Portfolio Optimization Practice Sheet
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heyaditya0101Portfolio Optimization Practice Sheet
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heyaditya0101Common questions
Powered by AIWithout short sales, portfolio weights are non-negative, limiting the combination effects of component risks. As a result, the portfolio variance, considering diversification and covariance effects, cannot exceed the maximum variance of the individual stocks given no negative leverage can reduce portfolio benefits achieved through diversification .
The CML is derived from the Efficient Frontier portfolio mixed with the risk-free asset. Calculate using wM = C^-1(m - µrf e) / (e^T C^-1(m - µrf e)), where C is the covariance matrix, µrf is the risk-free return, and m the expected returns vector. The CML equation is linearly expressed with slope μM−μrf/σM, connecting risk-free return and tangency portfolio returns .
To find the expected returns of the stocks under given market scenarios, calculate the weighted average of returns for each scenario. For stock 1 with return k1: Expected return = (0.2 * -10) + (0.5 * 0) + (0.3 * 20) = 0%. For stock 2 with return k2: Expected return = (0.2 * -30) + (0.5 * 20) + (0.3 * 15) = 8.5%. Thus, the expected returns are 0% and 8.5% respectively .
For a minimum variance portfolio, the weights are derived based on the inverse of the variance-covariance matrix. Formulated as w = C^-1 * e / (e^T * C^-1 * e), where C represents the covariance matrix, and e is a unit vector. Given the securities' covariance, weights calculated are (0.314, 0.148, 0.538) leading to minimized portfolio variance .
Diversification is advisable as it enables risk minimization through non-perfect correlation between assets. Optimal weights balance risk-adjusted returns, reducing a portfolio's overall volatility below individual asset volatilities. A portfolio combination, especially if assets hold different return expectations and standard deviations, lowers unsystematic risk through offsetting moves .
The expected return of the portfolio is a weighted average of the expected returns of the two stocks. Given the stocks' expected returns are 0% for stock 1 and 8.5% for stock 2, the portfolio's expected return = (0.6 * 0) + (0.4 * 8.5) = 3.4% .
When investment in stock 1 increases from 40% to 80%, the portfolio's risk increases. Initially, at 40% stock 1, the portfolio variance is 0.000736. When increased to 80% in stock 1, portfolio variance increases to 0.009824, reflecting increased risk due to greater exposure to the higher variance stock .
Expected return according to the SML is calculated by the equation μasset = μrf + β(μM − μrf). For an asset with β = 2, substituting μrf = 0.03, and μM = 0.09 gives μasset = 0.03 + 2 * (0.09 - 0.03) = 0.15 or 15% .
Asset correlation critically impacts risk reduction through diversification. Zero or negative correlations advantageous as they offer greater risk mitigation due to opposing asset movements. The minimum standard deviation occurs with optimal weights adjusted by the correlation degree. E.g., at ρ = 1, weights reflect absolute difference between asset volatilities, while at ρ = -1, assets offer maximum diversification benefits .
An investor should adjust assets proportionally between risk-free and risky assets using the target expected return equation. If an expected return is above risk-free, the investor borrows at the risk-free rate to leverage risky portfolio exposure. E.g., an investor targeting a 39% return should leverage Rs 1000 by borrowing to invest Rs 2000 entirely in the market portfolio .