CHAPTER 2 - EFFICIENT PORTFOLIOS

INVESTMENT
MANAGEMENT
TUTORING

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FIRST QUIZ
Time has changed:
October 7th at 8h00 (morning)
Enter at 8h00: Sign !!
Start at 8h10
30 min
Open-book

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TODAY:
1. Matrices
2. Return and Risk of a portfolio
3. Variance Covariance Matrix
4. Efficient Portfolios
5. Optimal Portfolio
6. Utility function
7. Investor’s choice

© Investment Management, EHL

THE MATRIX 101

0 * 1 + 1 * 6 + 3 * 0 (cf. circled lines)

A
(2x3) = ( 013
320 ) 12
C
12
=> (2x2) = [Cij] = AB = ( 013
320 ) 60 = ( 6 3
15 6 )
B 01
(3x2) = 60
01

Size of the result = #rowsA x #columnsB

Size of a matrix = #rows x #columns

!! You need: #columnsA = #rowsB

RETURN OF A PORTFOLIO
n
TRANSPOSE is your BFF to transform a
Return = Σ weight i * return i column into a row and vice versa.
i=1
MMULT() is used to calculate the result
of your matrice (Don't forget to use
Return = w T * returns line column CTRL + SHIFT + ENTER)

Return = SUMPRODUCT(Weights; Returns) = MMULT(Weights; Returns)

RISK OF A PORTFOLIO
n n
Variance = Σ Σ weighti * weightj * σij
i=1 j=1

where w is the vector of portfolio

T
Variance = w * Ω * w weights and Ω the VCV matrix

Volatility = SQRT(MMULT(MMULT(Weights;VCV); Weights))

line column
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VARIANCE COVARIANCE MATRIX (VCV)
It represents the covariance between the different assets

COVARIANCES

VARIANCES

3 WAYS TO CALCULATE:
1. Covariance = VolatilityA * VolatilityB * CorrelationA/B

2. COVARIANCE.S() * #periods

3. Covariance (Data Analysis) * #periods * n/(n-1) n being the number of observations

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EFFICIENT PORTFOLIOS
Minimum Variance Frontier: lowest volatility for a certain expected return
Global Minimum Variance PF : lowest volatility
Efficient Frontier: best return for a certain volatility level

With riskless asset - Efficient frontier = Capital Market line

Optimal Portfolio (MSR): maximizes the Sharpe Ratio (best risk-return tradeoff)
Mean Variance Efficient PF : combination of riskless asset and MSR PF

Efficient Frontier
MSR
s et
s as
kles
ris
itha
ierw e
t n
GMV F ron et Li GMV
ie nt ark
ic l M
Eff pita
a
=C
Minimum Variance Frontier Rf

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OPTIMAL PORTFOLIO
> the portfolio that maximizes the sharpe ratio

Equation:
Expected Return = Rf + Sharpe Ratio MSR* Volatility
where Sharpe Ratio MSR = Return MSR - Rf
VolatilityMSR
If you have a target volatility or return:

Volatility Target
Weight =
MSR VolatilityMSR

Return Target - Rf
Weight =
MSR
ReturnMSR - Rf

Weight Actually Allocated to an asset

= Weight allocated to the asset in the optimal PF * Weight allocated to the optimal PF

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 UTILITY FUNCTION
You maximize the Utility
Function in the solver in
Calculates the allocation to different assets order to find the best weight
based on the risk tolerance of the investor allocation

“Measures the satisfaction

that an investor can obtain
from a portfolio’s
Mean Variance Utility Function = ReturnPF - 0.5 * Degree of risk aversion (𝛾) * VariancePF performance”

Degree of risk aversion (𝛾) = 1

Risk tolerance level t

The higher your risk tolerance level, the more risk you are ready to take.

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INVESTOR'S CHOICE
To remember:
Mean-Variance Optimal (MVO) Portfolio for an INVESTOR → maximize Utility function
MSR with riskless asset

r
Love
t = 1000; 𝛾 = 0.001 Ris
k

MSR
Average Investor
GMV
Risk averse (t = 0; 𝛾 = ∞)

verse
ka
Ris
GMV

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MEME OF THE DAY

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