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Minimum Variance Portfolio Analysis

The document discusses calculating the minimum variance portfolio weights when combining two risky securities (stocks and bonds) with different expected returns, standard deviations, and correlations. It provides the formulas for determining the portfolio weights that achieve minimum variance given correlations of 0.15, 0, and -1 between the two securities. The weights are calculated to be 17.53% stocks, 82.47% bonds for a correlation of 0.15 and 21.53% stocks, 78.47% bonds for a correlation of 0.

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Ettore Trucco
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65 views3 pages

Minimum Variance Portfolio Analysis

The document discusses calculating the minimum variance portfolio weights when combining two risky securities (stocks and bonds) with different expected returns, standard deviations, and correlations. It provides the formulas for determining the portfolio weights that achieve minimum variance given correlations of 0.15, 0, and -1 between the two securities. The weights are calculated to be 17.53% stocks, 82.47% bonds for a correlation of 0.15 and 21.53% stocks, 78.47% bonds for a correlation of 0.

Uploaded by

Ettore Trucco
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Determining the Minimum Variance Portfolio

Consider the two risky securities listed below.

Expected Standard
Return Deviation
Stocks (S) 15.0% 21.0%
Bonds (B) 6.0% 11.0%

1) If the correlation between these two securities is 0.15, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

The general formula for the portfolio weight that gives the minimum variance
portfolio is:

σ B2 − Cov S , B
wSMVP = =
σ S2 + σ B2 − 2Cov S , B

Here the covariance equals ρ·σS·σB = 0.15(0.21)(0.11) = 0.003465, so the formula


gives:

(0.11) 2 − 0.003465
w MVP
= = 0.1753 = 17.53%
(0.21) 2 + (0.11) 2 − 2(0.003465)
S

w BMVP = 1 − wSMVP = 1 − 0.1753 = 0.8247 = 82.47%


Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation
2) If the correlation between these two securities is 0.0, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

With a correlation of zero, the formula for the portfolio weights in the minimum
variance portfolio simplifies to:

σ B2 (0.11) 2 0.0121
wSMVP = = = = 21.53%
σ S + σ B (0.21) + (0.11)
2 2 2 2
0.0441 + 0.0121

w BMVP = 1 − wSMVP = 1 − 0.2153 = 0.7847 = 78.47%

Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation

3)
If the correlation between these two securities is -1.0, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

With a correlation of -1.0, the formula for the portfolio weights in the minimum
variance portfolio simplifies to:

σB 0.11
wSMVP = = = 0.3438 = 34.38%
σ S + σ B 0.21 + 0.11

w BMVP = 1 − wSMVP = 1 − 0.3438 = 0.6562 = 65.62%

Note that this represents a perfect hedge portfolio. If you plug these weights into
Rule 2*, you will find that the resulting standard deviation is zero.

Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation

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