Lecture 1 (contd)

Mathematical and Statistical Foundations

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Functions
A function is a mapping or relationship between an input or

set of inputs and an output

We write that y, the output, is a function f (x), the input, or y

=f(x)
y could be a linear function of x where the relationship can be

expressed on a straight line

Or it could be non-linear where it would be expressed

graphically as a curve
If the equation is linear, we would write the relationship as

y = a + bx
where y and x are called variables and a and b are parameters
a is the intercept and b is the slope or gradient
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Straight Lines
The intercept is the point at which the line crosses the y-axis
Example: suppose that we were modelling the relationship

between a students average mark, y (in percent), and the

number of hours studied per year, x
Suppose that the relationship can be written as a linear

function
y = 25 + 0.05x
The intercept, a, is 25 and the slope, b, is 0.05
This means that with no study (x=0), the student could

expect to earn a mark of 25%

For every hour of study, the grade would on average improve

by 0.05%, so another 100 hours of study would lead to a 5%

increase in the mark
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Plot of Hours Studied Against Mark Obtained

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Straight Lines
In the graph above, the slope is positive
i.e. the line slopes upwards from left to right
But in other examples the gradient could be zero or negative
For a straight line the slope is constant i.e. the same along

the whole line

In general, we can calculate the slope of a straight line by

taking any two points on the line and dividing the change in y
by the change in x
(Delta) denotes the change in a variable
For example, take two points x = 100, y = 30 and x = 1000,

y = 75
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Straight Lines (Contd)

We can write these using coordinate notation (x,y) as

(100,30) and (1000,75)

We would calculate the slope as

y
75 30
=
= 0.05
x
1000 100

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Roots
The point at which a line crosses the x-axis is known as the

root
A straight line will have one root (except for a horizontal line

such as y=4 which has no roots)

To find the root of an equation set y to zero and rearrange

0 = 25 + 0.05x
So the root is x = 500
In this case it does not have a sensible interpretation: the

number of hours of study required to obtain a mark of zero!

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Quadratic Functions
A linear function is often not sufficiently flexible to accurately

describe the relationship between two series

We could use a quadratic function instead. We would write it

as
y = a + bx + cx 2
where a, b, c are the parameters that describe the shape of
the function
Quadratics have an additional parameter compared with linear

functions
The linear function is a special case of a quadratic where c=0
a still represents where the function crosses the y-axis
As x becomes very large, the x 2 term will come to dominate
Thus if c is positive, the function will be -shaped, while if c

is negative it will be -shaped.

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The Roots of Quadratic Functions

A quadratic equation has two roots
The roots may be distinct (i.e., different from one another), or

they may be the same (repeated roots); they may be real

numbers (e.g., 1.7, -2.357, 4, etc.) or what are known as
complex numbers
The roots can be obtained either by factorising the equation

(contracting it into parentheses), by completing the square,

or by using the formula:

b b 2 4ac
x=
2c
If b 2 > 4ac, the function will have two unique roots and it will

cross the x-axis in two separate places

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The Roots of Quadratic Functions (Contd)

If b 2 = 4ac, the function will have two equal roots and it will

only cross the x-axis in one place

If b 2 < 4ac, the function will have no real roots (only complex

roots), it will not cross the x-axis at all and thus the function
will always be above the x-axis.

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Calculating the Roots of Quadratics - Examples

Determine the roots of the following quadratic equations:

1. y = x 2 + x 6
2. y = 9x 2 + 6x + 1
3. y = x 2 3x + 1
4. y = x 2 4x

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Calculating the Roots of Quadratics - Solutions

We solve these equations by setting them in turn to zero
We could use the quadratic formula in each case, although it

is usually quicker to determine first whether they factorise

1. x 2 + x 6 = 0 factorises to (x 2)(x + 3) = 0 and thus the
roots are 2 and 3, which are the values of x that set the
function to zero. In other words, the function will cross the
x-axis at x = 2 and x = 3.
2. 9x 2 + 6x + 1 = 0 factorises to (3x + 1)(3x + 1) = 0 and thus
the roots are 1/3 and 1/3. This is known as repeated
roots since this is a quadratic equation there will always be
two roots but in this case they are both the same.

