FINS5513 Lecture 2B

Forming Efficient Portfolios

 Forming Efficient
Portfolios Lecture Outline
❑ Risk aversion and the risk-reward trade-off
❑ Preference and utility
➢ Utility functions
➢ Indifference curves

❑ Forming portfolios
➢ Portfolio risk, covariance and correlation
➢ Diversification

❑ Optimal portfolios
➢ Minimum Variance Frontier
➢ Efficient Frontier

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 Risk/Reward Trade-off
❑ Choosing the optimal asset when one dominates is straight forward
❑ But what about where no asset or fund dominates?
All Weather Fund Expected Return Risk Premium Risk
(rf = 5%) σ
AW Low 7.0% 2.0% 5.0%
AW Moderate 9.0% 4.0% 10.0%
AW High 13.0% 8.0% 20.0%

❑ Return increases but so does risk - so which would you choose?

❑ Each portfolio receives a utility (welfare, happiness) score to
assess the investor’s risk/return trade-off
❑ The portfolio with the highest utility is preferred
BKM 6.1
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 Risk Aversion and the
Utility Function
❑ What is a reasonable method for determining a utility score?

❑ Utility Function (Mean-variance utility function)

U = Utility
E(r) = Expected return on the asset or portfolio
A = Coefficient of risk aversion
σ2 = Variance of returns
½ = A scaling factor

U = E (r ) − 1 A 2
2

BKM 6.1
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 Estimating Your Risk
Aversion (A)
For each individual investor, the distinctive element in the utility
function is the value of A. It often depends on life cycle and
personality. So how do we estimate it?
❑ Use questionnaires (see for example BKM pg 164)
❑ Discussion with broker/financial advisor
❑ Observe individuals’ decisions when confronted with risk
❑ Observe how much people are willing to pay to avoid risk
➢ Would you take “$100 for certain” or “$200 or nothing” on the
flip of a coin?

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 Utility Score and Risk
Aversion (A)
❑ Q2.9

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 Indifference Curves
❑ Plotted in the mean-variance (E(r)-) space
❑ Connects all portfolio points with the same utility value
➢ Graphical representation of the utility function for different
levels of risk and return which offer the same utility
➢ Addresses the question “For each higher level of risk, what
additional return do I require to make me just as happy as I
was at the lower risk and return level”
❑ Indifference “Curve” because the utility function is quadratic:
➢ Risk averse investors (A>0) will be convex/upward sloping
➢ Risk seekers (A<0) will be concave/downward sloping
➢ Risk neutral (A=0) will be linear and flat
➢ We will focus on risk averse investors

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 Indifference Curves
❑ Q2.10a-c)

BKM 6.5
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 Portfolios of Two Risky
Assets: Return
❑ Portfolio returns are simply a weighted average of individual
asset classes in the portfolio. For example consider Bonds and
Equities asset classes
❑ Portfolio return: rp = wDrD + wErE
wD = Bond weight
rD = Bond return
wE = Equity weight
rE = Equity return
❑ Similarly, portfolio expected return is a weighted average of
expected returns of individual asset classes in the portfolio
E(rp) = wD E(rD) + wEE(rE)
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 Portfolios of Two Risky
Assets: Risk
❑ Calculating portfolio risk on the other hand is not simply a
weighted average as we need to take into account the covariance
between asset classes (or individual assets) within the portfolio
❑ Portfolio variance for a 2 asset class portfolio is given by:
 p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )
 D2 = Bond variance
 E2 = Equity variance
Cov ( rD , rE ) = Covariance of returns for bonds and equity
❑ For n assets (or asset classes), portfolio risk can be calculated
with a covariance matrix, consisting of:
➢ n variances
➢ (n2 – n)/2 covariances

BKM 7.2
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 Portfolios of Two Risky
Assets: Covariance
❑ Covariance measures how 2 assets move together:
➢ Sum of deviations from mean of 2 assets in different states

❑ Correlation scales the covariance to 1

❑ Covariance of returns on bonds and equity:
Cov(rD,rE) = DE = DEDE
Cov(rD,rE)
or DE =
DE
D,E = Correlation coefficient of returns
D = Standard deviation of bond returns
E = Standard deviation of equity returns
❑ Range of values for DE : - 1.0 ≤ DE ≤ +1.0
BKM 7.2
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 Two Risky Asset
Portfolio Example
❑ Q2.11a-c) – Stand alone returns and risk:

❑ See file “L2 Portfolio Return, Risk, Covariance & Correlation”

