Chapter 4

- 1 -
Chapter 4: Portfolios with Multiple Assets

In case of two assets, we studied concepts such as returns, risks, short selling etc.. In
real life, most investment portfolios contain more than two assets.

In this case, the expected return and risk forms a region in the return-risk space
bounded by a hyperbolic curve. The upper bound is called the (Markowitz 1989
Nobel prize laureate in economics) efficient frontier and is the focus of our study.

There are no constraints on the portfolio weights as short selling is permitted.

If riskless assets are allowed in the portfolio, the form of the efficient frontier
becomes a straight line to form the so-called capital allocation line.

4.1: The Efficient Frontier

The portfolio (M) with highest return among the portfolios that has lowerest risk
among all possible portfolios is called the minimum risk portfolio.

Now we look at the efficient frontier: this is defined by portfolios that no point has
high return with the risk of H and no point with the return of H has lower risk.

If short selling is allowed, this boundary can be unlimited. This curve consists of all
portfolios that have special attractions to investors and should be logically considered.

However, efficient frontier does not tell where the optimal portfolio is. This is decided
by the investors risk tolerance or aversion. Mathematically, this is measured by the
expected utility function u(
p
,
p
) as discussed in Section 2.1.

Example 4.1.1: Given expected utility function
u(
p
,
p
) =
p
-
p
2
Then it is easy to see that

M
Efficient
frontier

Chapter 4
- 2 -

p
= u +
p
2
,
It is clear that for a given
p
, increasing will lead to decreasing u or decreasing
p
.
Hence is the risk tolerance coefficient.

Example 4.1.2: Given expected utility function
u(
p
,
p
) =
p
-
p

Then it is easy to see that

p
= u +
p
,
The risk return space curves are linear with intersection points giving the expected
utility values.

4.2 Efficient Frontier Portfolios with Multiple Risky Assets

The efficient frontier is decided by portfolios which minimise the risk for a required
expected return, or, equivalently, which maximise the expected return for a given
level of risk.

We are dealing with the general case of n assets A
1
, A
2
, ..., A
n
with the i
th
having random
variable return R
i
with mean
i
, standard deviation
i
and R
i
, R
j
having covariance
ij
. The
simplest random variable model for the R
i
is hence given by
R
i
=
i
+e
i
, with E(e
i
) =0, var(e
i
) =
i
2
, cov(e
i
,e
j
) =
ij


It is easier to use matrix notation, and set

R =(R
1
,R
2
, , R
n
)
T
, asset returns
w =(w
1
,w
2
, , w
n
)
T
, wrights of the assets
=(
1
,
2
, ,
n
)
T
, expected returns
V =
|
|
|
|
|
.
|

\
|
2
2 1
2
2
2 12
1 12
2
1
n n n
n
n
o o o
o o o
o o o

, the nn variance (symmetric) matrix of returns

l =(1,1, , 1)
T
, a column of n ones

We allow short selling (by permitting weights > 1 or < 0) but no investment in riskless
assets, so all
i

> 0 here. In Section 4.6 this restriction is removed.

The problem can now be stated as follows:

Minimise the variance of the portfolio return
R =w
1
R
1
+...+w
n
R
n
=w
T
R
by choice of w, we obtain
var(R
p
) = w
T
V w
Chapter 4
- 3 -
subjecting to the restrictions
w
T
= r
w
T
l = 1
since the sum of the weights is to be 1.

We solve this minimisation problem using the Lagrange multiplier method. Set
L = w
T
V w
1
(w
T
- r)
2
(w
T
l - 1).

Differentiate with respect to each component in w, we obtain a n 1 vector of
derivatives

c
c
w
L
= 2 V w
1

2
l
Exercise: Write the expression L and differentiate component by component with
respect to w, summarize the results to get the above expression.

Set

c
c
w
L
= 0, we get V w =
2
1
(
1
+
2
l) which leads to
w =
2
1
V
-1
(
1
+
2
l) =
2
1
V
-1
[ , l ]
|
|
.
|

\
|
2
1

Multiplying both sides by [ , l ]
T
, we obtain
[ , l ]
T
w =
2
1
[ , l ]
T
V
-1
[ , l ]
|
|
.
|

\
|
2
1

=
2
1
A
|
|
.
|

\
|
2
1

where the 22 symmetric matrix A is defined in an obvious way and will be a strong
focus of attention in numerical calculations. From the above, we get
2
1

|
|
.
|

\
|
2
1

= A
-1
[ , l ]
T
w = A
-1

|
|
.
|

\
|
1
r
because
T
w = r and l
T
w = 1
In turn, if the mean (expected) return r is given, we can decide
w =
2
1
V
-1
[ , l ]
|
|
.
|

\
|
2
1

= V
-1
[ , l ] A
-1

|
|
.
|

\
|
1
r
()
on the effective frontier. This is a key result.

