4.

Portfolio theory

Suppose there are N risky assets, whose rates of returns are given
by the random variables R1, , RN , where
Sn(1) Sn(0)
Rn = , n = 1, 2, , N.
Sn(0)
Let w = (w1 wN )T , wn denotes the proportion of wealth invested
N
X
in asset i, with wn = 1. The rate of return of the portfolio is
n=1
N
X
RP = wnRn.
n=1
Assumptions

1. There does not exist any asset that is a combination of other

assets in the portfolio.
2. = (R1 R2 RN ) and 1 = (1 1 1) are linearly indepen-
dent.
The first two moments of RP are
N
X N
X
P = E[RP ] = E[wnRn] = wnn, where n = Rn,
n=1 n=1
and
X N
N X N X
X N
2 = var(R ) =
P wiwj cov(Ri, Rj ) = wiij wj .
P
i=1 j=1 i=1 j=1
Let denote the covariance matrix so that
2 = w T w .
P

Remark

2 . In mean-variance
The portfolio risk of return is quantified by P
analysis, only the first two moments are considered in the port-
folio model. Investment theory prior to Markowitz considered the
maximization of P but without P .
Two-asset portfolio

Consider two assets with known means R1 and R2, variances 12 and
22, of the expected rates of returns R1 and R2, together with the
correlation coefficient .

Let 1 and be the weights of assets 1 and 2 in this two-asset

portfolio.

Portfolio mean: RP = (1 )R1 + R2, 0 1

2 = (1 )2 2 + 2(1 ) + 2 2.
Portfolio variance: P 1 1 2 2
We represent the two assets in a mean-standard deviation diagram

(recall: standard deviation = variance)

As varies, (P , RP ) traces out a conic curve in the R plane.

With = 1, it is possible to have = 0 for some suitable choice
of weight.
In particular, when = 1,
q
P (; = 1) = (1 )212 + 2(1 )12 + 222
= (1 )1 + 2.
This is the straight line joining P1(1, R1) and P2(2, R2).

When = 1, we have
q
P (; = 1) = [(1 )1 2]2 = |(1 )1 2|.
When is small (close to zero), the corresponding point is close to
P1(1, R1). The line AP1 corresponds to

P (; = 1) = (1 )1 2.
1
The point A corresponds to = .
1 + 2

1
The quantity (1 )1 2 remains positive until = .
1 + 2
1
When > , the locus traces out the upper line AP2.
1 + 2
Suppose 1 < < 1, the minimum variance point on the curve that
represents various portfolio combinations is determined by
2
P
= 2(1 )12 + 222 + 2(1 2)12 = 0


set
giving
12 12
= 2 .
1 212 + 22
Mathematical formulation of Markowitzs mean-variance analysis
N N
1 XX
minimize wi wj ij
2 i=1 j=1
N
X N
X
subject to wi Ri = P and wi = 1.
i=1 i=1

Solution

We form the Lagrangian

N X
N
N
! N !
1 X X X
L= wi wj ij 1 wi 1 2 w i R i P
2 i=1 j=1 i=1 i=1

where 1 and 2 are Lagrangian multipliers.

We then differentiate L with respect to wi and set the derivative to zero.

N
X
L
= ij wj 1 2 Ri = 0, i = 1, 2, , N. (1)
wi j=1
N
X
L
= wi 1 = 0; (2)
1 i=1
XN
L
= wi Ri P = 0. (3)
2 i=1
From Eq. (1), the portfolio weight admits solution of the form

w = 1(11 + 2) (4)
where 1 = (1 1 1)T and = (R1 R2 RN )T .

To determine 1 and 2, we apply the two constraints

1 =1T 1w = 11T 11 + 21T 1. (5)

P = T 1w = 1T 11 + 2T 1. (6)
T T
Write a = 1 11, b = 1 1 and c = T 1, we have

1 = 1a + 2b and P = 1b + 2c.
c bP aP b
Solving for 1 and 2 : 1 = and 2 = , where

2
= ac b .

Note that 1 and 2 have dependence on P , which is the target

mean prescribed in the variance minimization problem.
Assume 6= h1, and 1 exists. Since is positive definite, so
a > 0, c > 0. By virtue of the Cauchy-Schwarz inequality, > 0.
The minimum portfolio variance for a given value of P is given by
T T
2
P = w w
= w (11
1 + 21)
a2 P 2bP +c
= 1 + 2P = .

