Chapter 7

PORTFOLIO THEORY
The Benefits of Diversification

Compiled by: Dr. Rajsee Joshi

 CHAPTER OUTLINE

Portfolio Return and Risk

Measurement of Co-movements in Security Returns

Calculation of Portfolio Risk

Efficient Frontier

Optimal Portfolio

Riskless Lending and Borrowing

The Single Index Model

Compiled by: Dr. Rajsee Joshi

 Portfolio Expected Return
n
E(RP) = ∑ wi E(Ri)
i=1
where E(RP) = expected portfolio return
wi = weight assigned to security i
E(Ri) = expected return on security i
n = number of securities in the portfolio
Example A portfolio consists of four securities with expected returns of
12%, 15%, 18%, and 20% respectively. The proportions of portfolio
value invested in these securities are 0.2, 0.3, 0.3, and 0.20 respectively.
The expected return on the portfolio is:
E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)
= 16.3% Compiled by: Dr. Rajsee Joshi
 Portfolio Risk

The risk of a portfolio is measured by the

variance (or standard deviation) of its return.

Although the expected return on a portfolio is the

weighted average of the expected returns on the
individual securities in the portfolio, portfolio risk
is not the weighted average of the risks of the
individual securities in the portfolio (except when
the returns from the securities are uncorrelated).

Compiled by: Dr. Rajsee Joshi

 Measurement Of Co-movements
In Security Returns

To develop the equation for calculating portfolio risk

we need information on weighted individual security
risks and weighted co-movements between the
returns of securities included in the portfolio.

Co-movements between the returns of securities

are measured by covariance (an absolute measure)
and coefficient of correlation (a relative measure).

Compiled by: Dr. Rajsee Joshi

 Covariance:
Covariance reflects the degree to which the returns of the
securities vary or change together. A positive covariance
means that the returns of the two securities move in the same
direction

COV (Ri , Rj) = p1 [Ri1 – E(Ri)] [ Rj1 – E(Rj)]

+ p2 [Ri2 – E(Rj)] [Rj2 – E(Rj)]

+ ••
•

+ pn [Rin – E(Ri)] [Rjn – E(Rj)]

Compiled by: Dr. Rajsee Joshi
 Illustration
The returns on assets 1 and 2 under five possible states of nature are given
below

State of nature Probability Return on asset 1 Return on asset 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

The expected return on asset 1 is :

E(R1) = 0.10 (-10%) + 0.30 (15%) + 0.30 (18%) + 0.20 (22%) + 0.10 (27%)
= 16%

The expected return on asset 2 is :

E(R2) = 0.10 (5%) + 0.30 (12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%)
= 14%

Compiled by: Dr. Rajsee Joshi

The covariance between the returns on assets 1 and 2 is calculated below :

State of Probability Return on Deviation of Return on Deviation of Product of the

nature asset 1 the return on asset 2 the return on deviations
asset 1 from its asset 2 from times
mean its mean probability
(1) (2) as(3) (4) (5) (6) (2) x (4) x (6)

1 0.10 -10% -26% 5% -9% 23.4

2 0.30 15% -1% 12% -2% 0.6
3 0.30 18% 2% 19% 5% 3.0
4 0.20 22% 6% 15% 1% 1.2
5 0.10 27% 11% 12% -2% -2.2
Sum = 26.0

Thus the covariance between the returns on the two assets is 26.0.

Compiled by: Dr. Rajsee Joshi

 Coefficient Of Correlation
Cov (Ri , Rj)
Cor (Ri , Rj) or ρij =
σ (Ri , Rj)
where ρij = correlation coefficient
between the returns on securities i and j
σij = covariance between the returns on securities
i and j
σi , σj = standard deviation of the returns on
securities i and j

Compiled by: Dr. Rajsee Joshi

Coefficient Of Correlation
The coefficient of correlation is simply
covariance divided by the product of
standard deviations
Coefficient of correlation can vary between
-1 to 1.