One interesting consequence is that if portfolios P
1
and P
2
on the efficient frontier
have compositions with weights w
1
and w
2
for corresponding returns r
1
and r
2
, and portfolio
P on the efficient frontier has return
1
r
1
+
2
r
2
, then its composition is
1
w
1
+
2
w
2
.
This result can be used to calculate the compositions of portfolios on the efficient
frontier once two such compositions have been obtained.

The return R
p
as a random variable for a portfolio P on the efficient frontier with
mean return r is, by using () after transposing the vector (remember that V, A are
symmetric),
R
p
(r) = w
T
R = (r,1) A
-1
[ , l ]
T
V
-1
R (**)
Chapter 4
- 4 -
Next we get the (
p
,
p
) relationship for portfolios on the efficient frontier with mean
return r.

From the definition of the variance
2
= w
T
V w and w = V
-1
[ , l ] A
-1

|
|
.
|

\
|
1
r
, we get

2
= (r,1) A
-1
[ , l ]
T
V
-1
V V
-1
[ , l ] A
-1

|
|
.
|

\
|
1
r

= (r,1) A
-1

|
|
.
|

\
|
1
r

Exercise: Verify the second equality.

Thus, the efficient frontier in the (
p
,
p
) space is given by the equation

p
2
= (
p
,1) A
-1

|
|
.
|

\
|
1
p

This is a quadratic, it can be written more explicitly after obtaining A
-1
more fully.

Exercise: Use the fact that A = [ , l ]
T
V
-1
[ , l ] to deduce that
A
-1
=
|
|
.
|

\
|

a b
b c

with
a = (
T
V
-1
) / [(
T
V
-1
) ( l
T
V
-1
l ) - (
T
V
-1
l )
2
]
b = (
T
V
-1
l ) / [(
T
V
-1
) ( l
T
V
-1
l ) - (
T
V
-1
l )
2
]
c = ( l
T
V
-1
l ) / [(
T
V
-1
) ( l
T
V
-1
l ) - (
T
V
-1
l )
2
]
(It is the elements of this matrix a, b and c which are particularly useful in portfolio
calculations, as well as being convenient for exhibiting results.)

We then use the exercises result to get

p
2
= a 2b
p
+ c
p

2

Exercise: Show that this efficient frontier curve is the right-hand upper branch of a
hyperbola in (
p
,
p
) and can be re-written in the more standard form
1
/ ) (
) / (
/ ) (
2 2
2
2
2
=

c b ac
c b
c b ac
p p
o
.
the same form as found for the return risk relationship for two asset portfolios. With
two assets the return risk region is just a hyperbolic curve, whereas here it is a region
with a hyperbolic efficient frontier as upper boundary.

The above hyperbolic curve has asymptotes (tangents at infinity) given by
p
=
c
b

c
1

p

Chapter 4
- 5 -
M
effective frontier
not effective frontier

Figure 4.2.1

Exercise: Work out the coordinate of the point M.

Exercise: Explain how would you define the effective frontier of the (
p
,
p
) curve.
Explain that any level of expected return can be obtained but the cost of high return is
high risk. All portfolios of practical interest should be on the efficient frontier.

It is further noted that the derivations here have assumed that A
-1
has an inverse, that
is ac = b
2
. In fact we require
p
2
= a 2b
p
+ c
p

2
is non-negative, which is
equivalent to ac > b
2
.

Exercise: Explain what happens to the hyperbola when ac + b
2
.

4.3 Optimal Efficient Frontier Portfolios

The efficient frontier identifies a range of attractive portfolios from among which a
unique portfolio can sensibly be chosen because of their optimal return for given risk.

In practice, we want the one with minimum risk or the one that maximizes the risk
return utility.