The set of minimum variance portfolios is represented by a parabolic
curve in the P2 plane. The parabolic curve is generated by
P
varying the value of the parameter P .
 dP
How about the asymptotic values of lim ?
dP

dP dP dP2
= 2 d
dP dP P

= 2P
2a
P q 2b

= a2P 2bP + c
aP b
so that
s
dP
lim = .
dP a
Summary
c bP aP b
Given P , we obtain 1 = and 2 = , and the optimal weight

w = 1(1 1 + 2).
To find the global minimum variance portfolio, we set
dP2 2aP 2b
= =0
dP
so that P = b/a and P2 = 1/a. Also, 1 = 1/a and 2 = 0. We obtain

wg =
1 1= 1 .
1
T
a
1 11
Another portfolio that corresponds to 1 = 0 is obtained when P is taken to be
c
. The value of the other Lagrangian multiplier is given by
b

a cb b 1
2 = = .
b
The optimal weight of this particular portfolio is
1 1
wd = = T
.
b
1 1
c 2 c
a 2b +c c
Also, d2 = b b
= .
b2
Feasible set

Given N risky assets, we form various portfolios from these N assets.

We plot the point (P , RP ) representing the portfolios in the R
diagram. The collection of these points constitutes the feasible set
or feasible region.
Consider a 3-asset portfolio, the various combinations of assets 2
and 3 sweep out a curve between them (the particular curve taken
depends on the correlation coefficient 12).

A combination of assets 2 and 3 (labelled 4) can be combined with

asset 1 to form a curve joining 1 and 4. As 4 moves between 2 and
3, the curve joining 1 and 4 traces out a solid region.
Properties of feasible regions

1. If there are at least 3 risky assets (not perfectly correlated

and with different means), then the feasible set is a solid two-
dimensional region.

2. The feasible region is convex to the left. That is, given any two
points in the region, the straight line connecting them does not
cross the left boundary of the feasible region.
The left boundary of a feasible region is called the minimum variance
set. The most left point on the minimum variance set is called the
minimum variance point. The portfolios in the minimum variance
set are called frontier funds.

For a given level of risk, only those portfolios on the upper half
of the efficient frontier are desired by investors. They are called
efficient funds.

A portfolio w is said to be mean-variance efficient if there exists

no portfolio w with P P and P2 2 . That is, you cannot find
P
a portfolio that has a higher return and lower risk than those for an
efficient portfolio.
Two-fund theorem

Two frontier funds (portfolios) can be established so that any fron-

tier portfolio can be duplicated, in terms of mean and variance, as
a combination of these two. In other words, all investors seeking
frontier portfolios need only invest in combinations of these two
funds.

Remark

Any convex combination (that is, weights are non-negative) of ef-

ficient portfolios is an efficient portfolio. Let i 0 be the weight
h i b
i I
of Fund i whose rate of return is Rf . Since E Rf for all i, we
a
have
n
X h i Xn
i b b
iE Rf i = .
i=1 i=1 a a
Proof

Let w1 = (w11 wn
1 ), 1, 1 and w 2 = (w 2 w 2)T , 2, 2 are two
1 2 1 n
known solutions to the minimum variance formulation with expected
rates of return 1 2
P and P , respectively.

n
X
ij wj 1 2Ri = 0, i = 1, 2, , n (1)
j=1
Xn
wiri = P (2)
i=1
n
X
wi = 1. (3)
i=1

It suffices to show that w1 + (1 )w2 is a solution corresponds

to the expected rate of return 1
P + (1 )2.
P
1. w1 + (1 )w2 is a legitimate portfolio with weights that sum
to one.

2. Eq. (1) is satisfied by w1 + (1 )w2 since the system of

equations is linear.

3. Note that
n h
X i
wi1 + (1 )wi2 Ri
i=1
Xn n
X
= wi1Ri + (1 ) wi2Ri
i=1 i=1
= 1
P + (1 ) 2.
P
Proposition

Any minimum variance portfolio with target mean P can be uniquely

decomposed into the sum of two portfolios

wP = Awg + (1 A)wd
c bP
where A = 1a = a.

