Session 4 :

Portfolio Theory

Financial Markets and Securities (MSc Finance, MSc

Corporate Finance)

Dr Dirk Nitzsche (E-mail : [email protected])

Content
• Principal of diversification (i.e. widely applied in hedging and risk
management in the insurance industry and asset management)
• Introduction to portfolio theory (e.g. Markowitz approach) – considering
risk and return
• Combining risky assets
• Combining (a bundle of) risky assets and a risk free rate – capital allocation line (also
known as transformation line).
• Capital market line (best capital allocation line).
• Security market line
• Issues of international diversification
• Statistical and practical issues related to the implementation of the theory
Two Questions
• Question 1 : Asset Allocation
• How much money are you going to put into risky assets and how much into the risk
free security? (What proportion of your ‘own’ money should you put into a bundle
of risky stocks?)
• Allowing you to borrow and lend (from a bank). How does this alter your choice of
‘weights’ and the amount you actually choose to borrow or lend?
• Depends on your attitude towards risk
• Question 2 : Portfolio Theory
• How do you allocate the money which you invest into risky assets amongst different
risky securities?
• Different weights give rise to different ‘risk-return combinations and this leads to the
‘efficient frontier’
We will address Q2 first!
Introduction
• Two questions : How should our wealth (say $100) be divided
between risky and a risk free investments.
• Principal of insurance is based on concept of diversification
• Pooling of uncorrelated events
• Allows insurance premium to be relatively small compared to the value of
item insured (i.e. car, building)

• Other applications : hedging, risk management, structuring and here

investments (i.e. asset management)
Investments : Risk – Return Profile

ERi

Asset B

Asset A
Asset C

si

Risk averse investor would prefer asset-B to asset-A or

risk averse investor would prefer asset-C to asset-A.
An Intuitive Example :
Diversification
Portfolio Theory (Question 2)
• Portfolio theory works out the ‘best combination’ of stocks to hold in your
portfolio of risky assets.
• What proportions of your $100 (which you invest in risky assets – Question
2) should you put into different stocks – say two? For instance if weights
are 25%, 75% than that means $25 and $75 respectively.

• Objective : We assume the investor is trying to mix or combine stocks to

get the best risk return outcome.

• Rem. : Investors like returns and dislike risk.

League of their Own : Football in Scotland
• Scottish Football League :
• Suppose there are only 2 teams in Glasgow : Celtic and Rangers ‘Glasgow
Premier League’
• Suppose both teams are equally good (i.e. 50-50 chance of winning) and both
clubs are the same size.
• They play each other a number of times (say 10 times : 5 home games, 5 away
games) a ‘season’ (no draws – one team wins, the other loses)
• Suppose performance on the pitch is linked with prize money.
• Win (good news) : +£100
• Defeat (bad news) : £0
League of their Own : Football in Scotland
• (Say) investment of £1,000 entitles investor to 1% of the prize money (e.g. £1.-)
• Rangers (Celtic) fan :
• Invest ONLY in their club
• Invest £1,000 into Rangers (Celtic) and receive £1.- if your team wins
• Expected Pound Payout per game : 0.5(£1.0) + 0.5(£0) = £0.50
• Actual Pound Payout : either £1.- or nothing
• ‘Smart’ investor :
• Invest 50% of their wealth in Rangers and 50% in Celtic
• Invest £500 in Rangers and £500 in Celtic and receive £0.50 from either Rangers or Celtic,
whoever wins. (1% of investment).
• Hence receive £0.50 every game (as one team always wins)
• Therefore Expected Pound Payout per game = actual payout = £0.50.
• NO RISK!
League of their Own : Football in Scotland

Pound Sterling
Payout (£)
Investing 50% in Rangers
and 50% in Celtic

Investing 100% in either

£0.50
Rangers or Celtic

0.5 si
Diversification : Mathematical
Concepts
Portfolio : Expected Return and Variance
• Formula for 2-asset case :
• Expected portf. return : ERp = wA ERA + wB ERB
• Var. of portf. return : Var(Rp) = wA2 Var(RA) + wB2 Var(RB) + 2wAwBCov(RA,RB)

• Using matrix notation :