There appear to be two useful approaches for practically determining optimal
portfolios using utility functions:

Method 1: Globally maximise u(
p
,
p
) over portfolio weights w, using the Lagrange
multiplier method without explicit recourse to the efficient frontier condition; the
maximum will always lie on the efficient frontier since the maximization can in
principle be done in two stages. First as a function of
p
(w) = r, using
p
(w) as the
objective function, which produces the efficient condition to give
p
(r) , and at the
second stage as a function of r to give the global maximization.
Chapter 4
- 6 -

Method 2: Maximise u(
p
,
p
(
p
)) over
p
where
p
(
p
) is the efficient frontier relation.
This produces the expected return of the optimum portfolio on the efficient frontier, and its
composition must then be found from a formula giving portfolio weights for given return on
the efficient frontier.

Example (of an optimal portfolio): Consider the minimum risk portfolio, MV; this
is the ultimate portfolio for the risk-averse or very timid investor whose only concern
is to avoid risk. We use method 2 by trying to identifying the minimum variance point
M in Figure 4.2.1.

Solution: This can be done using the general hyperbola formula or by direct
differentiation of the efficient frontier hyperbolic equation.

The vertical tangent condition for the efficient frontier curve is then
p
p
d
d

o
2
= -2b + 2c
p
= 0,
hence
MV
= b/c = (
T
V
-1
l ) / ( l
T
V
-1
l ).

From
MV
= (
T
V
-1
l ) / ( l
T
V
-1
l ) and the definition that
MV
=
T
w
MV
, we can
easily deduce that
w
MV
= V
-1
l / ( l
T
V
-1
l ).

Exercise: Use the result
w
MV
= V
-1
[ , l ] A
-1

|
|
.
|

\
|
1
r

in Section 4.2 with r =
MV
to verify the same conclusion. (hint: you have to use the
expression of A
-1
in Section 4.2)

These weights give the proportion of funds which should be invested in each asset.

However, the key point to notice is that the weights w
MV
thus defined do not depend
on the expected returns, but only on the variance matrix of the returns; this is the
consequence of requiring minimum variance - expected returns are completely
ignored in determining the composition of the portfolio.

The variance of this minimum risk portfolio is given by using the weights obtained
above to get

MV
2
= w
T
V w =1/ ( l
T
V
-1
l )
which is clearly non negative.
Notice again that, as with the weights, the minimum risk itself does not depend on the
expected returns at all, only the variance matrix of returns.

If we use the elements of A
-1
, we see that

MV

= c b ac / ) (
2
.
Chapter 4
- 7 -
In summary, for minimum risk portfolio, we obtained

MV
= b/c and
MV

= c b ac / ) (
2
.

4.4 The Maximum Return Risk Ratio Portfolio

The risk tolerant investor might be interested in the maximum expected return to risk
portfolio, which can be called the MRR portfolio. The properties of this portfolio will
be worked out using the first method of Section 4.3 as a Lagrange minimization
problem with the utility function u(
p
,
p
) =
p
/
p
. Graphically, the portfolio is on the
efficient frontier at the tangent point of the line from the origin.

Since ratio is difficult to differentiate, we consider log (
p
/
p
). The appropriate Lagrange
function is
L = log (w
T
) -
2
1
log (w
T
V w) (w
T
l - 1) (1)
Thus, differentiating L

0
2
2
1
= =
c
c
l
w V w
w V
w
w
L
T T

(2)
Multiplying (2) by w
T
, to get
0
2
2
1
w
= = l w l w
w V w
w V w
w
T T
T
T
T
T

which implies that =0. Use this in (2), we get
) (
1
w V w
w
V w
T
T

= (3)
Multiplying this by
T
l , using the constraint
T
l w =1, we get
) (
1
w V w
w
V l
T
T
T

=1 (4)
T
MRR=(
MRR
,
MRR
)

p
u

p

Chapter 4
- 8 -
Combining (3) and (4), we get
w
MRR
=

1
1

V l
V
T
.
Note here that the weights are functions of the asset expected returns.

Exercise: Compare with the minimum risk portfolio.

Exercise: Use the formulae (Section 2.2)

P

= w
T

P
2
= w
T
V w
to get
MRR
and
MRR
, further, justify that (
MRR
,
MRR
) is located on the efficient frontier,
hence the portfolio MRR is on the efficient frontier.

Exercise: Extend the theory to the utility function
u(
p
,
p
) =
p
/ (
p
)

for some = 1.