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 Diversification Benefit
❑ Combining two or more imperfectly correlated assets in one portfolio is
called diversification
➢ The risk reduction is called a diversification benefit
➢ This concept is at the heart of portfolio theory
➢ Sophisticated version of “not putting all your eggs in one basket”
➢ The lower the correlation the better (same portfolio return for lower
portfolio risk)
➢ We typically want to combine many assets with low (ideally
negative) correlations to maximise the diversification benefits
❑ Why is there a diversification benefit?
➢ Low correlated assets are unlikely to return below their respective
means at the same time (cancels out some portfolio risk)
➢ If correlations are negative, they even work as insurance for each
other (a riskless hedge may be possible)
BKM 7.2
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 Low Correlation
Diversification Benefit
❑ Q2.11d)

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 Low Correlation
Diversification Benefit
❑ The lower the correlation the better (same portfolio return for
lower portfolio risk)

❑ The amount of possible risk reduction through diversification

depends on the correlation:

➢ If  = +1.0, no risk reduction is possible

➢ If  = 0, σP will be less than the standard deviation of either

component asset

➢ If  = -1.0, a riskless hedge is possible

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 Portfolio Diversification

❑ As we add more assets to our portfolio through diversification,

the average portfolio σ drops from ~50% to ~19%
➢ However, the diversification benefit increased rapidly at first
then diminished significantly
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 So What is the Optimal
Portfolio of Risky Assets?
❑ Imagine an investment universe with risky assets characterised
by the risk-return profile as plotted below:

BKM 7.4
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 So What is the Optimal
Portfolio of Risky Assets?
❑ By combining risky assets in different proportions we can construct
portfolios with risk-return profiles which are on the red line
➢ The red line is known as the minimum variance frontier MVF – the
lowest risk portfolio at each level of return. The derivation steps are:
① Set target expected portfolio return, e.g., 10%
② Optimise portfolio weights to minimise variance at this level of return
③ Repeat at different return levels till we have plotted the frontier

In mathematical terms:
N
min (Var (rP ) = Var (  wi ri )),
wi
i =1

Subject to the constraint:

 N 
E (rP ) = E   wi ri  = 10%
 i =1 
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 So What is the Optimal
Portfolio of Risky Assets?
❑ From the mean-variance criterion, we know that any portfolio or asset
combinations below the MVF will be dominated by a portfolio on the MVF
❑ Similarly, any portfolio below the turning point of the MVF will be
dominated by one above the turning point
➢ The turning point is the portfolio (asset combination) that has the
lowest possible risk level
➢ It is known as the Global Minimum Variance Portfolio (GMVP)

Portfolio
combinations or
individual
assets which
are dominated

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 Deriving the GMVP for
a 2 Asset Portfolio
❑ The Global Minimum Variance Portfolio (GMVP) is the lowest
possible risk level (SD) for a portfolio of assets
❑ For a 2 risky asset class portfolio (eg bonds and equity), the GMVP
portfolio weights (see BKM, note 4 pg 201) are given by:

 −
2

wD = E DE
; wE = 1 − wD
 +  − 2
2 2
D E DE

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 The Efficient Frontier
❑ As each portfolio in the portion of the MVF above the GMVP dominates
each portfolio below the GMVP, we discard the portion below the GMVP
➢ This is called the Efficient Frontier
➢ It is the section of the MVF above the GMVP (to plot it we would
need to identify the GMVP first)
➢ Risk averse investors should only choose portfolios on the efficient
frontier
E(r)
Efficient assets
are those sitting
on the Efficient
Frontier (lowest
risk at each level
g mvp of return)

σ
BKM 7.4
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 Markowitz Portfolio
Optimisation Model
❑ Markowitz Portfolio Optimisation is a generalised model which
aims to optimise portfolio construction for multiple risky assets
and the risk-free asset
❑ It comprises 3 steps and we have completed the first step:
① Identify the optimal risk-return combinations from all risky
assets to produce a curve - the MVF. Identify the GMVP and
discard the MVF’s bottom part to derive the Efficient Frontier
❑ Q2.12 –
❑ See file “L2 Deriving the MVF and Efficient Frontier”
➢ See also Appendix 7A pg 232 for Excel-based application
➢ This will assist you in your iLab project

BKM 7.4
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 This lecture
❑ Risk aversion and the risk-reward trade-off
❑ Preference and utility
➢ Utility functions
➢ Indifference curves

❑ Forming portfolios
➢ Portfolio risk, covariance and correlation
➢ Diversification

❑ Optimal portfolios
➢ Minimum Variance Frontier
➢ Efficient Frontier

Lecture 3 FINS5513 23
 Next Lecture
❑ BKM Chapter 6 and 7, including end-of-chapter questions

❑ Commence Case Study III Questions

❑ Focus on understanding the Markowitz Optimisation Model and

the steps required to derive the Optimal Complete Portfolio

Lecture 2B FINS5513 24