Proof

For a minimum-variance portfolio whose solution of the Lagrangian

multipliers are 1 and 2, the optimal weight is

wP = 1(11 + 1) = 1(awg ) + 2(bwd).

Observe that the sum of weights is
c P b P a b ac b2
1a + 2b = a +b = = 1.

We set 1a = A and 2b = 1 A.
Indeed, any two minimum-variance portfolios can be used to substi-
tute for wg and wd. Suppose

wu = (1 u)wg + uwd
wv = (1 v)wg + v wd
we then solve for wg and wd in terms of wu and wv . Then

wP = 1awg + (1 1a)wd
1a + v 1 1 u 1a
= wu + wv ,
vu vu
where sum of coefficients = 1.
Example

Mean, variances, and covariances of the rates of return of 5 risky

assets are listed:

Security covariance Ri
1 2.30 0.93 0.62 0.74 0.23 15.1
2 0.93 1.40 0.22 0.56 0.26 12.5
3 0.62 0.22 1.80 0.78 0.27 14.7
4 0.74 0.56 0.78 3.40 0.56 9.02
5 0.23 0.26 0.27 0.56 2.60 17.68
Solution procedure to find the two funds in the minimum variance
set:

1. Set 1 = 1 and 2 = 0; solve the system of equations

5
X
ij vj1 = 1, i = 1, 2, , 5.
j=1

Normalize vk1s so that they sum to one

vi1
wi1 = Pn 1
.
j=1 vj
1
After normalization, this gives the solution to wg , where 1 =
a
and 2 = 0.
2. Set 1 = 0 and 2 = 1; solve the system of equations:
5
X
ij vj2 = Ri, i = 1, 2, , 5.
j=1

Normalize vi2s to obtain wi2.

After normalization, this gives the solution to wd, where 1 = 0

1
and 2 = .
b
The above procedure avoids the computation of a = 1T 11
T
and b = 1 1.
 security v1 v2 w1 w2
1 0.141 3.652 0.088 0.158
2 0.401 3.583 0.251 0.155
3 0.452 7.284 0.282 0.314
4 0.166 0.874 0.104 0.038
5 0.440 7.706 0.275 0.334
mean 14.413 15.202
variance 0.625 0.659
standard deviation 0.791 0.812

* Note that w1 corresponds to the global minimum variance point.

We know that g = b/a; how about d?

1 c
T
d = wd = T = .
b b

c b
Difference in expected returns = d g = = > 0.
b a ab

c 1
Also, difference in variances = d2 g2 = 2 = 2 > 0.
b a ab
How about the covariance of portfolio returns for any two minimum
variance portfolios?

Write
u = w T R and Rv = w T R
RP u P v
where R = (R1 RN )T . Recall that

11 1
gd = cov R, R
a b
T !
=
1 1
1
a b

=
11 = 1 since b = 11.
ab a
cov(RPu , Rv ) = (1 u)(1 v) 2 + uv 2 + [u(1 v) + v(1 u)]
P g d gd
(1 u)(1 v) uvc u + v 2uv
= + 2 +
a b a
1 uv
= + 2
.
a ab
In particular,

cov(Rg , RP ) = wTg wP =
1 1wP 1
= = var(Rg )
a a
for any portfolio wP .

For any Portfolio u, we can find another Portfolio v such that these
two portfolios are uncorrelated. This can be done by setting
1 uv
+ 2
= 0.
a ab
Inclusion of a riskfree asset

Consider a portfolio with weight for a risk free asset and 1 for
a risky asset. The mean of the portfolio is

RP = Rf + (1 )Rj (note that Rf = Rf ).

The covariance f j between the risk free asset and any risky asset
is zero since
E[(Rj Rj ) (Rf Rf ) = 0.
| {z }
zero
2 is
Therefore, the variance of portfolio P
2 = 2 2 +(1 )2 2 + 2(1 )
P f j fj
|{z} |{z}
zero zero
so that P = |1 |j .
The points representing (P , RP ) for varying values of lie on a
straight line joining (0, Rf ) and (j , Rj ).

