Portfolio optimization

Mean-Variance-Dominance Rule

• -it is the basis used by risk averse investors to choose among

various risky alternatives. They find a set of portfolios that is
stochastically dominant and then select a portfolio from among
those in the set.
• -an asset is said to be dominant over another if an individual
receives greater wealth from it in every state of nature.
• Assumption: investors measure the expected utility of choices
among risky assets by looking at the mean and variance
provided by combinations of assets.
illustration

Probability Xi (%) Y (%)

0.2 15 -5
0.2 -5 15
0.2 5 25
0.2 35 5
0.2 25 35
Determine the expected return.
E(Rx)=15%
E(Ry) = 15%
• VAR (X) = 200
• VAR (Y) = 200
• COV (X,Y) = p x-E(x) y – E (y)
= -0.0024
• σi2 = ∑ pi Ri – E(Ri) 2
• VAR ( Rp) = Wx2 VAR (X) ) + Wy2VAR (Y) + 2wxwyCov (x,y)= 90
DETERMINE MEAN AND STANDARD DEVIATIONS
FOR THE FOLLOWING COMBINATIONS
• Percentage in X Percentage in Y E(R)p (%) σ (Rp) (%)
• 100 0
• 75 25
• 50 50
• 25 75
•0 100
• The combinations give an efficient frontier which is the locus of
risk and return combinations offered by portfolios of risky
assets. It can be used to determine the portfolio with minimum
variance.
THE EFFICIENT SET THEOREM
•An investor will choose his optimal portfolio
from the set of portfolios that offer
•maximum expected returns for varying
levels of risk, and
•minimum risk for varying levels of returns
Efficient Frontier: Diversification

Expected
Return
A
.
.

C
RISK, 
8
Two risky assets ( and no risk – free asset)

• The assumption of no risk free asset implies that there are

no borrowing or lending opportunities i.e. there is no
opportunity to exchange.
• utility will be maximized at the point where the
indifference curve is tangent to the efficient set offered by
combinations of the two assets.
• An indifference curve is a mapping of all combinations of
risk and return that yield the same expected utility of
wealth.
• -even though different investors may have the same
assessment of the return and risk offered by risky assets they
may hold different portfolios because of their different attitudes
towards risk
• -no rational investor will choose a portfolio below the minimum
variance point. They can always attain higher expected utility
along the positively sloped portion of the efficient frontier. This
leads to the definition of the efficient set.
• -efficient set is the set of mean – variance choices from the
efficient frontier where for a given variance no other investment
opportunity offers a higher return.
• -efficient set is the locus of highest returns for a given risk.
Optimal portfolio choice: many assets with Risky
free asset
• -when the riskless asset is introduced, portfolio along any of the
lines are possible but only one line dominates. All investors will
prefer combinations of the risk free asset and portfolio M (
market portfolio of all risky assets)on the efficient set.
• If the following assumptions hold:
1.Equality between the borrowing and lending rate
2.Frictionless capital markets
3.Investors have homogenous beliefs about the expected
distributions of returns offered by all assets.
Risk-Free Asset and Risky Portfolios on the Efficient Frontier

E(R port )

D
M

C
B
A
RFR

E( port )
• Then all investors will perceive the same efficient set. Therefore
they will try to hold some combination of the risk-free asset and
portfolio M.
• The fact that the portfolios of all risk-averse investors will
consist of different combinations of only two portfolios is
known as the two-fund separation principle.
The Market Portfolio
• Because portfolio M lies at the point of tangency, it has the highest
portfolio possibility line and includes all risky assets.
The Market Portfolio
Because it contains all risky assets, it is a completely diversified
portfolio, which means that all the unique risk of individual assets
(unsystematic risk) is diversified away
• Two fund separation
• Each investor will have a utility – maximizing portfolio that is a
combination of the risk free asset and a portfolio ( or fund) of
risky assets that is determined by the line drawn from the risk
free rate of return tangent to the investor’s efficient set of risky
assets.
• the straight line will be efficient set for all investors and the line
is known as the capital market line. It represents a linear
relationship between risk and return. If investors have
homogenous beliefs, then they all have the same linear efficient
set called the CML.
• Slope of CML= E (Rm) – Rf
• σm
• The slope of the CML is the market price of risk. The implication
is that managers of firms can use the market determined
equilibrium price of risk to evaluate investment projects
regardless of the tastes of shareholders . Every shareholder will
unanimously agree on the price of risk even though different
shareholders have different degrees of risk aversion.
•
Equation of the CML

 E ( Rm )  R f 
E ( Rp )  R f   
 p
 m 
Risk-diversification

• As the number of assets in a portfolio increases, the portfolio risk

reduces. Portfolio Risk Depends on Correlation between Assets.
• When correlation coefficient of returns on individual securities is
perfectly positive (i.e., cor = 1.0), then there is no advantage of
diversification.
• diversification always reduces risk provided the correlation coefficient
is less than 1.
• r = Cov( R1, R2)
• σ1, σ2
• State of nature prob. Return on security 1 return on security 2
1 0.10 -10% 5%
2 0.30 15 12
3 0.30 18 19
4 0.20 22 15
5 0.10 27 12
Determine the portfolio risk when r=-1,0,+1
• E(R1) = 16%
• E(R2)=14%
• COVARIANCE = 26
• Risk has two parts:
• Systematic risk arises on account of the economy-wide uncertainties and the tendency of
individual securities to move together with changes in the market. This part of risk cannot be
reduced through diversification. It is also known as market risk.
• Unsystematic risk arises from the unique uncertainties of individual securities. It is also
called unique risk. Unsystematic risk can be totally reduced through diversification.
• Total risk = Systematic risk + Unsystematic risk
• Systematic risk is the covariance of the individual securities in the portfolio. The difference
between variance and covariance is the diversifiable or unsystematic risk.
International diversification
• portfolio theory can reduce risks of asset portfolios held by MNEs,
and risks incurred by MNEs in general from internationally diversified
activities.
• international portfolio’s market risk is lower than that of a domestic
portfolio because an investor is able to combine assets that are less
than perfectly correlated, reducing the total risk of the portfolio.
• When the portfolio is diversified internationally, the portfolio’s beta
i.e the level of systematic risk is lowered.
INTERNATIONAL DIVERSIFICATION

• Using International diversification to reduce

systematic risk
• While there is systematic risk within a domestic
portfolio, it may be nonsystematic and diversifiable in
a global portfolio.
•

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 INTERNATIONAL PORTFOLIO INVESTMENT

• Theoretical Conclusion
• International diversification pushes out the
efficient frontier.

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The New Efficient Frontier
C
E(r)


27