4.5 Optimally Adjusted Return Portfolios

Attention is now directed to the variance-adjusted and risk-adjusted return portfolios.
In this case, we use utility functions
u(
p
,
p
) =
p
-
p
2
and u(
p
,
p
) =
p
-
p

respectively. An implementation of the former is available in MATLAB. Both these
models traded-off good returns against increased risk.

For the variance-adjusted return portfolio, it is thus required to maximise by choice
of
p
, the function
u(
p
) =
p
-
p
2
=
p
- ( a 2b
p
+ c
p
2
)

The result obtained is

VadjR
=
c
b
+
o 2
1
c
1
.

The second term shows how the expected return is increased relative to the minimum
risk portfolio. The corresponding variance of return is

VadjR
2
=
c c
b ac 1
4
1
2
2
o
+

.

For the risk adjusted return portfolio the results are not quite as explicit, but follow
from the same process of derivation. The quantity now minimised is
u(
p
) =
p
-
p
=
p
- ( a 2b
p
+ c
p
2
)
1/2
.


4.6 Multiple Asset Portfolios Including a Riskless Return

The set up of the problem is as follows:

Chapter 4
- 9 -
There is an asset A
0
with risk1ess return rate
0
. A general portfolio composition is to be
made from the risk1ess asset A
0
and the risky assets (A
1
, A
2
, , A
n
) , with money weights (w
0
,
w
1
, w
2
,..., w
n
) summing to unity. We write w = (w
1
, w
2
,..., w
n
)
T
, without w
0
. The overall
random variable return is,
R
P
= w
0

0
+ w
1
R
1
+ + w
n
R
n
= w
0

0
+ w
T
R (1)
where R = (R
1
, ,R
n
) are the random variable returns from (A
1
, A
2
,,A
n
), respectively.

It is instructive to regard (1) as having the structure of a two-asset portfolio, one asset
A
0
being risk1ess and the other being composed of the risky assets with weights w/(1-
w
0
) (refer to two-asset case):
R
P
= w
0

0
+ (1-w
0
) {w
T
/ (1-w
0
)} R
Let the vector of expected returns of the risky assets be = (
1
,
2
, ,
n
)
T
, and the
corresponding variance matrix of these returns be V. In this setting, the portfolio
expected return and variance of return are given by
E(R
P
) = w
0

0
+ w
1

1
+ + w
n

n
= w
0

0
+ w
T

Var(R
P
) =
p
2
= w
T
V w
respectively.

The efficient frontier problem is to choose (w
0
, w
T
) to
minimise { w
T
V w }
subject to { w
0

0
+ w
T
= r, (w
0
, w
T
)
|
|
|
.
|

\
|
1
1
=1 }
and hence determine the (
p
,
p
) relation of the efficient frontier.

Set up the Lagrange function L, using multipliers
1
and
2
as follows
L = w
T
V w -
1
(w
0

0
+ w
T
- r) -
2
(w
0
+ w
T

|
|
|
.
|

\
|
1
1
- 1).
The derivative equations required are
w
L
c
c
= 2 V w -
1
-
2
|
|
|
.
|

\
|
1
1
=0,
0
w
L
c
c
= -
1

0
-
2
= 0.
Solving these equations, we get
w =
2
1
V
-1
(, l)
|
|
.
|

\
|
2
1

.
Multiply this by (, l)
T
, we have
Chapter 4
- 10 -
(, l)
T
w =
2
1
(, l)
T
V
-1
(, l)
|
|
.
|

\
|
2
1

(A was defined earlier and A=(, l)
T
V
-1
(, l))
|
|
.
|

\
|
2
1

= 2 A
-1
(, l)
T
w =(minimization condition)= 2 A
-1

|
|
.
|

\
|

0
0 0
1 w
w r

Using (, l)
T
w =
2
1
A
|
|
.
|

\
|
2
1

,
|
|
.
|

\
|
2
1

= 2 A
-1

|
|
.
|

\
|

0
0 0
1 w
w r
and
1

0
+
2
= 0, we get
(, l)
T
w =
|
|
.
|

\
|

0
0 0
1 w
w r

(
0
, 1) A
-1

|
|
.
|

\
|

0
0 0
1 w
w r
= (
0
, 1) A
-1
(, l)
T
w =
2
1
(
0
, 1)
|
|
.
|

\
|
2
1

= 0
Hence
w
0
=
( )
( )
|
|
.
|

\
|
|
|
.
|

\
|

1
1 ,
1
1 ,
0 1
0
1
0

A
r
A
.
Notice that w
0
= 1 when r=
0
, so that if return at the riskless rate is required, all funds
should be invested in the riskless asset, as is sensible.

