Financial Economics

Chapter 2: Portfolio Theory

Grau en Economia i Empresa
UPF

J. Gil-Bazo, D. Kuvshinov, A. Marcet

April 24, 2023

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Outline

1 Risk and Return in Financial Markets

2 Portfolio Return and Risk

3 Optimal Portfolios

References: Essentials of Investments, Chapters 5 and 6

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Roadmap

1 Risk and Return in Financial Markets

2 The Risk of a Portfolio

3 Building Efficient Portfolios

J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 3 / 43

1. Return and Risk in Financial Markets

Main assumption: investors care about

1 Return on their investment: The higher, the better

2 Risk of their portfolio: The lower, the better

We need to define the return on an investment:

Final Price + Dividend or Interest − Initial Price
R=
Initial Price

Example: You buy a share for 100 euros. You sell it a year later for
110 and receive a dividend of 4 euros. What is the return on your
investment?

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Worked Example

You buy a share for 100 euros. You sell it a year later for 110 and receive
a dividend of 4 euros.
What is the return on your investment?

Final Price + Dividend − Initial Price 110 + 4 − 100

R= = = 14%
Initial Price 100

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Real Rate of Return

We care about how much we can buy with the proceeds of the
investment

For this, we need to measure the “real return” net of inflation

1 + Nominal Return
Real Return = −1
1 + Inflation

Example: Your nominal return is 14%. Inflation is 5%. What is the real
return on your investment?

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Real Rate of Return

We care about how much we can buy with the proceeds of the
investment

For this, we need to measure the “real return” net of inflation

1 + Nominal Return
Real Return = −1
1 + Inflation

Example: Your nominal return is 14%. Inflation is 5%. What is the real
return on your investment?
1 + 0.14
Real Return = − 1 = 8.6%
1 + 0.05

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Risk
Investing in assets with risk implies that we do not know a priori the return on
investment. Example:

We can summarize this information in two fundamental quantities:

Expected return:
P
E(R) = p(s)R(s)
s

Variance or standard deviation:

2
√
Var (R) = σ 2 =
P
p(s) (R(s) − E(R)) SD(R) = σ = σ2
s

Task: Try to calculate E(R) and SD(R) for the above asset
J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 7 / 43
Risk: Example

Expected return:
P
E(R) = p(s)R(s)
s

Variance and standard deviation:

2
√
Var (R) = σ 2 =
P
p(s) (R(s) − E(R)) SD(R) = σ = σ2
s

This investment offers a return on average of 10% but with a standard deviation
of 18.6% with respect to that 10%

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Estimating R and Var (R)
In practice, we do not know the distribution of returns. But we can
estimate it from historical returns data
X X
R= R(t)/T Var (R) = (R(t) − R)2 /T
t t

Real returns and risk by asset class, 17 countries, 1870–2015:

Mean real return, % Standard deviation, %

Equity Equity

Bonds Bonds

Bills Bills

0 2 4 6 8 0 5 10 15 20

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Historical stock returns by country: above average

Table: Historical stock returns by country

Country Real equity return Standard deviation
Japan 9.7 26.4
Finland 9.3 30.1
Germany 8.5 28.0
Australia 8.4 15.7
USA 8.4 18.7
Sweden 7.8 19.8
Denmark 7.4 16.4
Canada 7.1 16.4
Netherlands 7.1 21.3
Average 7.0 21.4
World Portfolio 7.0 13.3
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Historical stock returns by country: below average

Table: Historical stock returns by country

Country Real equity return Standard deviation
Average 7.0 21.4
UK 6.9 17.9
Switzerland 6.5 18.1
Italy 6.1 26.2
Belgium 5.9 22.0
Spain 5.6 20.8
Norway 5.6 19.4
Portugal 5.2 24.3
France 3.3 22.1

World Portfolio 7.0 13.3

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Roadmap

1 Risk and Return in Financial Markets

2 The Risk of a Portfolio

3 Building Efficient Portfolios

J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 12 / 43

Return on a Portfolio
For a portfolio C of J assets, the rate of return is
XJ
RC = ωj Rj
j=1

ωj : proportion of portfolio invested in asset j

XJ
ωj = 1
j=1

Example: Portfolio of 1 million euros invested as follows:

