Portfolio and Fund Management

Topic 3 Portfolio Theory

Dr Reza Bradrania
Business School
University of South Australia
 Portfolio and Fund Management
(BANK 3004)

The principle of diversification

Diversification and Portfolio Risk
• Risk has two components; firm-specifc and market specific:
1. Market/Systematic/Non-diversifiable Risk
• Risk factors common to whole economy

2. Unique/Firm-Specific/Nonsystematic/ Diversifiable Risk

• Risk that can be eliminated by diversification

3
Risk as Function of Number of Stocks in Portfolio

4
Risk vs Diversification

5
 Portfolio and Fund Management
(BANK 3004)

Covariance and the covariance

matrix
Covariance and Correlation
• Covariance Calculations (Scenario analysis)
S
Cov(rS , rB )  p (i )[rS (i )  E (rS )][rB (i )  E (rB )]
i 1
Or (Time-series analysis)

• Correlation Coefficient

Cov(rS , rB )
ρ SB  Cov(rS , rB ) ρ SB σ S σ B
σ S σ B
7
Covariance matrix
• Covariance matrix is used to compute the portfolio variance
and standard deviation
• A five-stock covariance matrix:
Asset A B C D E
A Var(A) Cov(A,B) Cov(A,C) Cov(A,D) Cov(A,E)
B Cov(B,A) Var(B) Cov(B,C) Cov(B,D) Cov(B,E)
C Cov(C,A) Cov(C,B) Var(C) Cov(C,D) Cov(C,E)
D Cov(D,A) Cov(D,B) Cov(D,C) Var(D) Cov(D,E)
E Cov(E,A) Cov (E,B) Cov (E,C) Cov (E,D) Var (E)
• If you only look at the four terms to the top-left (variance and covariance between return of Stock A and
stock B), you will notice that multiply them by the corresponding weights, then adding them up gives
you the variance of a two-stock portfolio:

8
Covariance matrix and diversification
• We noticed that for a five-asset portfolio, there are 5 variance
terms (along the diagonal) and 20 covariance terms.
• In fact, if a portfolio has n assets (assumed to be equally
weighted), the portfolio variance is:

• As n approaches infinity, = 0 and = 1. In other words, the

portfolio’s riskiness is determined by the average covariance
of its assets.

9
 Portfolio and Fund Management
(BANK 3004)

Expected return and standard

deviation of a two-asset portfolio
Mean and Variance (single asset)
• Scenario based:
• Expected return based on S scenarios:

• Variance: expected value of squared deviation from mean

Standard deviation, ) or = Square root of

• Using time series of returns:

11
Expected return and variance
• Expected return on two-security portfolio

𝐸(𝑟 𝑃)=𝑊 1 𝑟 1+𝑊 2𝑟 2

W1 Proportion of funds in security 1
W2 Proportion of funds in security 2
r1 Expected return on security 1
r 2 Expected return on security 2

• Variance of the two-security portfolio

• Portfolio standard deviation is the square root of its variance:

=

12
 Portfolio and Fund Management
(BANK 3004)

Investment opportunity set

Example: Investment Opportunity Set (stock and bond)
• Let’s compute returns and standard deviations of various
portfolio by changing weights (Ws)

14
Opportunity Sets: Various Correlation Coefficients
• Various correlation coefficients between two assets give you
different frontiers.

15
 Portfolio and Fund Management
(BANK 3004)

The minimum variance portfolio

How to find the minimum variance portfolio
• The minimum variance portfolio, by definition, has the
minimum variance (or standard deviation), among all
possible combination of assets.
• For a two-asset portfolio, the weights are given by:

• It can be found using Excel Solver if there are more than

two assets in the portfolio.
• We will demonstrate this in Excel.

17
Example: Investment Opportunity Set (stock and bond)
• And show the pairs of (Return, SD) on a graph:

• This plot is shows all possible investment opportunity sets based on these two assets.
18
 Portfolio and Fund Management
(BANK 3004)

The optimal risky portfolio

The Optimal Risky Portfolio with a Risk-Free Asset
• CAL gives us combinations (portfolios) of a risky asset
(or portfolio) and a safe asset.
• Slope of CAL is Sharpe Ratio of Risky Portfolio

• We are after a risky portfolio that maximize this

Sharpe ratio; it is called optimal risky portfolio.
• Optimal Risky Portfolio
• The best combination of risky assets to be mixed
with a safe asset to form the complete portfolio
20
Two Capital Allocation Lines
• CAL (A) gives better combinations (portfolios) compared to CAL
(MIN).

21
Bond, Stock and T-Bill Optimal Allocation
• CAL (o) is tangent to the frontier of risky assets and has the maximum
Sharpe ratio. The tangency point is the optimal portfolio.

Portfolio O:
Weight(bond)=0.568
Weight (stocks)=0.432

22
The Complete Portfolio
• Example: portfolio C is a complete portfolio (45% on Rf and 55% on the
optimal risky portfolio).

Portfolio O:
Weight(bond)=0.568
Weight (stocks)=0.432

Portfolio C Return
0.45X3%+0.55X7.16%=5.29%

23
 Portfolio and Fund Management
(BANK 3004)

To find the optimal risky portfolio

The Optimal Risky Portfolio for two risky assets
• No need to have the frontier of the risky
assets to find out the optimal portfolio.
• For two risky assets and a risk-free asset, it
can be calculated using below formula
[ E (rB )  rf ] S2  [ E (rs )  r f ] B S  BS
wB 
[ E (rB )  rf ] S2  [ E (rs )  rf ] B2  [ E (rB )  r f  E (rs )  r f ] B S  BS

wS 1  wB

25
The Optimal Risky Portfolio of more than two assets
• Solver must be used
• This can be done in Excel, the goal is to maxmise the
Sharpe Ratio of the portfolio.
• We will demonstrate this in Excel.

26
 Portfolio and Fund Management
(BANK 3004)

The efficient frontier

Portfolios Constructed with Three Stocks

28
Efficient Frontier: Risky and Individual Assets
• If you increase the number of assets, the frontier will shift towards north-west.
Efficient frontier is the frontier (combinations of assets) with the maximum returns
for a specific risk

29
Efficient Frontier
• Efficient frontier of risky assets: a graph representing
set of portfolios that maximizes expected return at each
level of portfolio risk
• Three methods to find out the efficient frontier:
• Maximize risk premium for any level standard
deviation
• Minimize standard deviation for any level risk
premium
• Maximize Sharpe ratio for any standard deviation or
risk premium
30
Efficient Diversification with Many Risky Assets
• Efficient diversification by choosing Optimal Risky Portfolio as the
tangency point of the CAL and the efficient frontier
• Preferred complete portfolio is a personal choice of weights for the
risky portfolio and risk-free asset depending on investors’ level of risk
aversion.
• Separation Theorem: the portfolio choice is separated into two
tasks:
1. Determination of optimal risky portfolio. You are able to do this
without knowing investors’ preferences.
2. Personal choice of best mix of risky portfolio and risk-free asset

31