If borrowing of risk free asset is allowed, then can be negative. In

this case, the line extends beyond the right side of (j , Rj ) (possibly
up to infinity).
Consider a portfolio with N risky assets originally, what is the impact
of the inclusion of a risk free asset on the feasible region?

Lending and borrowing of risk free asset is allowed

For each original portfolio formed using the N risky assets, the new
combinations with the inclusion of the risk free asset trace out the
infinite straight line originating from the risk free point and passing
through the point representing the original portfolio.

The totality of these lines forms an infinite triangular feasible region

bounded by the two tangent lines through the risk free point to the
original feasible region.
No shorting of risk free asset

The line originating from the risk free point cannot be extended
beyond points in the original feasible region (otherwise entail bor-
rowing of the risk free asset). The new feasible region has straight
line front edges.
The new efficient set is the single straight line on the top of the
new triangular feasible region. This tangent line touches the original
feasible region at a point F , where F lies on the efficient frontier of
the original feasible set.

b
Here, Rf < .
a
One fund theorem

Any efficient portfolio (any point on the upper tangent line) can be
expressed as a combination of the risk free asset and the portfolio
(or fund) represented by F .

There is a single fund F of risky assets such that any efficient

portfolio can be constructed as a combination of the fund F and
the risk free asset.

Remark Under the assumptions that

every investor is a mean-variance optimizer

they all agree on the probabilistic structure of assets

unique risk free asset

Then everyone will purchase a single fund, market portfolio.

New Lagrangian formulation
2
P 1
minimize = wT w
2 2

subject to wT + (1 wT 1)r = P .
1 T
Define L = w w + [P r ( r1)T w]
2
N
X
L
= ij wj ( r1) = 0, i = 1, 2, , N (1)
wi j=1
L
=0 giving ( r1)T w = P r. (2)

Solving (1): w = 1( r1). Substituting into (2)

P r = ( r1)T 1( r1) = (c 2rb + r2a).

Lastly, the relation between P and P is given by the following pair
of half lines
T T T
2 = w w = (w r w
P 1)
= (P r) = (P r)2/(c 2rb + r2a).
With the inclusion of the riskfree asset, the set of minimum variance
portfolios are represented by portfolios on the two half lines
q
Lup : P r = P ar2 2br + c (1a)
q
Llow : P r = P ar2 2br + c. (1b)

Recall that ar2 2br + c > 0 for all values of r since = ac b2 > 0.
The minimum variance portfolios without the riskfree asset lie on
the hyperbola
2 a2
P 2bP + c .
P =

 b
When r < g = , the upper half line is a tangent to the hyperbola.
a
The tangency portfolio is the tangent point to the efficient frontier
(upper part of the hyperbolic curve) through the point (0, r).
The tangency portfolio M is represented by the point (P,M , MP ),
and the solution to P,M and M
P are obtained by solving simultane-
ously

2 a2
P 2bP + c
P =

q
P = r + P c 2rb + r2a.
Once P is obtained, we solve for and w from
P r = 1( r 1).
= and w
c 2rb + r2a
The tangency portfolio M is shown to be
1( r1) c br c 2rb + r2a
wM = , M
P = and 2
P,M = 2
.
b ar b ar (b ar)
 b
When r < , it can be shown that M
P > r. Note that
a

b b c br b b ar
M
P r
=
a a b ar a a
c br b2 br
= 2+
a a a
ca b2
= 2
= 2
> 0,
a a
M b b
so we deduce that P > > r, where g = . Indeed, we can
a a
b
deduce (P,M , M
P ) does not lie on the upper half line if r .
a
 b
When r < , we have the following properties on the minimum
a
variance portfolios.

1. Efficient portfolios

Any portfolio on the upper half line

q
P = r + P ar2 2br + c
within the segment F M joining the two points (0, r) and M
involves long holding of the market portfolio and riskfree asset,
while those outside F M involves short selling of the riskfree asset
and long holding of the market portfolio.
2. Any portfolio on the lower half line
q
P = r P ar2 2br + c
involves short selling of the market portfolio and investing the
proceeds in the riskfree asset. This represents non-optimal in-
vestment strategy since the investor faces risk but gains no extra
expected return above r.
What happens when r = b/a? The half lines become
s s

b b2
P = r P c 2 b = r P ,
a a a
which correspond to the asymptotes of the feasible region with risky
assets only.

b
When r = , M
P does not exist. Recall that
a
w = 1( r1) so that
T
1 w = (11 r111) = (b ra).
T
When r = b/a, 1 w = 0 as is finite. Any minimum variance port-
folio involves investing everything in the riskfree asset and holding
a portfolio of risky assets whose weights sum to zero.
 b
When r > , only the lower half line touches the feasible region with
a
risky assets only.

