CHAPTER 7

Optimal Risky
Portfolios

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) is a foundational
concept in finance that guides investors on how to
construct a portfolio of assets to maximize expected
return for a given level of risk (or equivalently,
minimize risk for a given expected return).

The theory was introduced by Harry Markowitz in

his groundbreaking 1952 paper, and it has since
reshaped the way investors think about
diversification, risk management, and portfolio
construction.
 Key concepts of MPT
1. Risk and Return Trade-Off:
• Expected Return: The anticipated return of a portfolio is calculated as
the weighted average of the expected returns of its individual assets.
• The risk of a portfolio: is not merely the weighted average of individual
asset risks; it also depends on how the assets interact.
• Mean-Variance Optimization: Investors seek to identify the portfolio
that meets their risk tolerance while maximizing return,

2. Diversification
By combining assets that do not perfectly correlate with each other, an
investor can reduce the overall portfolio risk.

3. Efficient Frontier
The efficient frontier is a set of optimal portfolios that offer the highest
expected return for a defined level of risk or the lowest risk for a given
expected return
 7-2

The Investment Decision

• Top-down process with 3 steps:
1. Capital allocation between the risky
portfolio and risk-free asset.
2. Asset allocation across broad asset
classes
3. Security selection of individual assets
within each asset class

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 7-3

Diversification and Portfolio

Risk
• Market risk
– Systematic or
nondiversifiable

• Firm-specific risk
– Diversifiable or
nonsystematic

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 7-4

Figure 7.1 Portfolio Risk as a

Function of the Number of
Stocks in the Portfolio

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 7-6

Covariance and Correlation

• Portfolio risk depends on the

correlation between the returns
of the assets in the portfolio.

• Covariance and the correlation

coefficient provide a measure
of the way returns of two
assets vary.

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 Covariance and Correlation
Feature Covariance Correlation
Measures how two variables Measures the strength and
Definition
move together direction of the relationship

Formula

Scale Unbounded (∞) Bounded between -1 and 1

Positive → Stocks move
together +1 → Perfect positive correlation
Interpretation Negative → Stocks move 0 → No correlation
opposite -1 → Perfect negative correlation
 7-7

Two-Security Portfolio: Return

rp  wr D D
 wr
E

rP E Portfolio
Return
wD 
Bond
Weight rD 
Bond Return wE
E(rp )  wD E(rD )  wE
 Equity
E(rE Weight
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 7-8

Two-Security Portfolio: Risk

  w   w   2w w Covr , r
2 2 2 2 2

p D D E E D E D
E

 D2 = Variance of
Security D
 E2 = Variance of
Security E
CovrD , rE  = Covariance of returns
for
Security INVESTMENTS
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 7-
10

Covariance
CovrD , rE   DE D
E
D,E = Correlation coefficient of
returns
D = Standard deviation of
returns for Security D

E = Standard deviation of
returns for Security E

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 7-9

Two-Security Portfolio: Risk

• The covariance of a variable with itself is

the variance of that variable.

• This portfolio variance equation

highlights a key insight: portfolio
risk is not just the weighted
sum of individual risks but also
depends on the correlation
between assets.
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 7-
19

Correlation Coefficients: Possible

Values
Range of values for correlation 
+ 1.0 >  > -1.0
If  = 1.0, the securities are
perfectly positively correlated
If  = - 1.0, the securities are
perfectly negatively correlated

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 7-
21

Correlation Coefficients
• When ρDE = 1, there is no diversification
P  wEE  wDD
• When ρDE = -1, a perfect hedge is
when:
2  w22  w22  2w w 
p 0
D D E E D E D E

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 Exercise
Suppose you have two risky assets with the following characteristics:

Asset A:
Expected return, E(R)=10%
Standard deviation, σA=15%
Asset B:
Expected return, E(R)=15%
Standard deviation, σB=20%

An investor creates a portfolio by investing 40% in Asset A and

60% in Asset B.

Calculate portfolio return and risk given correlation coefficient of

a) -0,5 b) 0,5.
Efficient frontier
Efficient frontier represents
the set of optimal portfolios
that offer the highest
expected return for a given
level of risk (standard
deviation) or, equivalently, the
lowest risk for a given level
of expected return.
Portfolios lying on the
efficient frontier are the best
possible combinations of
assets because no other
portfolio provides better risk-
adjusted returns.
 7-24

The Minimum Variance

Portfolio
The minimum variance portfolio is defined
as the portfolio of risky assets that has the
lowest possible variance (or standard
deviation) among all portfolios that can be
formed from the given assets.

Since it represents the absolute lowest

risk combination, it is, by definition, the
global minimum variance portfolio.

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 The Minimum Variance
Portfolio
Portfolio Diversification and Minimum Variance Portfolio
In case of 2 asset portfolio, by varying the weights w1,w2 we
can form different portfolios with different risk-return trade-
offs.

The minimum variance portfolio (MVP) is the portfolio with

the lowest possible risk among all combinations.
Exercise
You are given two stocks, A and B, with the following statistics:

Stock Expected return Standard deviation

A 10% 15%
B 7% 10%

The correlation coefficient between A and B is 0.3.