• Expected portfolio return : ERp = w’ERi
• Variance of portfolio return : Var(Rp) = w’Sw

where w is (n x1) vector of weights

ERi is (n x 1) vector of expected return of individual assets
S is (n x n) variance covariance matrix
Diversification : Focusing ONLY on
Risk
Power of Diversification
• As the number of assets (n) in the portfolio increase, the portfolio SD
(total riskiness) falls
• Assumptions (for simplification) :
• All assets have the same variance : si2 = s2
• All assets have the same covariance : sij = rs2
• Invest equally in each asset (i.e. 1/n)

• General formula for calculating the portfolio variance :

s2p = Swi2 si2 + SS wiwj sij
Power of Diversification
• Starting with the general formula for portfolio variance :
s2p = Swi2 si2 + SS wiwj sij

• Include the (three) assumptions we get

s2p = (1/n) s2 + ((n-1)/n) rs2

• If n is large (1/n) is small and ((n-1)/n) is close to 1.

• Hence s2p  rs2
Power of Diversification : Random Selection
of Stocks

Standard deviation

Diversifiable /
idiosyncratic risk

C
None-diversifiable risk
0 1 2 ... 20 40
No. of shares in portfolio
Self Study Exercise
• Suppose you have n assets. All assets have the same standard
deviation (s = 25) and the same correlation (r = 0.35)

• Questions :
• Calculate the portfolio standard deviation for an equally weighted portfolio of
size n = 2, 20 and infinity.
• How many assets do you have to include in your equally weighted portfolio so
that the portfolio standard deviation does not exceed 16?
Excel Spreadsheet : Sigma = 25, Corr = 0.35

Risk Reduction - Portfolio Theory

30

25

20

15

10

0
0 10 20 30 40 50 60
Diversification : Considering Risk
and Expected Return
Example (Two Risky Assets) : Summary
Statistics
Equity 1 Equity 2

Mean 8.75% 21.25%

SD 10.83% 19.80%

Correlation -0.9549

Covariance -204.688
Example (Two Risky Assets) : Portfolio Risk
and Portfolio Expected Return
Share of wealth Portfolio
in
w1 w2 ERp sp
1 1 0 8.75% 10.83%

2 0.75 0.25 11.88% 3.70%

3 0.5 0.5 15% 5%

4 0 1 21.25% 19.80%
Example (Two Risky Assets) : Efficient Frontier

25
0, 1

20

0.5, 0.5
Expected return (%)

15

10 1, 0
0.75, 0.25
5

0
0 5 10 15 20 25
Standard deviation
Efficient Frontier : Different Correlation
Assumptions (2 Risky Assets)

Y
r = -0.5
Expected return

r = -1 r = +1
B A
r = 0.5
Z

r=0
C
X

Std. dev.
Minimum Variance Portfolio (2 Risky Asset)
• Two asset case : wA + wB = 1 or wB = 1 – wA
Var(Rp) = wA2 sA2 + wB2 sB2 + 2wAwB rsAsB
Var(Rp) = wA2 sA2 + (1-wA)2 sB2 + 2wA(1-wA) rsAsB

• To minimise the portfolio variance : Differentiating with respect to wA

∂sp2/∂wA = 2wAsA2 – 2(1-wA)sB2 + 2(1-2wA)rsAsB = 0

• Solving the equation :

wA = [sB2 – rsAsB] / [sA2 + sB2 – 2rsAsB]
= (sB2 – sAB) / (sA2 + sB2 – 2sAB)
Minimum Variance Portfolio (2 Risky Asset)

ERp
0% Asset 1.
Minimum Variance
100% Asset 2
portfolio

100% Asset 1,
0% Asset 2

sp
Efficient Frontier : N-assets

ERp

U A
ERp* = 5% x
x x
L x
ERp** = 4% x
x x P1
B x x
x x
x
x x
P1 x
x
x C

sp** sp* sp
 Summary : Portfolio Theory

Expected Return

ER2
ER1
Formula for Varp
→ function of weights
→ different weights give different
values for Varp

sp
Asset Allocation : Risky Assets
and Risk Free Investment
Example : One ‘Bundle’ of Risky Assets Plus
Risk Free Rate
Suppose the ‘one-bundle’ of risky assets consists of 3
securities, i.e. 0.45 asset-A, 0.3 asset-B and 0.25 asset-C

Returns
T-Bill Equity
(safe) (Risky)
Mean 10% 22.5%

SD 0% 24.87%
Introducing Borrowing and Lending at the
Risk Free Rate
• Stage 2 of the investment process :