200,000 INTEL (INTC)
300,000 NETFLIX (NFLX)
500,000 DELTA AIR (DAL)
ωINTC = 200, 000/1, 000, 000 = 0.2; ωNFLX = 0.3 ωDAL = 0.5

J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 13 / 43

Expected Return on a Portfolio

General case:
 
J
X J
X
E (RC ) = E  ωj R j  = ωj E (Rj )
j=1 j=1

For the case where J = 2:

E (RC ) = ω1 E (R1 ) + ω2 E (R2 ) = ω1 E (R1 ) + (1 − ω1 )E (R2 )

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Covariance and correlation
Portfolio risk depends not only how volatile each return is (variance), but
also on how much returns co-move (co-variance)

Covariance is a measure of common variation between the returns of two

assets

If it is positive (negative), the returns tend to move in the same (opposite)

direction
X
Cov (Ri , Rj ) = σij = p(s)(Ri − E[Ri ])(Rj − E[Rj ])
s

Correlation is a “relative” form of measuring covariance, which is unit free:

σij
Corr (Ri , Rj ) = ρij =
σi σj
− 1 ≤ ρij ≤ 1

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Risk of a Portfolio

The variance of portfolio C is the variance of its return

For J = 2:
X 2
σC2 = p(s) (RC ,s − E(RC ))
s
X 2
= p(s) (ω1 (R1,s − E(R1 )) + ω2 (R2,s − E(R2 )))
s

= ω12 σ12 + ω22 σ22 + 2ω1 ω2 σ12

Note: the standard deviation of the portfolio, σC , is generally not equal to

the average SD of A and B, ω1 σ1 + ω2 σ2 .
A similar logic extends to more assets. For J = 3:
σC2 = ω12 σ12 + ω22 σ22 + ω32 σ32 + 2ω1 ω2 σ12 + 2ω1 ω3 σ13 + 2ω2 ω3 σ23

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Diversification

Example 1: Consider two assets, A and B, whose returns are distributed

according to the following table. Consider the portfolio D consisting of 50% of
each asset:

E(RA ) = 4; E(RB ) = 5; E(RC ) = 4.5

Var (RA ) = 5.2; Var (RB ) = 5.2 Var (RD ) = 5.2
SD(RA ) = 2.28; SD(RB ) = 2.28 SD(RD ) = 2.28

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Example 1: Graph

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Diversification: Example 2

Now imagine a slightly different distribution:

Here,
E(RA ) = 4; E(RB ) = 5; E(RC ) = 4.5
Var (RA ) = 5.2; Var (RB ) = 5.2 Var (RD ) = 3.1
SD(RA ) = 2.28; SD(RB ) = 2.28 SD(RD ) = 1.76

J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 19 / 43

Example 2: Graph

A and B still have the same expected return and risk

But the variance of the portfolio has decreased! Why?

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RA (x-axis) vs RB (y-axis)

Example 1: increases and decreases with respect to the mean are identical
for both assets
Example 2: above-mean returns on one assets sometimes compensated by
below-mean returns on the other asset
This “compensation” reduces the risk of the portfolio by combining both
assets. It is called “diversification”
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How much do stock returns co-move in reality?

Correlation = 57.68% Correlation = 80.86%

Returns of individual stocks co-move, but not perfectly

Can reduce risk of portfolios by combining assets: DIVERSIFICATION
Can diversify further through other countries / asset classes
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How much risk can we diversify in practice?

In general, as we increase the number of assets in a portfolio, total portfolio

risk tends to decrease due to diversification.
However, portfolio risk does not disappear completely
Mean covariance of returns across assets is positive
⇒ Cannot get rid of market-wide movements
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Two sources of risk
1 Idiosyncratic risk (firm-specific risk, unique risk) can be eliminated
through diversification. Represents firm-specific uncertainty factors.
2 Systematic risk (market risk): cannot be eliminated through
diversification. Represents uncertainty factors common to all firms.