Tasks:
1. Compute the Minimum Variance Portfolio (MVP) weights for asset A
and Asset B.
2. Calculate the expected return of the minimum variance portfolio.
3. Calculate the risk (standard deviation) of the minimum variance
portfolio.
 Exercise
An investor is considering investing in a
small-cap stock fund and a general bond
fund. Their returns and standard deviations
are given below and the correlation of fund
returns is 0.10.
Expected annual Standard deviation
return of returns
Small cap fund 19% 33%
Bond fund 8% 13%

1. If the investor requires portfolio return of

12%, what should be proportions in each
fund?
2. What is standard deviation of such
portfolio?
 7-
12

A portfolio of 3 Assets
• You have three assets with
weights w1, w2, w3
• The portfolio return is simply the
linear combination of the returns
with same coefficients:
E(rp )  w1E(r1 )  w2 E(r2 ) 
w3 E(r3 )
Q. is the portfolio’s variance also
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 7-
13

Bordered Matrix for 3

Assetsmatrix and its
Step 1: write the covariance
weights
w1 w2 w3

w1 Cov(1,1) Cov(1,2) Cov(1,3)

w2 Cov(2,1) Cov(2,2) Cov(2,3)

w3 Cov(3,1) Cov(3,2) Cov(3,3)

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 7-
15

Bordered Matrix for 3

Step 3: multiply by Assets
the weights around the
border
w1 w2 w3
2
w1 w 2

1 1 w1w2Cov1,2 w1w3 Cov1,3

w2 w2 2
w1w2Cov1,2 2 2 w2 w3 Cov2,3

w2 w3Cov 2,3 w2 
w3 w1w3Cov1,3 2
3
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 7-
17

Bordered Matrix for 3

All in one Assets
step
w1 w2 w3

w1 w2
w1w2 1,21 2 w1w3 13, 13
 2

w2 w2 2
w1w2 1,21 2 2 w3w32,323
2
w2  2
w3 w1 w3 13, 13 w3w2 2,3INVESTMENTS
 23 3
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 7-
18

Bordered Matrix for 3

Assets
Add-up all the
pieces
 p  w1 1  w2 2  w3 3
2 2 2 2 2 2 2

 2w1w212, 12
 2w1w313, 13
 2w2 w323, 23

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 A portfolio of 3 Assets
For a portfolio with multiple assets (NNN
assets), the efficient frontier is found by
solving a mean-variance optimization
problem.

The goal is to identify the set of portfolios that

provide the highest expected return for a
given level of risk or lowest risk for a
given level of return.
 A portfolio of 3 Assets
To construct the efficient frontier for multiple assets, we solve the
following constrained optimization problem:

Subject to:
1. The portfolio must generate a specific expected return

2. The sum of all portfolio weights must be 1

3. If no short selling is allowed, add the constraint:

 Adding Risk-free asset
The tangency portfolio or optimal risky portfolio is the portfolio on
the efficient frontier that, when combined with a risk‐free asset, gives
the highest possible Sharpe ratio (i.e., the best excess return per unit
of risk).

In other words, it is the portfolio that “touches” (is tangent to) the
Capital Allocation Line (CAL) drawn from the risk-free rate
 7-28

The Sharpe Ratio

• Maximize the slope of the CAL for
any possible portfolio, P.
• The objective function is the
slope:
ErP  rf
SP

P
• The slope is also the Sharpe
ratio.
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 7-29

Figure 7.7 The Opportunity Set of the Debt and

Equity
withFunds
the Optimal CAL and the Optimal Risky
Portfolio

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Complete portfolio
 7-30

Figure 7.8 Determination of the

Optimal Overall
Portfolio

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 7-
31

Markowitz Portfolio Selection

Model
• Security Selection
– The first step is to determine
the risk- return opportunities
available.
– All portfolios that lie on the
minimum- variance frontier from
the global minimum-variance
portfolio and upward provide the
best risk-return combinations

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 7-32

Figure 7.10 The Minimum-

Variance Frontier of
Risky Assets

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 7-33

Markowitz Portfolio Selection

Model

• We now search for the CAL with

the highest reward-to-
variability ratio

• That means to find that optimal

line that stems from the risk-
free point and is tangent to the
efficient frontier
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 7-34

Figure 7.11 The Efficient Frontier

of Risky Assets with the
Optimal CAL

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 7-35

Markowitz Portfolio Selection

Model
• Everyone invests in P, regardless of
their degree of risk aversion.

– More risk averse investors put more

in the risk-free asset.

– Less risk averse investors put more

in P.

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 7-36

Capital Allocation and the

Separation Property
• The separation property tells us
that the portfolio choice problem
may be separated into two
independent tasks:
– Determination of the optimal
risky portfolio is purely
technical
– Allocation of the complete portfolio
to T- bills versus the risky portfolio
depends on personal preference.
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 7-43

Optimal Portfolios and Nonnormal

Returns
• The optimal portfolio approach we just
studied assumes normal returns.
• Fat-tailed distributions can result in
extreme values of Value-at-Risk (VaR) and
Expected Shortfall (ES) and encourage
smaller allocations to the risky portfolio.
• If other portfolios provide sufficiently
better VaR and ES values than the mean-
variance efficient portfolio, we may prefer
these when faced with fat-tailed
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