Lecture5 2017-18 Upload
Lecture5 2017-18 Upload
Lecture5 2017-18 Upload
Panagiotis Couzo↵
Outline
Portfolio Theory
Diversification
Outline
Portfolio Theory
Diversification
Portfolio theory
higher return
lower variance
0
Lecture 5: Portfolio theory
Portfolio Theory
Dominating investments
I Consider two investments I1 and I2 which are mutually exclusive, i.e.
you can only invest in one of the two:
E[R]
I1
I2
0
Lecture 5: Portfolio theory
Portfolio Theory
Dominating investments
I I1 dominates I2 as it has both higher expected return and lower
standard deviation.
E[R]
I1
I2
0
Lecture 5: Portfolio theory
Portfolio Theory
£120K £500K
0.5 0.5
p= p=
1 1
p p
£100K £280K
Risk aversion
Utility functions
d 2u
>0
dw 2
Lecture 5: Portfolio theory
Portfolio Theory
Indi↵erence curves
Choosing a portfolio
Outline
Portfolio Theory
Diversification
I The line formed by the portfolios with the lowest variance (or
standard deviation) for a given expected return is called the
minimum-variance frontier.
I The left-most point on the minimum-variance frontier is called the
global minimum-variance portfolio.
I The set of portfolios with the highest expected return for a given
level of risk is called the efficient frontier.
Lecture 5: Portfolio theory
Diversification
Limits to diversification
Theory
Theory (cont’d)
A graph
I Equally-weighted portfolio of assets where all assets have the same
standard deviation of returns and their returns are equally correlated
to each other:
Lecture 5: Portfolio theory
Diversification
353-364.
Outline
Portfolio Theory
Diversification
I Noting that the variance (and also the standard deviation) of the
risk-free asset is zero and its covariance with the risky asset is also
zero:
2 2 2
P =w i =) P = w i
Portfolio with the riskless and more than one risky asset
I We can easily add risky assets, simply by combining the risk-free
with portfolios from the feasible portfolio set of risky assets:
Lecture 5: Portfolio theory
Optimal portfolio including a riskless asset
Portfolio with the riskless and more than one risky asset
I Notice that the portfolio with the steepest slope dominates all other
portfolios. Hence, this is in fact the efficient frontier!
Lecture 5: Portfolio theory
Optimal portfolio including a riskless asset
Outline
Portfolio Theory
Diversification
d P2 X
2
= 2 wn n +2 wm Cov rn , rm
d wn
m6=n
= 2 Cov rn , rM
I Define the Buck for the Bang Ratio as the ratio of change in the
expected return (buck) to the change in variance (bang).
I We have found this ratio to be
d E[ rP ] ⇥ ⇤
d wn E rn rf
d P2
=
2 Cov (rn , rM )
d wn
Lecture 5: Portfolio theory
Implications on asset risk
Takeaways
d P2 X
2
= 2 wn n +2 wm Cov rn , rm
d wn
m6=n
0 1
X
= 2 Cov rn , wn rn + 2 Cov @rn , wm r m A
m6=n
0 1
X
= 2 Cov @rn , wn rn + wm r m A
m6=n
= 2 Cov rn , rM