Compiled by: Dr. Rajsee Joshi

Calculation of Portfolio Risk
σp = [w12 σ12 + w22 σ22 + 2w1w2 ρ12 σ1 σ2]½

A portfolio consists of two securities, 1 and 2 in

the proportions of 0.6 and 0.4. The standard
deviations of the returns of the securities are
10 and 16 respectively. The co-effecient of
correlation between the returns on securities is
0.5

What is the standard deviation of the portfolio?

Compiled by: Dr. Rajsee Joshi

 Portfolio Risk : 2 – Security Case

Example : w1 = 0.6 , w2 = 0.4,

σ1 = 10%, σ2 = 16%
ρ12 = 0.5
σp = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½
= 10.7%

Compiled by: Dr. Rajsee Joshi

 Portfolio Risk : n – Security Case
Example : w1 = 0.5 , w2 = 0.3, and w3 = 0.2
σ1 = 10%, σ2 = 15%, σ3 = 20%
ρ12 = 0.3, ρ13 = 0.5, ρ23 = 0.6
σp = [w12 σ12 + w22 σ22 + w32 σ32 + 2 w1 w2 ρ12 σ1 σ2
+ 2w1 w3 ρ13 σ1 σ3 + 2w2 w3 ρ23σ2 σ3] ½

= 10.79%

Compiled by: Dr. Rajsee Joshi

Example : A portfolio consists of 4 securities. The proportion
of these securities are: w1 = 0.2 , w2 = 0.3, w3 = 0.4 and w4 = 0.1.
The standard deviations of the securities are: σ1 = 4, σ2 = 8, σ3
= 20 and σ4 = 10. The correlation coefficient among securities
are: ρ12 = 0.3, ρ13 = 0.5, ρ14 = 0.2, ρ23 = 0.6, ρ24 = 0.8 and ρ34 =
0.4. What is the standard deviation of portfolio return?

Compiled by: Dr. Rajsee Joshi

 Dominance Of Covariance
As the number of securities included in a portfolio
increases, the importance of the risk of each
individual security decreases whereas the
significance of the covariance relationship
increases.

Compiled by: Dr. Rajsee Joshi

 Efficient Frontier
For A Two Security-Case
Security A Security B
Expected return 12% 20%
Standard deviation 20% 40%
Coefficient of correlation -0.2
Portfolio Proportion of A Proportion of B Expected return Standard deviation
wA wB E (Rp) σp
1 (A) 1.00 0.00 12.00% 20.00%

2 0.90 0.10 12.80% 17.64%

3 0.75 0.25 13.93% 16.27%

4 0.50 0.50 16.00% 20.49%

5 0.25 0.75 18.00% 29.41%

6 (B) 0.00 1.00 20.00% 40.00%

Compiled by: Dr. Rajsee Joshi

Portfolio Options And The Efficient Frontier

Expected
return , E(Rp)

20% 5 6 (B)
4
3•
2•
12% 1 (A)

Risk, σp
20% 40%

Compiled by: Dr. Rajsee Joshi

Feasible Frontier Under Various Degrees Of
Coefficient of Correlation

Expected
return , E (Rp)

20% B (WB = 1)

•
12% A (WA = 1)

Standard deviation, σp

Compiled by: Dr. Rajsee Joshi

Portfolio is efficient if and only if
there in no alternative:

The same Expected return and a lower std
deviation

The same Std deviation and a Higher
Expected Return

A Higher Expected Return and Lower Std
deviation

Compiled by: Dr. Rajsee Joshi

 Efficient Frontier For The n-Security Case
Expected
return , E (Rp)

•X

F
• D
•B Z• •M

•N
•O
A
•

Standard deviation, σp

Compiled by: Dr. Rajsee Joshi

Efficient Frontier For The n-
n-Security
Case

All the feasible portfolios are contained in
the region AFXMNO, however only
portfolios AFX are efficient

All the other portfolios are inefficient.

Portfolio like Z is inefficient as portfolios

like B and D dominate it

Compiled by: Dr. Rajsee Joshi

 Indifference point curves

P & Q are hypothetical investors. Q is
more risk averse than P.

Each investor has a map of indifference
curves.