For the weights w associated with the risky assets, use
1

0
+
2
= 0 and w =
2
1
V
-1
(,
l)
|
|
.
|

\
|
2
1

, we get
w =
2
1
V
-1
(, l)
|
|
.
|

\
|
2
1

=
2
1
V
-1
(, l)
|
|
.
|

\
|

0
1

1
=
2
1
V
-1
( -
0
l)
1

Algebraic manipulation using the fact that weights add up to 1, we get
w =(1-w
0
)
) (
) (
0
1
0
1
l V l
l V
T

Combining what we get for w
0
and w, we obtain the weights for the efficient frontier
portfolios.

With these expressions, the return of the portfolio on the efficient frontier with
expected return r, as a random variable, has the structure
R
P
= w
0

0
+ (1-w
0
) {w
T
/ (1-w
0
)} R
= w
0

0
+ (1-w
0
)
l V l
R V l
T
T
1
0
1
0
) (
) (

Notice from the above structure that the composition of portfolios on the efficient
frontier with return r consist of weight w
0
of available funds in the riskless asset
and weight 1- w
0
in a 'new' portfolio T with composition weights
Chapter 4
- 11 -
w =
) (
) (
0
1
0
1
l V l
l V
T

(*)

which do not depend on r but do depend on the riskless return rate
0
.

Proposition: The efficient frontier formed with a riskless asset is thus, in (
p
,
p
)
space, a straight line through (
0
, 0) and the (
T
,
T
) point of the risky asset portfolio
T given by weights of (*). This straight line is called the 'capital allocation line'.

Figure 4.6.1 The efficient frontier capital allocation line when there is a riskless asset


Proof: Using the standard formula for (
p
,
p
), we have,

T
=
c b
b a
0
0

,
T
2
=
2
0
2 2
0 0
) (
) )( 2 (
c b
b ac c b a

+
()
which leads to

P
=
0
+
T
T
o

0

p

and this is a linear relationship.

Exercise: Prove ().

4.7 The Tangent Portfolio with a Riskless Return

In this section, we show that, as in the diagram below, the point T is the tangent point
to the hyperbola of the line from the riskless asset return point.

0

T(
0
)

T

P

Capital
allocation
line
Chapter 4
- 12 -


Figure 4.7.1 The tangent portfolio T when there is return from a riskless asset

The slope of the efficient frontier line involving a riskless asset is (from Section 4.6)
T
T
o

0

(*)
The slope of the risky assets efficient frontier hyperbola at (
T
,
T
) will need d
p
/ d
p
at p =
T which is (differentiating
p
2
= a-2b
p
+2
p
2
)
T
T
d
d

o
=
b c
T
T

o
(**)
Exercise: Show that the numbers in (*) and (**) are the same.

Question for thought: Is it possible that
0
>
M
= b/c? Can you give a geometric
explanation?


Exercise (*): Discuss the efficient frontier when there is a riskless asset with return
0

with utility functions
u (
p
,
p
) =
p
/
p

, u (
p
,
p
) =
p
-
p

.


4.8 The Market Model for Returns

The market model postulates that all returns are linearly related to the random variable
return R
m
of a notional market portfolio, defined as all stocks traded in the defined
market in proportion to their aggregate values. Examples would be the Footsie 100,
the Dow Jones Index and the Hang Seng Index. R
m
is assumed to have mean
m
and
variance
m
2
. This model can be justified by the Capital Asset Pricing Model, the
CAPM, as it is known.

T

T
M
M
Chapter 4
- 13 -
With the market model assumption, the random variable return R
i
for the ith asset takes the
form
R
i
=
i
+
i
R
m
+
i
, i=1,2,...,n (1)
where
i
is a constant giving the individual asset or non-market component of return,

i
R
m
is the market component,
i
being a constant expressing the stock's sensitivity to
market volatility. Random variation about the linear relations are described by
i
.

This model supposes that there is a systemic element in the value of an asset which the
market controls and which its company cannot control, and a company specific part of
its stock price due to good profits and efficiency, and so on.

Note that
i
would be determined from a time series of (R
i,t
,R
m,t
) values, as illustrated.