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Calculating the Roots of Quadratics - Solutions

(Contd)
3. x 2 3x + 1 = 0 does not factorise and so the formula must
be used with a = 1, b = 3, c = 1 and the roots are 0.38 and
2.62 to two decimal places.
4. x 2 4x = 0 factorises to x(x 4) = 0 and so the roots are 0
and 4.
All of these equations have two real roots
But if we had an equation such as y = 3x 2 2x + 4, this

would not factorise and would have complex roots since

b 2 4ac < 0 in the quadratic formula.

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Powers of Number or of Variables

A number or variable raised to a power is simply a way of

writing repeated multiplication

So for example, raising x to the power 2 means squaring it

(i.e., x 2 = x x).
Raising it to the power 3 means cubing it (x 3 = x x x),

and so on
The number that we are raising the number or variable to is

called the index, so for x 3 , the index would be 3

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Manipulating Powers and their Indices

Any number or variable raised to the power one is simply that

number or variable, e.g., 31 = 3, x 1 = x, and so on

Any number or variable raised to the power zero is one, e.g.,

50 = 1, x 0 = 1, etc., except that 00 is not defined (i.e., it

does not exist)
If the index is a negative number, this means that we divide

one by that number for example, x 3 =

1
x3

1
xxx .

If we want to multiply together a given number raised to more

than one power, we would add the corresponding indices

together for example, x 2 x 3 = x 2 x 3 = x 2+3 = x 5 .

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Manipulating Powers and their Indices (Contd)

If we want to calculate the power of a variable raised to a

power (i.e., the power of a power), we would multiply the

3
indices together for example, x 2 = x 23 = x 6 .
If we want to divide a variable raised to a power by the same

variable raised to another power, we subtract the second index

3
from the first for example, xx 2 = x 32 = x.
If we want to divide a variable raised to a power by a different

variable raised to the same power, the following result applies:

 n
x
xn
= n
y
y

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Manipulating Powers and their Indices (Contd)

The power of a product is equal to each component raised to

that power for example, (x y )3 = x 3 y 3 .

The indices for powers do not have to be integers, so x 1/2 is

the notation we would use for taking the square root of x,

sometimes written x
Other, non-integer powers are also possible, but are harder to

calculate by hand (e.g. x 0.76 , x 0.27 , etc.)

In general, x 1/n = n x.

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The Exponential Function, e

It is sometimes the case that the relationship between two

variables is best described by an exponential function

For example, when a variable grows (or reduces) at a rate in

proportion to its current value, we would write y = e x

e is a simply number: 2.71828. . .
It is also useful for capturing the increase in value of an

amount of money that is subject to compound interest

The exponential function can never be negative, so when x is

negative, y is close to zero but positive

It crosses the y-axis at one and the slope increases at an

increasing rate from left to right.

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A Plot of the Exponential Function

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Logarithms
Logarithms were invented to simplify cumbersome

calculations, since exponents can then be added or subtracted,

which is easier than multiplying or dividing the original
numbers
There are at least three reasons why log transforms may be

useful.
1. Taking a logarithm can often help to rescale the data so that
their variance is more constant, which overcomes a common
statistical problem known as heteroscedasticity.
2. Logarithmic transforms can help to make a positively skewed
distribution closer to a normal distribution.
3. Taking logarithms can also be a way to make a non-linear,
multiplicative relationship between variables into a linear,
additive one.
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How do Logs Work?

Consider the power relationship 23 = 8
Using logarithms, we would write this as log2 8 = 3, or the

log to the base 2 of 8 is 3

Hence we could say that a logarithm is defined as the power

to which the base must be raised to obtain the given number

More generally, if ab = c, then we can also write loga c = b
If we plot a log function, y = log x, it would cross the x-axis

at one see the following slide

It can be seen that as x increases, y increases at a slower rate,

which is the opposite to an exponential function where y

increases at a faster rate as x increases.
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A Graph of a Log Function

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How do Logs Work?