All the points lying on a given indifference
curve offer the same level of satisfaction

Compiled by: Dr. Rajsee Joshi

 Optimal Portfolio
Expected
return , E (Rp) I P3 I I
IQ2 P2 P
1
IQ3 IQ1
•X
• *
P
•
Q* • M

•
N

•
O

Standard deviation, σp
Compiled by: Dr. Rajsee Joshi
Consider two stocks, P and Q
Expected SD (%)
Return (%)
P 16 25
Q 18 30

The returns on the two stocks are perfectly

negatively correlated. What is the expected return
of a portfolio constructed to drive the standard
deviation of the portfolio to zero?

Compiled by: Dr. Rajsee Joshi

The following information is available
Stock A Stock B
Expected Return 16% 12%
SD 15% 8%
Coefficient of Correlation 0.60

What is the covariance between stocks A & B?

What is the expected return and risk of a portfolio in
which A & B have weights of 0.6 and 0.4?

Compiled by: Dr. Rajsee Joshi

 Portfolio Options And The Efficient Frontier

Lets form an Efficient Frontier with actual securities..

Compiled by: Dr. Rajsee Joshi

 Riskless Lending And Borrowing Opportunity

•Suppose that investors can lend and borrow money at a risk-

free rate of Rf .
•Since Rf is risk-free asset it has zero correlation with all the
points in the feasible region of risky securities.
•So a combination of Rf and any point in the feasible region
will be represented by a straight line

Compiled by: Dr. Rajsee Joshi

 Riskless Lending And Borrowing Opportunity
Expected
return , E (Rp)
G
II

EV•
• •X
•
S
• B I

D •M
• •F Y
C• •
u •N
•
Rf • •O
•
A

Standard deviation, σp
Thus, with the opportunity of lending and borrowing, the efficient frontier
changes. It is no longer AFX. Rather, it becomes Rf SG as itCompiled by: Dr. Rajsee Joshi
domniates AFX.
 Separation Theorem
• Since Rf SG dominates AFX, every investor would do well to
choose some combination of Rf and S. A conservative investor
may choose a point like U, whereas an aggressive investor may
choose a point like V.

• Thus, the task of portfolio selection can be separated into two

steps:
1. Identification of S, the optimal portfolio of risky securities.
2. Choice of a combination of Rf and S, depending on one’s
risk attitude.

Compiled by: Dr. Rajsee Joshi

 Single Index Model- William Sharpe

INFORMATION - INTENSITY OF THE MARKOWITZ MODEL

If there are n SECURITIES, the Markowitz Model requires n
expected returns, n Variance terms & n(n -1) /2 Covariance terms.

Clearly, there is a problem of estimating large no. of covariance terms,

particularly for institutional investors, who may have invested in 50 to 100
securities in their portfolio
Hence, until the Markowitz model is simplified, in terms of covariance
inputs, its scarcely operational
SHARPE’S MODEL
Rit = ai + bi RMt + eit

Rit is the return on security, Rmt is the return on market index, ai is the
constant return, bi is the measure of the sensitivity of the security’s
return to the market’s return and e is the error term
Compiled by: Dr. Rajsee Joshi
 SUMMING UP

Portfolio theory, originally proposed by Markowitz,

is the first formal attempt to quantify the risk of a
portfolio and develop a methodology for
determining the optimal portfolio.

A portfolio is efficient if (and only if) there is an

alternative with (i) the same E(Rp) and a lower σp
or (ii) the same σp and a higher E(Rp), or (iii) a
higher E(Rp) and a lower σp

Compiled by: Dr. Rajsee Joshi

Given the efficient frontier and the risk-return indifference
curves, the optimal portfolio is found at the tangency between
the efficient frontier and a utility indifference curve.

If we introduce the opportunity for lending and borrowing at the

risk-free rate, the efficient frontier changes dramatically.

It is simply the straight line from the risk-free rate which is

tangential to the broken-egg shaped feasible region
representing all possible combinations of risky assets.

The Markowitz model is highly information-intensive.

The single index model, proposed by sharpe, is a very helpful

simplification of the Markowitz model.

Compiled by: Dr. Rajsee Joshi