Figure 4.8.1 Asset returns plotted against market returns over time

The market model has also been called a single index model - the returns are just
related to R
m
; may be other variables could affect returns and enter into (1), when the
model would then be described as a multiple index matrix model.

The assumptions for the random variation terms
i
in (1) are important, and are as follows:
E(
i
) = 0 (2a)
var(
i
) =
i
2
(2b)
cov(
i
,
j
) = 0 (2c)
cov(R
m
,
i
) = 0 (2d)
Assumptions (2a) and (2b) are standard; the zero covariance in (2c) implying
independence via Normality and meaning that the returns are related only through
market effects; (2d) implies that the size of
i
is not related to the size of R
m
. The
above are satisfied when
i
are IID, as would often be assumed.

We aim to obtain the efficient frontier and its portfolios under these market model
assumptions; the full covariance matrix of all returns is then not required. This offers
computational and conceptual advantages.

The returns on a portfolio P are now given by
R
p
= w
T
R

where the returns of the individual assets, as a column vector, are
R = + R
m
+
Taking expectations and variances, we get
E(R) = +
m

Chapter 4
- 14 -
V(R) = (
T
)
m
2
+ diag(
2
)
where

2
= (
1
2
,
2
2
,
n
2
), var(R
m
) =
m
2
.

Now for the general portfolio return,
R
p
= w
T
R = w
T
( + R
m
+ )

Taking expectation and variance, we get
E(R
p
) = w
T
+ w
T

m


var(R
p
) = w
T
diag(
2
) w

+ ( w
T
)
2

m
2


This implies a structure which is like adding a 'market asset' to R
p
with mean w
T
,
and variance (w
T
)
2

m
2
.

To formulate the Lagrange function required for the efficient frontier derivation
define:

augmented weights g
T
= (w
T
, w
T
)
1x (n+1)
augmented non-market components v
T
= (
T
,
m
)
1x (n+1)

augmented variances D = diag(
2
,
m
2
)
(n+1)x(n+1)


The Lagrange efficient frontier problem is thus,

minimise (by choice of g) var(R
p
) = g
T
D g
subject to g
T
v = r (expected return = r)

There are, however, two further implicit constraints:

Since g
i
= w
i
(i=1,,n), g
n+1
=

=
n
i 1
g
i

i
, we get
g
T
b = g
T

|
|
.
|

\
|
1
|
= 0 (*)
Secondly, since w
1
+ w
2
+ + w
n
= g
1
+ g
2
+ + g
n
+ 0 g
n+1
= 1, we have
g
T
h = g
T

|
|
.
|

\
|
0
l
= 1 (**)
The Lagrange function is thus,
g
T
D g
1
(g
T
v - r )
2
(g
T
h - 1 )
3
(g
T
b )

Differentiate with respect to g, to get
2 D g
1
v
2
h
3
b = 0 D g =
2
1
( v ,

h ,

b ) (
1
,
2
,
3
)
T
g =
2
1
D
-1
( v ,

h ,

b ) (
1
,
2
,
3
)
T

( v ,

h ,

b )
T
g =
2
1
( v ,

h ,

b )
T
D
-1
( v ,

h ,

b ) (
1
,
2
,
3
)
T

We can now define a new 3x3 matrix
Chapter 4
- 15 -
A =
2
1
( v ,

h ,

b )
T
D
-1
( v ,

h ,

b )
We get
(
1
,
2
,
3
)
T
= 2 A
-1
( v ,

h ,

b )
T
g = 2 A
-1
(r,1,0)
T

This in turn, gives
g =
2
1
D
-1
( v ,

h ,

b ) (
1
,
2
,
3
)
T
= D
-1
( v ,

h ,

b ) A
-1
(r,1,0)
T
.
After obtaining all unknowns, we now decide the form of the efficient frontier:
var(R
p
) = g
T
D g = (r,1,0) A
-1
( v ,

h ,

b )
T
D
-1
D

D
-1
( v ,

h ,

b ) A
-1
(r,1,0)
T

= (r,1,0) A
-1
A A
-1
(r,1,0)
T
= (r,1,0) A
-1
(r,1,0)
T

Write
A
-1
=
|
|
|
.
|

\
|

g f e
f a b
e b c
, r =
p
,
p
= var(R
p
)


We obtain, same as Section 4.2,

p
2
= a 2b
p
+ c
p

2
or 1
/ ) (
) / (
/ ) (
2 2
2
2
2
=

c b ac
c b
c b ac
p p
o
.
Exercise: Derive the minimum risk portfolio using above expression.