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Roadmap

1 Risk and Return in Financial Markets

2 The Risk of a Portfolio

3 Building Efficient Portfolios

J. Gil-Bazo, D. Kuvshinov, A. Marcet Chapter 2 April 24, 2023 25 / 43

3.1 A risky and a risk-free asset
Suppose we construct a portfolio C of risky asset, A, and a risk-free
asset

Rates of return: RA (risky), r (safe)

Variance σA2 (risky), 0 (safe)

ω: % of portfolio invested in A (1 − ω invested in risk-free)

ω > 1: borrowing at the rate r
ω < 0: short selling the risky asset

Portfolio return and risk:

RC = ωRA + (1 − ω)r
EC = E(RC ) = ωE(RA ) + (1 − ω)r
σC2 ≡ Var (RC ) = ω 2 Var (RA ) = ω 2 σA2

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A risky and a risk-free asset: return vs risk
Rearranging, we get
EC = r + ω(EA − r ) (1)
σC = |ωσA | (2)
Example: Let A be the S & P index and r the Treasury bills:
EA ≈ R̄A = 0.13
σA ≈ σ̄A = 0.203
r = 0.038
This table shows the characteristics of some portfolios:

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The trade-off between risk and return

From (2), we get

σC
ω=
σA
Substituting in (1) we get

σC
EC = r + (EA − r )
σA

EA − r
EC = r + σC (3)
σA

The risk premium per unit of risk is

EA − r
SA =
σA

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A risky and a risk-free asset: return vs risk
“S” is known as the Sharpe Ratio

S is the reward (in terms of expected RETURN) per unit of risk (as
measured by volatility)

In this example: SA = 0.45. Graphically:

When we have a
correlation <1, then our
risk curve will be
hyperbolic

To the right of A we have “leveraged” portfolios ω > 1

Between r and A we have inner wallets 0 < ω < 1

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3.2. Two risky assets; no risk-free asset

The return of a portfolio C composed of risky assets A and B is

RC = ωA RA + (1 − ωA )RB

Thus

EC = E(RC ) = ωA EA + (1 − ωA )EB
σC2 = Var (RC ) = ωA2 σA2 + (1 − ωA )2 σB2 + 2ωA (1 − ωA ) Cov (RA , RB )
| {z }
σA σB ρAB

Portfolio return EC is a weighted average of EA and EB

If we hold positive amounts of both stocks (ie. 0 < ωA < 1) portfolio

standard deviation σC is less than the weighted average of σA and σB
(diversification)

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Risk vs expected return in two-asset portfolios

Graphically, curve representing the possible portfolio mean-standard

deviation pairs is obtained by combining two active forms a hyperbola

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Effect of correlation

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Allowing for short sales

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3.3 Many (J) risky assets

Example, J=3:

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More 3-asset portfolios

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Investor preferences
An investor’s attitude towards risk can be shown with “indifference curves”
in the return/volatility space
These are combinations or risk & return which leave the investor indifferent
For example, these would be the indifference curves of an investor with low
risk aversion. Why?

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The effect of risk aversion

These would be the indifference curves of an investor with high risk

aversion. Why?

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Portfolio choice
What portfolio would a risk averse investor choose?

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Portfolio choice and the efficient frontier
The portfolio will be chosen in the mean-variance frontier: portfolios with
lowest risk among all of equal expected returns

MVP is the overall minimum variance portfolio

The investor will choose that portfolio where their indifference curves are
tangent to the boundary (Frontier)
The upper part of the frontier is called EFFICIENT
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3.4 Multiple (J) risky assets and one risk-free asset
Consider portfolios X and Y:

Are the portfolios in the graph optimal?

In the presence of a risk-free asset, these portfolios are not necessarily
efficient
Reason: we could combine the risk-free asset with a portfolio of risky assets
to construct a portfolio with higher mean E and lower variance σ than X
and Y
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Combining risky portfolios with the safe asset

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Tangency portfolio and Capital allocation line
All efficient portfolios will combine the risk-free asset with a single portfolio
of risky assets, “T”
The representation of efficient portfolios is known as the Capital
Allocation Line

T is the “tangency portfolio”

Maximise Sharpe ratio ST = (ET − r )/σT
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Choosing the optimal portfolio
The equation of the CAL is:
ET − r
EC = r + σC = r + ST σC
σT

Compare that with the first case (1 RFA and 1 risky asset)

Portfolio choice problem in two steps:

1 Choose risky portfolio T to maximise return per unit of risk
2 Choose ω according to your risk aversion
Fundamental result:
All investors will choose to combine the risk-free asset with the same
portfolio of risky assets: the tangency portfolio T
The weight of portfolio T in the investor’s optimal portfolio will (inversely)
depend on the investor’s risk aversion
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