Natural logarithms, also known as logs to base e, are more

commonly used and more useful mathematically than logs to

any other base
A log to base e is known as a natural or Naperian logarithm,

denoted interchangeably by ln(y) or log(y)

Taking a natural logarithm is the inverse of a taking an

exponential, so sometimes the exponential function is called

the antilog
The log of a number less than one will be negative, e.g.

ln(0.5) 0.69
We cannot take the log of a negative number
So ln(-0.6), for example, does not exist.
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The Laws of Logs

For variables x and y :
ln (x y ) = ln (x) + ln (y )
ln (x/y ) = ln (x) ln (y )
ln (y c ) = c ln (y )
ln (1) = 0
ln (1/y ) = ln (1) ln (y ) = ln (y ).
ln(e x ) = e ln(x) = x

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Sigma Notation
If we wish to add together several numbers (or observations

from variables), the sigma or summation operator can be very

useful
means add up all of the following elements. For example,

(1 + 2 + 3) = 6
In the context of adding the observations on a variable, it is

helpful to add limits to the summation

P4
For instance, we might write
i=1 xi
where the i subscript is an index, 1 is the lower limit and 4 is
the upper limit of the sum
This would mean adding all of the values of x from x1 to x4 .
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Properties of the Sigma Operator

n
X
i=1

xi +

n
X

zi

i=1
n
X

i=1

cxi

= c

i=1
n
X

n
X
(xi + zi )

n
X

xi .

i=1

xi zi

6=

i=1

n
X
i=1

n
X

xi

n
X

zi

i=1

= x + x + . . . + x = nx

xi

= x1 + x2 + . . . + xn = nx.

i=1
n
X
i=1
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Pi Notation
Similar to the use of sigma to denote sums, the pi operator

Q
( ) is used to denote repeated multiplications.
For example
n
Y

xi = x1 x2 . . . xn

i=1

means multiply together all of the x i for each value of i

between the lower and upper limits.
It also follows that
n
n
Y
Y
(cxi ) = c n
xi
i=1

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i=1

27

Differential Calculus
The effect of the rate of change of one variable on the rate of

change of another is measured by a mathematical derivative

If the relationship between the two variables can be

represented by a curve, the gradient of the curve will be this

rate of change
Consider a variable y that is a function f of another variable x,

i.e. y = f (x): the derivative of y with respect to x is written

df (x)
dy
=
dx
dx
or sometimes f 0 (x).
This term measures the instantaneous rate of change of y

with respect to x, or in other words, the impact of an

infinitesimally small change in x
Notice the difference between the notations y and dy
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Differentiation: The Basics

1. The derivative of a constant is zero e.g. if
e.g. if y = 10,

dy
= 0.
dx

This is because y= 10 would be a horizontal straight line on a

graph of y against x, and therefore the gradient of this
function is zero
2. The derivative of a linear function is simply its slope
e.g. if y = 3x + 2,

dy
= 3.
dx

But non-linear functions will have different gradients at each

point along the curve

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Differentiation: The Basics (Contd)

In effect, the gradient at each point is equal to the gradient of

the tangent at that point

The gradient will be zero at the point where the curve

changes direction from positive to negative or from negative

to positive this is known as a turning point.

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The Tangent to a Curve

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The Derivative of a Power Function or of a Sum

The derivative of a power function n of x,

i.e. y = cx n is given by

dy
= cnx n1 .
dx

For example:

dy
= (4 3)x 2 = 12x 2
dx
dy
3
3
= (3 1)x 2 = 3x 2 = 2 .
y = = 3x 1 ,
x
dx
x
The derivative of a sum is equal to the sum of the derivatives
of the individual parts: e.g., if
dy
= f 0 (x) + g 0 (x)
e.g. if y = f (x) + g (x),
dx
The derivative of a difference is equal to the difference of the
derivatives of the individual parts: e.g.,
dy
if y = f (x) g (x),
= f 0 (x) g 0 (x).
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dx
y = 4x 3 ,

32

The Derivatives of Logs and Exponentials

The derivative of the log of The derivative of the log of x is

given by 1/x
i.e.

d(log(x))
1
= .
dx
x

The derivative of the log of a function of x is the derivative of

the function divided by the function, i.e.

i.e.

f 0 (x)
d(log(f (x)))
=
.
dx
f (x)

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The Derivatives of Logs and Exponentials (Contd)

E.g., the derivative of log(x 3 + 2x 1) is given by
3x 2 + 2
.
x 3 + 2x 1

The derivative of e x is e x .
The derivative of e f (x) is given by f 0 (x)e f (x) .
2

E.g., if y = e 3x ,

dy
dx

= 6xe 3x .