Diversification and Market Exposure

Look again at expected return
E(R
p
) = w
T
+ w
T

m


= return of portfolio + return of portfolio
The associated risk is then
var(R
p
) =

= =
|
.
|

\
|
+
n
i
m
n
i
i i i i
w w
1
2
2
1
2 2
o | o
= diversiable risk + exposure to market
For example, if w
i
= 1/n, then the first tern tends to 0 as n tends to , but the second
term remains at average of .


Remark: The market model is considerably simpler than the full covariance model
because the variables involves are much less.

4.9 The Market Model with a Riskless Asset

This is an extension of the market model allowing for the availability of riskless
borrowing and lending at the same interest rate. It is closely related in a theoretical
sense to the capital asset pricing model, to be considered in the next section.

With a riskless asset A
0
with return
0
, we have

R
P
= w
0

0
+ w
T
R
Chapter 4
- 16 -
As in Section 4.8, let

augmented weights g
T
= (w
T
, w
T
)
1x (n+1)
augmented non-market components v
T
= (
T
,
m
)
1x (n+1)

augmented variances D = diag(
2
,
m
2
)
(n+1)x(n+1)


and our Lagrange minimization problem is:

Minimize (by the choice of g
0
and g
T
) var(R
p
) = g
T
D g
subject to g
0

0
+ g
T
v = r (fixed expected return)
g
0
+ g
T
h = 1 (weights sum to 1)
g
T
b = 0 (last term restraint)
where
g
T
= (g
1
, g
2
, , g
n
, g
n+1
), h
T
= (l
T
, 0), b
T
= (
T
, -1).

Differentiate the Lagrangian function,
L = g
T
D g -
1
(g
0

0
+ g
T
v - r) -
2
(g
0
+ g
T
h - 1) -
3
g
T
b
to obtain the equations
L
g
= 2 D g -
1
v -
2
h -
3
b = 0

L
g0
= -
1

0
-
2
=0 (*)
These can be simplified to
2 D g = (v , h , b ) (
1
,
2
,
3
)
T
, 0 = (
0
, 1, 0 ) (
1
,
2
,
3
)
T
,
So, as previously, we get
g =
2
1
D
-1
(v , h , b ) (
1
,
2
,
3
)
T

Multiplying the left-hand-side by (v, h, b)
T
and let A= (v, h, b)
T
D
-1
(v, h, b), we get
(v, h, b)
T
g =
2
1
A (
1
,
2
,
3
)
T

and
(
1
,
2
,
3
)
T
= 2 A
-1
(v, h, b)
T
g = 2 A
-1
(r-g
0

0
, 1-g
0
, 0)
T
(**)
Substituting into the expression for g again, we get
g = D
-1
(v , h , b ) A
-1
(r-g
0

0
, 1-g
0
, 0)
T
(***)
for weights on the efficient frontier.

Now, use (*) and (**), we get
(
0
, 1, 0) A
-1
(r-g
0

0
, 1-g
0
, 0)
T
= 0
Solve for g
0
, we get
g
0
w
0r
=
T
T
A
r A
) 0 , 1 , ( ) 0 , 1 , (
) 0 , 1 , ( ) 0 , 1 , (
0
1
0
0

(****)
Corollary: If r =
0
, g
0
= 1, as it should.

Corollary: Further algebraic manipulation leads to
g =( 1 - g
0r
) D
-1
(v -
0
h +
1
b ) / h
T
D
-1
(v -
0
h +
1
b )
Chapter 4
- 17 -
where g
0r
is as in (****),
1
is a constant = {ae+bf-(be+cf)
0
} / (ac-b
2
) and a,b etc are
defined by
A
-1
=
|
|
|
.
|

\
|

g f e
f a b
e b c

We see that apart from (1 - g
0r
), the expression defining g has nothing to do with r.
We regard the remaining part gives a portfolio T itself and it has the weight 1 - w
0r
= 1
- g
0r
.

This new augmented portfolio T has component
g
T
= D
-1
(v -
0
h +
1
b ) / h
T
D
-1
(v -
0
h +
1
b )
It is noted that the first n elements of g
T
and w
0r
forms the complete portfolio
composition.

Remark: The efficient frontier is the line through the portfolio T and the riskless asset
point (
0
, 0).