• You are now allowed to borrow and lend at the risk free rate r while still
investing in any SINGLE ‘risky bundle’ on the efficient frontier.
• For each SINGLE risky bundle, this gives a new set of risk-return combinations
known as the ‘capital allocation line’.
• Rather remarkable the risk-return combinations you are faced with is a
straight line (for each single bundle of risky assets) – capital allocation line
• You can be anywhere on this line.
New Portfolio of Risky Assets and the Risk
Free Investment
• ‘New’ Expected Portfolio Return : ERN = (1-x) rf + x ERp

• ‘New’ Portfolio Standard Deviation : s2N = x2 s2p or sN = x s p

where x = proportion invested in the portfolio of risky assets

ERp = expected return on the portfolio containing only risky assets
sp = standard deviation of the portfolio of risky assets
ERN = expected ‘new’ portfolio return (including the risk free asset)
sN = standard deviation of ‘new’ portfolio
Example : ‘New’ Portfolio ER and SD (One
Bundle of Risky Assets Plus Risk Free Rate)
Share of wealth Portfolio
in
(1-x) x ERN sN
1 1 0 10% 0%

2 0.5 0.5 16.25% 12.44%

3 0 1 22.5% 24.87%

4 -0.5 1.5 28.75% 37.31%

Example : Capital Allocation Line

35
30
0.5 lending +
25 0.5 in 1 risky bundle

20
15 No borrowing/
no lending
10
-0.5 borrowing +
5 All lending 1.5 in 1 risky bundle
0
0 5 10 15 20 25 30 35 40

Standard deviation (Risk)

Capital Allocation Line : Borrowing and
Lending
Expected Return
Borrowing/
leverage
Z
Lending
X all wealth in risky asset
L
Q
r
all wealth in
risk-free asset

sR
Standard Deviation, sN
Choosing the Most Efficient Portfolio

Expected Return

Portfolio B’ Portfolio B

rf
Portfolio A
sp
Capital Market Line – ‘Best’ Capital Allocation
Line
Capital allocation line 3
Expected Return
– best possible one
Portfolio M
Capital allocation line 2

Capital allocation line 1

rf Portfolio B
Portfolio A

sp
The Capital Market Line (CML)

Expected Return CML

Market Portfolio

Risk Premium / Equity Premium

(ERi – rf)

rf

sm Std. dev., si
Portfolio Choice – Capital Market Line and
Indifference Curves
IB Z’
Expected Return
Capital Market Line
K
IA
M Y
ERm
ERm - r
A

r
a L

sm s
The Security Market Line (SML)

Expected Return SML

Market Portfolio

Risk Premium / Equity Premium

(ERi – rf)

rf

0.5 1 1.2 Beta, bi

The larger is bi, the larger is ERi

Risk Adjusted Rate of Return
• Sharpe Ratio : SRi = (ERi – rf) / si
• Treynor Ratio : TRi = (ERi – rf) / bi

• Others :
• Jensen’s alpha
• Information ratio (similar to Sharpe ratio)
• Appraisal ratio (linked to Jensen’s alpha)

• Objective : maximise a risk adjusted rate of return measure.

Summary
• Power of diversification – Portfolio risk is covariance
• Mean variance approach (developed by H. Markowitz)
• Efficient frontier
• Capital allocation line and capital market line
• Market portfolio
• International investments : Cost and benefits
• Practical issues to make portfolio theory work

• Britton-Jones (1999) - Standard errors of the optimum weights and

the issue of home country biasness.
References
• Cuthbertson, K. and Nitzsche, D. (2008) ‘Investments’, J. Wiley (2nd edition)
• Chapters 10 and 11

• Solnik, B. (1974) ‘Why Not Diversify Internationally Rather Than

Domestically’, Financial Analyst Journal, July/August
• Odier, P. and Solnik, B. (1993) ‘Lessons for International Asset Allocation’,
Financial Analyst Journal, Vol. 49, pp. 63-77
• Britton-Jones, M. (1999) ‘The Sampling Error in Estimates of Mean-
Variance Efficient Portfolio Weights’, Journal of Finance, Vol. 52, No. 2, pp.
637-659
• Simons, K. (1999) ‘Should U.S. Investors Invest Overseas?’, New England
Economic Review
End of Lecture
[email protected]
Financial Markets and Securities