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Higher Order Derivatives

It is possible to differentiate a function more than once to

calculate the second order, third order, . . ., nth order

derivatives
The notation for the second order derivative, which is usually

just termed the second derivative, is

d( dy
d 2y
00
dx )
=
f
(x)
=
2
dx
dx
To calculate second order derivatives, differentiate the

function with respect to x and then differentiate it again

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Higher Order Derivatives (Contd)

For example, suppose that we have the function

y = 4x 5 + 3x 3 + 2x + 6, the first order derivative is

d(4x 5 + 3x 3 + 2x + 6)
dy
=
= f 0 (x) = 20x 4 + 9x 2 + 2.
dx
dx
The second order derivative is

d 2y
dx 2

00

= f (x) =

d( d(4x

5 +3x 3 +2x+6)

dx

dx
d(20x 4 + 9x 2 + 2)
=
dx
= 80x 3 + 18x.

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Higher Order Derivatives (Contd)

The second order derivative can be interpreted as the gradient

of the gradient of a function i.e., the rate of change of the

gradient
How can we tell whether a particular turning point is a

maximum or a minimum?
The answer is that we would look at the second derivative
When a function reaches a maximum, its second derivative is

negative, while it is positive for a minimum.

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Maxima and Minima of Functions

Consider the quadratic function y = 5x 2 + 3x 6.
Since the squared term in the equation has a positive sign

(i.e., it is 5 rather than, say, -5), the function will have a

-shape rather than an -shape, and thus it will have a
minimum rather than a maximum:
dy
d 2y
= 10x + 3, 2 = 10.
dx
dx
Since the second derivative is positive, the function indeed has

a minimum
To find where this minimum is located, take the first

derivative, set it to zero and solve it for x

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Maxima and Minima of Functions (Contd)

So we have 10x + 3 = 0, and x = 3/10 = 0.3. If

x = 0.3, y is found by substituting 0.3 into

y = 5x 2 + 3x 6 = 5 (0.3)2 + (3 0.3) 6 = 6.45.
Therefore, the minimum of this function is found at
(0.3,6.45).

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Partial Differentiation
In the case where y is a function of more than one variable

(e.g. y = f (x1 , x2 , . . . , xn )), it may be of interest to determine

the effect that changes in each of the individual x variables
would have on y
Differentiation of y with respect to only one of the variables,

holding the others constant, is partial differentiation

The partial derivative of y with respect to a variable x1 is

usually denoted
y
x1
All of the rules for differentiation explained above still apply

and there will be one (first order) partial derivative for each
variable on the right hand side of the equation.
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How to do Partial Differentiation

We calculate these partial derivatives one at a time, treating

all of the other variables as if they were constants.

To give an illustration, suppose y = 3x13 + 4x1 2x24 + 2x22 ,

the partial derivative of y with respect to x1 would be

y
= 9x12 + 4
x1
, while the partial derivative of y with respect to x2
y
= 8x23 + 4x2
x2

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How to do Partial Differentiation (Contd)

The ordinary least squares (OLS) estimator gives formulae for

the values of the parameters that minimise the residual sum of

squares, denoted by L
The minimum of L is found by partially differentiating this

function and setting the partial derivatives to zero

Therefore, partial differentiation has a key role in deriving the

main approach to parameter estimation that we use in

econometrics.

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Integration

Integration is the opposite of differentiation

If we integrate a function and then differentiate the result, we

get back the original function

Integration is used to calculate the area under a curve

(between two specific points)

Further details on the rules for integration are not given since

the mathematical technique is not needed for any of the

approaches used here.

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Matrices - Background
Some useful terminology:
A scalar is simply a single number (although it need not be a
whole number e.g. 3, 5, 0.5 are all scalars)
A vector is a one-dimensional array of numbers (see below for
examples)
A matrix is a two-dimensional collection or array of numbers.
The size of a matrix is given by its numbers of rows and
columns
Matrices are very useful and important ways for organising

sets of data together, which make manipulating and

transforming them easy
Matrices are widely used in econometrics and finance for

solving systems of linear equations, for deriving key results,

and for expressing formulae.
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Working with Matrices

The dimensions of a matrix are quoted as R C , which is the

number of rows by the number of columns

Each element in a matrix is referred to using subscripts.
For example, suppose a matrix M has two rows and four

columns. The element in the second row and the third column
of this matrix would be denoted m23 .
More generally mij refers to the element in the ith row and

the jth column.

