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Session Plan

Calculating and interpret major risk and return measures of

portfolio and describe their applicability.
Portfolio risk and return
Dr M Kannadhasan
Professor of Finance
Indian Institute of Management Raipur

Choosing a portfolio of risky assets Expected return of portfolio

Assumption 1 : The only two parameters that affect an investor’s

decision are the expected return and the variance. (That is, investors
make decisions using the two parameter model formulated by
Markowitz.)
§ E(R 1) = expected return on Asset 1
Assumption 2 : Investors are risk averse. (That is, when faced with two
§ E(R 2) = expected return on Asset 2
investments with the same expected return but two different risks,
§ w 1 = weight of Asset 1 in the portfolio
investors will prefer the one with the lower risk.)
§ w 2 = weight of Asset 2 in the portfolio
Assumption 3 : All investors seek to achieve the highest expected return
at a given level of risk.

Assumption 4 : All investors have the same expectations regarding

expected return, variance, and co-variances for all risky assets. (This is
referred to as the homogeneous expectations assumption .)
Assumption 5 : All investors have a common one-period investment
horizon. 3 4

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Variance of portfolio
Important Take-away

1. The first part of the formula for the 2-asset portfolio standard deviation tells
us that portfolio standard deviation is a positive function of (1) the standard
deviations of the assets held in the portfolio and (2) the weights of the
individual assets in the portfolio
2. The second part (2w1w2Cov1,2 ) shows us that portfolio standard deviation
is also dependent on how the two assets move in relation to each other
(covariance or correlation).

From the formula for portfolio variance it is also important to understand that:

1. The maximum value for portfolio standard deviation will be obtained when
the correlation coefficient equals +1.
2. Portfolio standard deviation will be minimized when the correlation
coefficient equals –1.
3. If the correlation coefficient equals zero, the second part of the formula will
equal zero and portfolio standard deviation will lie somewhere in between.
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Example Example (Contin…)

Assume that as an Indian investor, you decide to hold a portfolio

with 80 percent invested in the Nifty stock index and the remaining
20 percent in the MSCI Emerging Markets index. The expected
return is 9.93 percent for the Nifty Index and 18.20 percent for the
Emerging Markets index. The risk (standard deviation) is 16.21
percent for the Nifty and 33.11 percent for the Emerging Markets
index. What will be the portfolio’s expected return and risk given
that the covariance between the Nifty and the Emerging Markets
index is 0.0050?

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Covariance and Correlation Correlation of +1

s p = [w 2s 12 + (1 - w ) 2 s 22 + 2 r1, 2w (1 - w )s 1s 2 ]
m
COV AB = å[R
i =1
A ,i - E ( R A )][ RB ,i - E ( RB )] pi

r1, 2 = +1
s p = [w 2s 12 + (1 - w ) 2 s 22 + 2w (1 - w )s 1s 2 ]

r AB = s AB s A s B Þ= [(ws 1 + (1 - w )s 2 )]2 = ws 1 + (1 - w )s 2

Correlation of -1 Verification

sp = [w s 2 2
1 + (1 - w ) s - 2w (1 - w )s 1s 2
2 2
2 ] æ s2 ö æ s2 ö
s p = çç ÷÷s 1 - çç1 - ÷÷s 2
sp = (ws 1 - (1 - w )s 2 ) 2
è s1 + s 2 ø è s1 + s 2 ø
min risk s 1s 2 s 1s 2
sp = - =0
s p = ws 1 - (1 - w )s 2 = 0 s1 + s 2 s1 + s 2
Þ ws 1 + ws 2 - s 2 = 0
s2
w=
s1 + s 2

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Correlation < +1 Correlation and Portfolio Risk

s p < ws 1 + (1 - w )s 2
Correlation between
assets in the portfolio

Portfolio risk

Relationship between Risk and Return Relationship between Risk and Return

§ Given the information in the table below, compute the

expected return and standard deviation of the portfolio: 14
ρ = .2

Stock A Stock B
Expected Portfolio Return E (Rp)

Amount Invested Rs.50000 Rs.50000 ρ = −1

Expected return 10% 5% 11 ρ=1
Standard deviation 9% 7%
Correlation 0.5
ρ = .5
8

5 10 15 20 25

Standard Deviation of Portfolio sp

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Effect of Correlation on Portfolio Risk and Return Opportunity Set of Risky Assets

§ Correlation of +1: it indicates that stocks are linearly related and

hence no diversification benefits.

§ Correlation of <1: it indicates that correlation decreases,

diversification benefit increases.

