SDSC3022 Tutorial III
Examples
Pan Jiming
February 25, 2025
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Overview
1 Expected Return and Volatility
2 Tangency Portfolio & Minimum Variance Portfolio
3 Arbitrage Pricing Theory
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Expected Return and Volatility
Expected Return and Volatility
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Expected Return and Volatility
Expected Return and Volatility
Class Example: Fin Core I Page 34
ex1. Suppose you want to split your money evenly among stock A, stock B
and a risk-less asset. What s the expected return and standard deviation of
the portfolio
Asset Expected Return Standard Deviation
Stock A 12% 30%
Stock B 20% 50%
Risk-less Asset 4%
corr(A,B) 0.1
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Expected Return and Volatility
Expected Return and Volatility
rep = w1 re1 + w2 re2 + · · · + wN reN
A portfolio’s expected return is the weighted average of individual expected
returns
Expected return:
(1/3)(12%) + (1/3)(20%) + (1/3)(4%) = 12%
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Expected Return and Volatility
Expected Return and Volatility
rp ) = var (w1 re1 + w2 re2 ) = w12 σ12 + w22 σ22 + 2w1 w2 σ1,2
var (e
σ1,2 = ρ1,2 σ1 σ2
2
c1 σ1,2 w1
var (e
rp ) = w1 w2
σ1,2 σ22 w2
We can ignore the risk-less asset in calculating the volatility
Portfolio variance
(1/3)2 (0.3)2 + (1/3)2 (0.5)2 + 2(1/3)(1/3)(0.1)(0.3)(0.5) =
0.04111
√
Portfolio standard deviation is then 0.0411 ≈ 20.3%
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Tangency Portfolio & Minimum Variance Portfolio
Tangency Portfolio & Minimum Variance Portfolio
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Tangency Portfolio & Minimum Variance Portfolio
Tangency Portfolio & Minimum Variance Portfolio
Σ−1 1
wM V P =
1′ Σ−1 1
Σ−1 µ
wT = ′ −1
1Σ µ
Class Example: Fin Core II Page 21
ex2. Stock A has a standard deviation of 30% and stock B has a standard
deviation of 20%. The covariance between the two stocks is 0.02. What is
the minimum variance portfolio based on the two assets?
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Tangency Portfolio & Minimum Variance Portfolio
Tangency Portfolio & Minimum Variance Portfolio
var (r̃p ) = var (w1 r̃1 + w2 r̃2 ) = w12 σ12 + w22 σ22 + 2w1 w2 σ1,2
2
var (r̃p ) = w12 σ12 + (1 − w1 ) σ22 + 2w1 (1 − w1 ) σ1,2
2 2
minw (w1 ) (0.3)2 + (1 − w1 ) (0.2)2 + 2w1 (1 − w1 ) (0.02)
wM V P = (2/9, 7/9)
0.09 0.02 −1 12.5 −6.25
Σ= . Σ =
0.02 0.04 −6.25 28.125
Σ−1 1
wM V P = 1′ Σ−1 1 = (2/9, 7/9).
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Arbitrage Pricing Theory
Arbitrage Pricing Theory
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Arbitrage Pricing Theory
Arbitrage Pricing Theory
Class Example: Fin Core II Page 71
In the markets underlying APT, there are no opportunities for making
arbitrage profits. The price is then determined or there would bu arbitrage
profits.
Multi-Factor Asset Pricing Model
Tracking Portfolio and Pure Factor Portfolio
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Arbitrage Pricing Theory
Frame Title
ex3. Suppose we have a two-factor model
Design a portfolio to track an asset with factor loadings β1 = 2, β2 = 1
We have three assets to use to construct the tracking portfolio
(1) r1 = 0.03 + F1 − 4F2 + ϵ1
(2) r2 = 0.05 + 3F1 + 2F2 + ϵ2
(3) r3 = 0.10 + 1.5F1 + ϵ3
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Arbitrage Pricing Theory
Frame Title
The weights sum to one
w1 + w2 + w3 = 1
The loading on the first factor is 2
w1 + 3w2 + 1.5w3 = 2
The loading on the second factor is 1
−4w1 + 2w2 + 0w3 = 1
The solution is
w1 = −0.1, w2 = 0.3, w3 = 0.8
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