4.10: The Capital Asset Pricing Model

This is a model from mathematical economics and is the result of examining the
implications of the portfolio market model on the stock market if all investors used it.
There is a rationale for this if all investors hold the efficient frontier portfolio based
on all market assets, although they certainly do not.

A key aspect of the Capital Asset Pricing Model (CAPM) is that there is a capital
market line (CML). This requires that all investors use the efficient frontier of all the
market or index assets with their market or index weights (proportional to overall
value), and that there is a riskless asset with return
0
. Thus, all investors split their
funds between the riskless asset and the market portfolio M identified as the tangent
portfolio of the market in total from (
0
, 0). This idea is sometimes referred to as the
Separation Theorem and the line from (
0
, 0) through T is referred to as the Capital
Market Line (CML). Another way of expressing this, is to say that all investors hold
some of their funds in the market portfolio M, but fund the extent differently, possibly
borrowing to extend their holding, if wishing to do so. Just to emphasise, the market
portfolio has every asset in it being traded in the market or index set with weights in
proportion to their total value.

To derive the CAPM, consider a single-asset portfolio consisting of A
i
which is
included in the market portfolio M, and consider a two-asset portfolio P(w) which
includes A
i
with weight w and the market portfolio M with weight 1- w . This
portfolio has mean return and risk

P(w)
= w
i
+ (1-w)
m
,
2
) (w P
o = w
2

i
2
+ (1-w)
2

m
2
+ 2w (1-w)


im


Chapter 4
- 18 -

Figure 4.10.1 The capital market line and the market portfolio

Also consider the market portfolio without the asset A
i
which will be denoted as M
(i)
. This
portfolio is on the risk return hyperbolic relation between
i
and
i
, as an 'inverse'
consequence of the result (4.2 **) that all portfolios on an efficient frontier can be
expressed as linear weights of their individual compositions. Thus, there are two
efficient frontier curves passing through M. They cannot intersect or otherwise there
is a portfolio which is superior to the efficient frontier of the market risk assets, and
thus they must be tangents there; see Figure 4.10.1.

The slopes of both the market portfolio efficient frontier and the portfolio P
i
(w) can
be equated at w = 0 which is the contact point of the two curves, and this gives the
desired CAPM relation. For the slope of the market efficient frontier, which is the
capital market line, we have
Market Efficient Frontier Slope at M =
m
m
o

0

(*)
Now calculate the slope of the portfolio P
i
(w) efficient frontier curve at w = 0, from
the ratio of the two derivatives
dw
d
w Pi ) (

=
i

m
(**)
and
2
Pi(w)

dw
d
w Pi ) (
o
= 2w
i
2
- 2(1-w)
m
2
+ 2(1-2w)
im

simplifying at w = 0 to
dw
d
Pi ) 0 (
o
=(
im
-
m
2
) /
Pi(0)

= (
im
-
m
2
) /
m

(***)

Combining (**) and (***), we get
M
M
(i)

m


Chapter 4
- 19 -
) 0 (
) 0 (
Pi
Pi
d
d
o

=
dw
d
w Pi ) (

/
dw
d
Pi ) 0 (
o
=
m

(
i

m
) / (
im
-
m
2
)
Compare this with (*), we get

m

(
i

m
) / (
im
-
m
2
) =
m
m
o

0

or

i

m
= (
im
-
m
2
) (
m

0
) /
m
2

or

i
=
0
+ (
m

0
)
2
m
im
o
o
(CAPM)
This is the Capital Asset Pricing Model (CAPM).

It is the theoretical derivation of the market model assumption of linearity between
the return of the i
th
asset and the market return. Note that the key connection is the
covariance of return between the i
th
asset and the market return.

Notice that the coefficient
2
m
im
o
o
is the regression coefficient
i
in a theoretical sense,
so (CAPM) can be written as

i
=(1-
i
)
0
+
i

m
(****)
with the same linear form as assumed in the market model as in Section 4.5. However,
the models are not identical because in Section 4.5 just a linear relation is assumed,
where here, it is a particular relation.

It is also seen that
i
= 1 is a central value, by writing (****) as

i
=
m
+ ( -1) (
m
-
0
)
Any asset with > 1 will have return greater than the market return
m
and vice versa,
since
m
>
0
by assumption. Portfolios with > 1 are called aggressive and those
with < 1 are called defensive.