Chapter 3

Delineating Efficient
Portfolios
Jordan Eimer
Danielle Ko
Raegen Richard
Jon Greenwald
Goal
Examine attributes of combinations of two
risky assets
Analysis of two or more is very similar
This will allow us to delineate the preferred
portfolio
THE EFFICIENT FRONTIER!!!!

Combination of two risky assets
Expected Return
Investor must be fully invested
Therefore weights add to one
Standard deviation
Not a simple weighted average
Weights do not, in general add to one
Cross-product terms are involved
We next examine co-movement between
securities to understand this


Case 1-Perfect Positive Correlation
(p=+1)
C=Colonel Motors
S=Separated Edison

Here, risk and return of the portfolio are
linear combinations of the risk and return
of each security
Case2-Perfect Negative Correlation
(p=-1)
This examination yields two straight lines
Due to the square root of a negative number
This std. deviation is always smaller than
p=+1
Risk is smaller when p=-1
It is possible to find two securities with zero
risk
No Relationship between Returns
on the Assets ( = 0)

The expression for return on the

portfolio remains the same
The covariance term is eliminated from
the standard deviation
Resulting in the following equation for
the standard deviation of a 2 asset
portfolio









Minimum Variance Portfolio
The point on the Mean Variance Efficient
Frontier that has the lowest variance

To find the optimal percentage in each
asset, take the derivative of the risk
equation with respect to X
c

Then set this derivative equal to 0 and
solve for X
c

Intermediate Risk ( = .5)
A more practical example

There may be a combination of assets that
results in a lower overall variance with a
higher expected return when 0 < < 1

Note: Depending on the correlation between
the assets, the minimum risk portfolio may
only contain one asset

2 Asset Portfolio Conclusions

The closer the correlation between the two
assets is to -1.0, the greater the
diversification benefits

The combination of two assets can never
have more risk than their individual
variances


The Shape of the Portfolio
Possibilities Curve
The Minimum Variance Portfolio
Only legitimate shape is a concave curve

The Efficient Frontier with No Short Sales
All portfolios between global min and max return
portfolios
The Efficient Frontier with Short Sales
No finite upper bound
The Efficient Frontier with Riskless
Lending and Borrowing
All combinations of riskless lending and
borrowing lie on a straight line
Input Estimation Uncertainty
Reliable inputs are crucial to the proper use of
mean-variance optimization in the asset
allocation decision
Assuming stationary expected returns and
returns uncorrelated through time, increasing N
improves expected return estimate
All else equal, given two investments with equal
return and variance, prefer investment with more
data (less risky)

Input Estimation Uncertainty
Predicted returns with have mean R and
variance
Pred
2
=
2
+
2
/T where:

Pred
2
is the predicted variance series

2
is the variance of monthly return
T is the number of time periods

2
captures inherent risk

2
/T captures the uncertainty that comes from lack of
knowledge about true mean return
In Bayesian analysis,
2
+
2
/T is known as the
predictive distribution of returns
Uncertainty: predicted variance > historical variance

Input Estimation Uncertainty
Characteristics of security returns usually
change over time.
There is a tradeoff between using a longer
time frame and having inaccuracies.
Most analysts modify their estimates.
Choice of time period is complicated when
a relatively new asset class is added to the
mix.
Short Horizon Inputs and Long
Horizon Portfolio Choice
Important consideration in estimate inputs: Time
horizon affects variance
In theory, returns are uncorrelated from one
period to the next.
In reality, some securities have highly correlated
returns over time.
Treasury bill returns tend to be highly
autocorrelated standard deviation is low over
short intervals but increases on a percentage
basis as time period increases
Example
Solving for Xc yields for the minimum
variance portfolio:
Xc = (
s
2

c

cs
)
(
c
2
+
s
2
- 2
c

cs
)
In a portfolio of assets, adding bonds to
combination of S&P and international
portfolio does not lead to much
improvement in the efficient frontier with
riskless lending and borrowing.