Thus a 24 matrix would have elements

m11
m21

m12
m22

m13
m23

m14
m24

If a matrix has only one row, it is known as a row vector,

which will be of dimension 1 C , where C is the number of

columns
e.g.
(2.7 3.0 1.5 0.3)
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Working with Matrices

A matrix having only one column is a column vector, which

will be of dimension R 1, where R is the number of rows,

e.g.

1.3
e.g. 0.1
0.0
When the number of rows and columns is equal (i.e. R=C), it

would be said that the matrix is square, e.g. the 22 matrix:



0.3 0.6
0.1 0.7
A matrix in which all the elements are zero is a zero matrix.

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Working with Matrices (Contd)

A symmetric matrix is a special square matrix that is

symmetric about the leading diagonal so that

mij = mji i, j

e.g.

1
2
4
7
2 3
6
9

4
6
2 8
7
9 8
0

A diagonal matrix is a square matrix which has non-zero

terms on the leading diagonal and zeros everywhere else,

3 0 0
0
0 1 0
0

e.g.
0 0 2
0
0 0 0 1
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Working with Matrices (Contd)

A diagonal matrix with 1 in all places on the leading diagonal

and zero everywhere else is known as

denoted by I, e.g.

1 0
0 1

e.g.
0 0
0 0

the identity matrix,

0
0
1
0

0
0

0
1

The identity matrix is essentially the matrix equivalent of the

number one
Multiplying any matrix by the identity matrix of the

appropriate size results in the original matrix being left

unchanged

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Working with Matrices (Contd)

So for any matrix M, MI=IM=M

In order to perform operations with matrices , they must be

conformable
The dimensions of matrices required for them to be

conformable depend on the operation.

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Matrix Addition or Subtraction

Addition and subtraction of matrices requires the matrices

concerned to be of the same order (i.e. to have the same

number of rows and the same number of columns as one
another)
The operations are then performed element by element


,

0.1
e.g., if A =
and B =
0.3

 

0.3 + 0.2 0.6 0.1
0.5 0.5
A+B =
=
,
0.1 + 0 0.7 + 0.3
0.1 1.0

 

0.3 0.2 0.6 0.1
0.1 0.7
AB =
=
0.1 0 0.7 0.3
0.1 0.4
0.3 0.6
0.1 0.7

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0.2
0


,

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Matrix Multiplication
Multiplying or dividing a matrix by a scalar (that is, a single

number), implies that every element of the matrix is

multiplied by that number

 

0.3 0.6
0.6 1.2
e.g. 2A = 2
=
0.1 0.7
0.2 1.4
More generally, for two matrices A and B of the same order

and for c a scalar, the following results hold

A+B =B +A
A+0=0+A=A
cA = Ac
c(A + B) = cA + cB
A0 = 0A = 0
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Matrix Multiplication
Multiplying two matrices together requires the number of

columns of the first matrix to be equal to the number of rows

of the second matrix
Note also that the ordering of the matrices is important, so in

general, AB 6= BA
When the matrices are multiplied together, the resulting

matrix will be of size (number of rows of first matrix d7

number of columns of second matrix), e.g.
(3 2) (2 4) = (3 4).
More generally,

(a b) (b c) (c d) (d e) = (a e), etc.
In general, matrices cannot be divided by one another.
Instead, we multiply by the inverse.
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Matrix Multiplication Example

The actual multiplication of the elements of the two matrices

is done by multiplying along the rows of the first matrix and

down the columns of the second

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Matrix Multiplication Example (Contd)

1
e.g. 7
1

2 
0
3
6
6

(3 2)

2
3

4
0

9
2

(2 4)

((1 0) + (2 6)) ((1 2) + (2 3)) ((1 4) + (2 0))

= ((7 0) + (3 6)) ((7 2) + (3 3)) ((7 4) + (3 0))
((1 0) + (6 6)) ((1 2) + (6 3)) ((1 4) + (6 0))
(3 4)

12 8 4 13
= 18 23 28 69
36 20 4 21
(3 4)

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The Transpose of a Matrix

The transpose of a matrix, written A0 or AT , is the matrix

obtained by transposing (switching) the rows and columns of

a matrix
!


