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FRONTIER PORTFOLIOS
Given asset returns, asset standard deviations, and the current portfolio split, linear algebra operations
can be used to calculate Expected Return on the Portfolio of Assets and the Variance of the Portfolio
Cell I:14 - calculates the Expected Return on the Portfolio by employing equation 1.
Cell I:15 - calculates the Standard Deviation of the Portfolio by raising equation 2 to the one-half power.
Note: Both calculations use linear algegra operations. For Expected Return,Cell I:14, the dimensions of
vectors 'e' and 'w' must agree. In our case 'e'='w'=3x1 vector satisfying the agreement of dimesions. The
Expected Return is a scalar value. For our problem we observe Portfolio Return to be the matrix
mutliplication of a 1x3 vector 'wT'and a 3x1 vector 'e'. Dimension Multiplication: (1x3)*(3x1)=(1x1) .For
Standard Deviation,Cell I:15, the dimensions of the matrix 'V' and the vector 'w' must agree. In our case
'V'=3x3 matrix and 'w'=3x1 matrix satisfying the first part of our equation. The result of V*w is a 3x1
vector. Finally, we need the dimensions of w T and V*w to agree. In our case, wT = 1x3 vector and V*w
=3x1 vector. The resulting multiplication wTVw is a 1x1 or scalar, as desired. It is also critical to employ
Control+Shift+Enter when evaluating functions that use matrices and vectors as imputs.
split, linear algebra operations
he Variance of the Portfolio
quation 1.
uation 2 to the one-half power.
Asset Data
T-Bills 0.60% 4.30% Target Exp. Return 8% target1
Bonds 2.10% 10.10%
Stocks 9.00% 20.80%
RE 3.00%
Correlation Matrix T-Bills Bonds Stocks Frontier Portfolio Weights
T-Bills 1.00 0.63 0.09 T-Bills -24.31%
Bonds 0.63 1.00 0.23 Bonds 44.09% change1
Stocks 0.09 0.23 1 Stocks 80.22%
100.00%
Covariance Matrix T-bills Bonds Stocks Exp Ret 8.00% portret1
T-Bills 0.0018 0.0027 0.0008 Std Dev 18.02% portsd1
Bonds 0.0027 0.0102 0.0048
Stocks 0.0008 0.0048 0.0433
Installation of Solver
1. Click the Office Button in the top left hand corner
2. Click Excel Options from the drop down menu
3. Choose Add-Ins on the left panel menu
4. Highlight the Solver Add-In and Click Go
5. In the pop-up menu, select solver add-in and cick OK
6. Solver will be available in the DATA tab in the analysis subtab.
Application of Solver
Necessary Inputs:
'target cell' = value that will be minimized (maximized) = Std Dev (portsd1)
'changing cells' = values to be changed = Bonds and Stocks (change1)
'constraints' = Exp Return must equal Target Expected Return (target1)
Answer: The optimum weights imply the following: buy Bonds and Stocks and
short sell T-Bills in the corresponding proportions under the portfolio weights.
The Exp Ret verifies the constraint and minimizes the Std Dev in the process.
USING ALGEBRA TO REPRODUCE UNCONSTRAINED
FRONTIER PORTFOLIOS
u-VEC l m g
A 4.026
1 1.26 686.51 B 0.201 1.24
1 0.80 -93.46 C 613.825 -0.21
1 1.97 20.77 D 107.385 -0.03
Weights
T-Bills -5.78%
Bonds 36.02% Exp Return 7.00%
Stocks 69.76% Std Dev 15.70%
Solution to Reproduce Figure 4 from our in-class handout:
A=uTl
B=eTl
C=uTm
10.6179 D=BC-A2
-14.3342 Where: l=V-1e & m= V-1u
24.48752 g= [Bm - Al]/D -(3x1 vector)
h=[Cl-Am]/D -(3x1 vector)
Note: Portfolio g has an Expected Return of 0% and Portfolio (g+h) has an
Expected Return of 100%. A linear combination of these values will be very
useful.
h g+h T=Target Return
100.00% 100.00%
239.08% 237.55%
idual asset
algebra-
When using
+Enter must be
io (g+h) has an
alues will be very
ond to figure 3.
Asset Data Covariance Matrix T-bills Bonds Stocks
T-Bills 0.60% 4.30% T-Bills 0.0018 0.0027 0.0008
Bonds 2.10% 10.10% Bonds 0.0027 0.0102 0.0048
Stocks 9.00% 20.80% Stocks 0.0008 0.0048 0.0433
Exp Ret 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%
Std Dev 4.33% 4.12% 5.16% 6.91% 8.96% 11.14% 13.40% 15.70%
10%
8%
Expected Return
6%
4%
2%
0%
0% 5% 10% 15%
Efficient Frontier
k (Standard Deviation)