Portfolio Management
Portfolio analysis is concerned with finding the most
desirable group of securities to hold, given the
properties of each of the securities.
Techniques for Calculating the Efficient Frontier
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• The existence of a riskless lending and borrowing
rate implies that there is a single portfolio of
risky assets that is preferred to all other
portfolios.
• Furthermore, in return standard deviation space,
this portfolio plots on the ray connecting the
riskless asset and a risky portfolio that lies
furthest in the counterclockwise direction.
• The efficient frontier is the entire length of the
ray extending through RF and B.
• Different points along the ray RF—B represent
different amounts of borrowing and/or lending in
combination with the optimum portfolio of risky
assets B
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• An equivalent way of identifying the ray RF—B is to
recognize that it is the ray with the greatest slope.
• Recall that the slope of the line connecting a riskless asset
and a risky portfolio is the expected return on the portfolio
minus the risk-free rate divided by the standard deviation
of the return on the portfolio.
• Thus the efficient set is determined by finding that
portfolio with the greatest ratio of excess return (expected
return minus risk-free rate) to standard deviation that
satisfies the constraint that the sum of the proportions
invested in the assets equals 1.
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• This is a constrained maximization problem.
• The constraint could be substituted into the objective function and the
objective function maximized as in an unconstrained problem.
• Making this substitution in the objective function and stating the expected
return and standard deviation of return in the general form, derived in
yields
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• In calculus it is shown that to find the maximum of a function, you take
the derivative with respect to each variable and set it equal to zero.
• Thus the solution to the maximization problem just presented involves
finding the solution to the following system of simultaneous equations:
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• Note that each Xk is multiplied by a constant λ.
• Define a new variable Zk= λ Xk.
• The Xk are the fraction to invest in each security, and the Z k are
proportional to this fraction.
• To solve for the Xk after obtaining the Zk, one divides each Zk by the sum of
the Zk.
• Substituting Zk for λXk and moving the variance covariance terms to the
right-hand side of the equality yields
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• We have one equation like this for each value of i.
• Thus the solution involves solving the following system of simultaneous
equations:
• The Zs are proportional to the
optimum amount to invest in each
security.
• There are N equations and N
unknowns (the Zk for each
security).
• Then the optimum proportion to
invest in stock k is Xk, where
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• Let us solve an example.
• Consider three securities: Colonel Motors with expected return of 14% and
standard deviation of return of 6%,
• Separated Edison with average return of 8% and standard deviation of
return of 3%,
• and Unique Oil with mean return of 20% and standard deviation of return of
15%.
• Furthermore, assume that the correlation coefficient between Colonel Motors and
Separated Edison is 0.5,
• between Colonel Motors and Unique Oil is 0.2,
• and between Separated Edison and Unique Oil is 0.4.
• Finally, assume that the riskless lending and borrowing rate is 5%.
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• The solution to this system of simultaneous equations is
• As Zk is proportional to Xk so the proportion to invest in each security is
• The expected return on the portfolio is
SHORT SALES ALLOWED WITH RISKLESS LENDING
AND BORROWING
• The variance of the return on the portfolio is
SHORT SALES ALLOWED: NO RISKLESS LENDING
AND BORROWING
• When the investor does not wish to make the assumption that she can
borrow and lend at the riskless rate of interest, the solution developed in
the last section must be modified in the following manner;
• Assume that a riskless lending and borrowing rate exists and find the
optimum portfolio.
• Then assume that a different riskless lending and borrowing rate exists and
find the optimum portfolio that corresponds to this second rate.
• Continue changing the assumed riskless rate until the full efficient frontier is
determined.
SHORT SALES ALLOWED: NO RISKLESS LENDING
AND BORROWING
• The general expression
is;
Zk = C0k + C1k RF
RISKLESS LENDING AND BORROWING WITH SHORT
SALES NOT ALLOWED
• One portfolio is optimal.
• Once again, it is the one that maximizes the slope of the line connecting the
riskless asset and a risky portfolio.
• The set of portfolios that is available to combine with lending and borrowing
is different because a new constraint has been added.
• Investors cannot hold securities in negative amounts
• It is called a quadratic
programming problem and
computer packages are used to
solve the objective function.
NO SHORT SELLING AND NO RISKLESS LENDING AND
BORROWING
• An efficient set is determined by minimizing the risk for any level of
expected return.
• To get one point on the efficient frontier, we minimize risk subject to the
return being some level plus the restriction that the sum of the
proportions invested in each security is 1 and that all securities have
positive or zero investment.