1 2
1 7 1
7 3
then A0 = 2 3 6
e.g.if A =
1

If A is of dimensions R C , A0 will be C R.

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The Rank of a Matrix

The rank of a matrix A is given by the maximum number of

linearly independent rows (or columns). For example,



3 4
rank
=2
7 9

3
rank
2

6
4


=1

In the first case, all rows and columns are (linearly)

independent of one another, but in the second case, the

second column is not independent of the first (the second
column is simply twice the first)
A matrix with a rank equal to its dimension is a matrix of full

rank
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The Rank of a Matrix (Contd)

A matrix that is less than of full rank is known as a short rank

matrix, and is singular

Three important results: Rank(A) = Rank (A);
Rank(A) = Rank (A0 )
Rank(AB) min(Rank(A), Rank(B))
Rank (A0 A) = Rank (AA0 ) = Rank (A)

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The Inverse of a Matrix

The inverse of a matrix A, where defined and denoted A1 , is

that matrix which, when pre-multiplied or post multiplied by

A, will result in the identity matrix,
i.e. AA1 = A1 A = I .
The inverse of a matrix exists only when the matrix is square

and non-singular
Properties of the inverse of a matrix include:
I 1 = I
(A1 )1 = A
(A0 )1 = (A1 )0
(AB)1 = B 1 A1

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Calculating Inverse of a 2 2 Matrix

The inverse of a 22 non-singular matrix whose elements are

a
c

b
d

1
ad bc

d
c

will be
b
a

The expression in the denominator, (ad bc) is the

determinant of the matrix, and will be a scalar

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Calculating Inverse of a 2 2 Matrix (Contd)

If the matrix is

2
4

1
6

the inverse will be


  3
1
6 1
4
=
21
8 4 2

18
1
4


.

As a check, multiply the two matrices together and it should

give the identity matrix I.

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The Trace of a Matrix

The trace of a square matrix is the sum of the terms on its

leading diagonal
For example, the trace of the matrix


A=

3
7

4
9

Tr(A), is 3 + 9 = 12
Some important properties of the trace of a matrix are:
Tr(cA) = cTr(A)
Tr(A0 ) = Tr(A)
Tr(A + B) = Tr(A) + Tr(B)
Tr(IN ) = N
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The Eigenvalues of a Matrix

Let denote a p p square matrix, c denote a p 1

non-zero vector, and denote a set of scalars

is called a characteristic root or set of roots of the matrix
? if it is possible to
c = c
This equation can also be written as c = Ip c where Ip c is

an identity matrix, and hence ( Ip )c = 0

Since c 6= 0 by definition, then for this system to have a

non-zero solution, the matrix ( Ip )c = 0) is required to

be singular (i.e. to have a zero determinant), and thus
| I p | = 0
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Calculating Eigenvalues: An Example

Let be the 2 2 matrix


=

5
2

1
4

Then the characteristic equation is | I p |





 5 1
1 0 

=0

=
2 4
0 1 


 5
1 

=
= (5 )(4 ) 2 = 2 9 + 18
2
4 
This gives the solutions = 6 and = 3.
The characteristic roots are also known as eigenvalues
The eigenvectors would be the values of c corresponding to

the eigenvalues.
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Portfolio Theory and Matrix Algebra - Basics

Probably the most important application of matrix algebra in

finance is to solving portfolio allocation problems

Suppose that we have a set of N stocks that are included in a

portfolio P with weights w1 , w2 , . . . , wN and suppose that

their expected returns are written as E (r1 ), E (r2 ), . . . , E (rN ).
We could write the N 1 vectors of weights, w , and of
expected returns, E (r ), as

w1
E (r1 )
w2

E (r ) = E (r2 )
w =
...
...
wN
E (rN )
The expected return on the portfolio, E (rP ) can be calculated

as E (r )0 w .
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The Variance-Covariance Matrix

The variance-covariance matrix of the returns, denoted V

includes all of the variances of the components of the portfolio

returns on the leading diagonal and the covariances between
them as the off-diagonal elements.
The variance-covariance matrix of the returns may be written

V =

11
21
..
.