§ Correlation of -1: It indicates of no risk. Its expected return should

be equal to RFR. If there is a difference, it indicates that there is a
arbitrage opportunity

Minimum-Variance and Efficient Frontier Weights of GMV Portfolio

sp = [w s 2 2
1 + (1 - w ) 2 s 22 + 2 r1, 2w (1 - w )s 1s 2 ]
E(Rp) Efficient Frontier
s = (w s + (1 - w ) 2 s 22 + 2 r1, 2w (1 - w )s 1s 2 )
2
p
2 2
1
X A B
D ds p2
= 2ws 12 - 2(1 - w )s 22 + 2 r1, 2s 1s 2 - 4 r1, 2ws 1s 2 = 0
Portfolio Expected Return

dw
Þ= ws 12 - (1 - w )s 22 + r1, 2s 1s 2 - 2 r1, 2ws 1s 2 = 0
C Minimum-Variance

Global
Frontier
Þ= w (s 12 + s 22 ) - s 22 - 2 r1, 2ws 1s 2 = - r1, 2s 1s 2
Minimum-
Variance
Portfolio (Z)
Þ= w (s 12 + s 22 - 2 r1, 2ws 1s 2 ) = s 22 - r1, 2s 1s 2
s 2 (s 2 - r1, 2s 1 )
w=
0
Portfolio Standard Deviation
σ [s 12 + s 22 - 2 r1, 2ws 1s 2 ]

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Mean-Variance Approach Black (1972) - Two fund Theorem

§ The unconstrained MVF • The asset weights of any minimum-variance portfolio are a linear
combination of the asset weights of any other two minimum-
§ The Sign-Constrained MVF
variance portfolios.
• In an unconstrained optimization, therefore, we need only
determine the weights of two minimum-variance portfolios to know
the weights of any other minimum-variance portfolio.

z = α ⋅ m + (1− α ) ⋅ y

Example Solution

• In a three-asset-class optimization, if we determine that one • 9.57 = 10.5w + 7.4(1 − w)

minimum- variance portfolio has weights (80 percent, 15
• w = 0.70 and (1 − w) = 0.30
percent, 5 percent) with an expected return of 10.5 percent and
that a second has weights (40 percent, 40 percent, 20 percent) • where w is the weight in the 10.5%-expected-return portfolio and (1
with an expected return of 7.4 percent. − w) is the weight in the 7.4%-expected-return portfolio.
• To find the weights of the minimum-variance portfolio with an • Weight of Asset Class1: 0.70(80%)+0.30(40%) = 68.00%
expected return of 9.57 percent.
• Weight of Asset Class2: 0.70(15%)+0.30(40%) = 22.50%
• Weight of Asset Class3: 0.70(5%)+0.30(20%) = 9.50%

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Corner Portfolio Corner Portfolio

• As the minimum-variance frontier passes through a corner
• Each asset class in a minimum-variance portfolio is held in either
portfolio, an asset weight either changes from zero to positive or
positive weight or zero weight.
from positive to zero.
• But an asset class with a zero weight in one minimum-variance
• The GMV portfolio, however, is included as a corner portfolio
portfolio may appear with a positive weight in another minimum-
irrespective of its asset weights.
variance portfolio at a different expected return level.
• In a sign-constrained optimization, the asset weights of any
• This observation leads to the concept of corner portfolios.
minimum-variance portfolio are a positive linear combination of
• Moving along the efficient frontier, a corner portfolio occurs
the corresponding weights in the two adjacent corner portfolios
every time a new security enters an efficient portfolio or an old
that bracket it in terms of expected return (or standard deviation of
security leaves.
return).
• Adjacent corner portfolios define a segment of the minimum-
variance frontier within which (1) portfolios hold identical assets
and (2) the rate of change of asset weights in moving from one
portfolio to another is constant.

Effect of the Number of Assets on Portfolio Diversification Takeaways

In a large portfolio the variance terms are effectively diversified away, but The risk-return trade off of a portfolio can be improved by expanding the set of
s the covariance terms are not. 1.
investable assets.

2. The minimum variance portfolio for any level of expected return depends on
Diversifiable Risk;
Nonsystematic Risk; Firm (1) the expected returns on individual assets,
Specific Risk; Unique Risk (2) the variance of individual assets,
(3) the correlations between returns on assets, and
(4) the number of assets.
Portfolio risk
Nondiversifiable risk;
Systematic Risk; Market Risk

n
Thus diversification can eliminate some, but not all of the risk of individual
securities.

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Avenues for Diversification

Diversify
with asset
classes

Buy Diversify
insurance with index
funds
Thank you
Evaluate Diversify
assets among
countries

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