, we have E[RT] = 13.54% and T =
16.95% so that the slope of the line connecting the tangency
portfolio and the efficient frontier is (13.54% - 5%)/16.95% = 0.5
The equation of the efficient frontier with riskless lending and
borrowing is
Knowing the expected return of T we can easily determine its
composition:

The efficient frontier with no

short sales is to the right
In this case the GMVP is 100%
in bonds
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 26
Hints to techniques to calculate the efficient frontier
We distinguish among 4 cases:
o Short sales are allowed and riskless lending and borrowing is possible
o Short sales are allowed but riskless lending or borrowing is not
o Short sales are disallowed but riskless lending and borrowing exists
o Neither short sales nor riskless lending and borrowing are allowed
The derivation of the efficient set when short sales are allowed and
there is a riskless lending and borrowing rate is the simplest case
In this case, the efficient frontier is the entire length of the ray
extending through RF and B
An equivalent way of identifying the ray RF-B
is to recognize that it is the ray with the
greatest slope,

The efficient set is determined by finding

the ptf with the greatest (Sharpe) ratio
that satisfies the weight sum constraint
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 27
Hints to techniques to calculate the efficient frontier
o This is a constrained maximization problem for which there are
standard solution techniques
o For example, it can be solved by the method of Lagrangian multipliers
There is an alternative: the constraint could be substituted into the
objective function and the objective function maximized as in an
unconstrained problem

Making this substitution in the objective function and stating the

expected return and standard deviation of return in the general
form, one maximizes
This problem can be solved in
standard ways
by imposing
and solving
first order
conditions
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 28
Hints to techniques to calculate the efficient frontier
o In this case the FOCs are also sufficient because the objective function
is concave (we are dividing by a positive quadratic form)
We can prove that

Because each Xk is multiplied by a constant , define a new variable

Zk = Xk and substituting Zk for the Xk simplifies the formulation:

We have one equation like this for each value of i

Now solve the system of simultaneous equations:

Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 29

Hints to techniques to calculate the efficient frontier
To determine the optimum amount to invest, we first solve the
equations for the Zs and this is generally possible because there are
N equations (one for each security) and N unknowns (the Zk)
Then the optimum proportions to
invest in stock k is:
When short sales are allowed but there is no riskless lending and
borrowing rate, the solution above must be modified
o Assume a riskless lending and borrowing rate and find the optimum
o Assume that a different riskless lending
and borrowing rate exists and find the
optimum that corresponds to this rate
o Continue changing the riskless rate until
the full efficient frontier is deterrnined
One can show that the optimal
proportion to invest in any security is
simply a linear
function of RF
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 30
Hints to techniques to calculate the efficient frontier
Furthermore, the entire efficient frontier can be constructed as a
combination of any two portfolios that lie along it
Therefore the identification of the characteristics of the optimal
portfolio for any two arbitrary values of RF is sufficient to trace out
the total efficient frontier
When short sales are not allowed but there is riskless lending and
borrowing, the solution comes from solving

This is a nonlinear mathematical programming problem because of

the inequality restriction on the weights
o Equations involving squared terms and cross-product terms are called
quadratic equation
There are computer packages for solving quadratic programming
problems subject to constraints
In our case, the Excel solver will do
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 31
Hints to techniques to calculate the efficient frontier
The imposition of short sales constraints has complicated the
solution technique, forcing us to use quadratic programming
Once we resort to this technique, it is a simple matter to impose
other requirements on the solution
Any set of requirements that can be formulated as linear functions
of the investment weights can be imposed on the solution
o For example, some managers wish to select optimum ptfs given that
the dividend yield on the portfolios
is at least some number, D
o If one wants no short sale constraints, these can be imposed:

o Perhaps, the most frequent constraints are those that place an upper
limit on the fraction of the portfolio that can be invested in any asset
o Upper limits on the amount that can invested in any one stock are
often part of the charter of mutual funds
o It is possible to build in constraints on the amount of turnover in a
portfolio and to allow the consideration of transaction costs
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 32
Summary and conclusions
Provided that < 1 diversification offers a costless payoff: risk
reduction without any costs in terms of lower expected return
Such a risk-reduction is maximal when = -1, when a special ptf.
can be found that implies zero risk but positive expected return
When = 0, in the limit risk can also be removed by increasing the
total number of assets (N) in the portfolio
When > 0, even though N , the total amount of risk does not
level off to zero, but converges to the average covariance across all
pairs of assets in the economy
The efficient mean-variance set (frontier) is the subset of the
opportunity set that lies above the global minimum variance
portfolio and has a concave shape
The tangency portfolio is unique across all investors that perceive
the same efficient set
The separation theorem states that all investors will demand the
same risky portfolio irrespective of their risk aversion
Lecture 2: The Efficient Mean-Variance Frontier Prof. Guidolin 33