12
22

13
23

. . . 1N
. . . 2N
..
.

N1 N2 N3 . . . NN
For example:
11 is the variance of the returns on stock one, 22 is the
variance of returns on stock two, etc.
12 is the covariance between the returns on stock one and
those on stock two, etc.
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Constructing the Variance-Covariance Matrix

In order to construct a variance-covariance matrix we would

need to first set up a matrix containing observations on the

actual returns , R (not the expected returns) for each stock
where the mean, r i (i = 1, . . . , N), has been subtracted away
from each series i.
We would write

R=

r11 r1
r12 r1
..
.

r21 r2
r22 r2

r31 r3
r32 r3

r1T r1 r2T r2 r3T r3

rN1 rN
rN2 rN

. . . rNT rN
...
...
..
.

rij , is the jth time-series observation on the ith stock. The

variance-covariance matrix would then simply be calculated as

V = (R 0 R)/(T 1).
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The Variance of Portfolio Returns

Suppose that we wanted to calculate the variance of returns

on the portfolio P
A scalar which we might call VP
We would do this by calculating

VP = w 0 Vw
Checking the dimension of VP , w 0 is (1 N), V is (N N)

and w is (N 1) so VP is (1 N N N N 1), which is

(1 1) as required.

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The Correlation between Returns Series

We could define a correlation matrix of returns, C, which

would be

C =

1
C21
..
.

C12
1

C13
C23

. . . C1N
. . . C2N
..
.

CN1 CN2 CN3 . . .

This matrix would have ones on the leading diagonal and the

off-diagonal elements would give the correlations between

each pair of returns
Note that the correlation matrix will always be symmetrical

about the leading diagonal

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The Correlation between Returns Series (Contd)

Using the correlation matrix, the portfolio variance is

VP = w 0 SCSw
where S is a diagonal matrix containing the standard
deviations of the portfolio returns.

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Selecting Weights for the Minimum Variance

Portfolio
Although in theory the optimal portfolio on the efficient

frontier is better, a variance-minimising portfolio often

performs well out-of-sample
The portfolio weights w that minimise the portfolio variance,

VP is written

min w 0 Vw
w

We also need to be slightly careful to impose at least the

restriction that all of the wealth has to be invested (weights

sum to one)
This restriction is written as w 0 1N = 1, where 1N is a column

vector of ones of length N.

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Selecting Weights for the Minimum Variance

Portfolio (Contd)

The minimisation problem can be solved to

wMVP =

1N V 1
1N V 1 10N

where MVP stands for minimum variance portfolio

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Selecting Optimal Portfolio Weights

In order to trace out the mean-variance efficient frontier, we

would repeatedly solve this minimisation problem but in each

case set the portfolios expected return equal to a different
target value, R
We would write this as

min
w

w 0 Vw

subject to

w 0 1N = 1, w 0 E (r ) = R

This is sometimes called the Markowitz portfolio allocation

problem
It can be solved analytically so we can derive an exact solution
But it is often the case that we want to place additional

constraints on the optimisation, e.g.

Restrict the weights so that none are greater than 10% of
overall wealth
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Selecting Optimal Portfolio Weights (Contd)

Restrict them to all be positive (i.e. long positions only with

no short selling)
In such cases the Markowitz portfolio allocation problem

cannot be solved analytically and thus a numerical procedure

must be used

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Selecting Optimal Portfolio Weights

If the procedure above is followed repeatedly for different

return targets, it will trace out the efficient frontier

In order to find the tangency point where the efficient frontier

touches the capital market line, we need to solve the following

problem
max
w

w 0 E (r ) rf
1

(w 0 Vw ) 2

subject to

w 0 1N = 1

If no additional constraints are required on weights, this can

be solved as

V 1 [E (r ) rf 1N ]
10N V 1 [E (r ) rf 1N ]
Note that it is also possible to write the Markowitz problem
where we select the portfolio weights that maximise the
expected portfolio return subject to a target maximum
variance level.
w=

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