Any portfolio on the upper half line involves short selling of the
tangency portfolio and investing the proceeds in the riskfree asset.
Alternative approach

Given a point (P , P ) in the feasible region, we draw a line joining

this point and the risk free asset. Let be the angle of inclination
P rf
of this line, where tan = . The tangency portfolio is the
P
feasible point that maximizes or tan .
n
X
Write RP = wiRi, where wi is the weight associated with the
i=1
n
X n
X
risky asset i. Since P = wiRi and rf = wirf , we have
i=1 i=1
n
X
wi(Ri rf )
tan = i=1 1/2 .
n X
X n
ij wiwj
i=1 j=1
Set the derivative of tan with respect to each wk equal to zero:-

tan
wi
1/2 " # n 1/2
n
X n
X X n
X

Ri rf ij wi wj wi (Ri rf ) i,j wi wj ij wj
i,j=1 i=1 i,j=1 j=1
= n
X
ij wi wj
i,j=1
= 0.

This leads to the following system of equations:-

n
X
ij wj = (Ri rf ), is some constant, i = 1, 2, , n.
j=1
Hint Use the following relation
1/2 1/2
n
X X X
wiij wj = wiij wj ij wj .
wi i,j i,j j=1
We write vj = wj for each j, the above system becomes
n
X
ij vj = ri rf , i = 1, 2, , n.
j=1
We then solve for vj by a linear system solver.

vj
Finally, we normalize wj s by wj = Pn , j = 1, , n.
j=1 vk
Example (5 risky assets and one risk free asset)

Data of the 5 risky assets are given in the earlier example, and
rf = 10%.

The system of linear equations to be solved is

5
X
ij vj = Ri rf = 1 Ri rf 1, i = 1, 2, , 5.
j=1

Recall that v 1 and v 2 in the earlier example are solutions to

5
X 5
X
ij vj1 =1 and ij vj2 = Ri, respectively.
j=1 j=1

Hence, vj = vj2 rf vj1, j = 1, 2, , 5 (numerically, we take rf =

10%).
Addition of risk tolerance factor

2 , with 0, where is the risk tolerance.

Maximize 2 P P

2 subject to
Optimization problem: max 2 P P 1 w = 1.
wRN

Remark

is closely related to the relative risk aversion coefficient. Given an

initial wealth W0 and under a portfolio choice w, the end-of-period
wealth is W0(1 + RP ). Let P = E[RP ] and P 2 = var(R ).
P

Consider the Taylor expansion

W 2
u[W0(1 + RP )] u(W0) + W0u0(W0)RP + 0 u00(W0)RP
2 + .
2
2] =
Neglecting third and higher order moments and noting E[RP
2 + 2 .
P P
 W 2
E[u(W0(1 + P ))] u(W0) + W0u0(W0)P + 0 u00(W0)(P 2 + 2 ) +
P
" 2 #
2
W0 00 0
2u (W0)
= u(W0) u (W0) ( 2 + 2 )
P P P
2 W0u00(W0)
+
W u00 (W )
0 0
Neglecting 2
P compared to P
2 and letting R =
R , we
u0(W0)
2 2.
have the objective function: P P
RR

Note that the expected utility can be expressed solely in terms of

2 when
mean P and variance P

(i) u is a quadratic function, or

(ii) RP is normal.
Quadratic optimization problem

max [2 T w wT w] subject to 1 w = 1.
wRN
The Lagrangian formulation becomes:

L(w; ) = 2 T w wT w + (wT 1 1).

The first order conditions are
(
2 2w + 1 = 0
.
1w =1
Express the optimal solution w as wg + z , 0.

1. When = 0, 2w = 01 and 1T w g = 1
0 1 T T
wg = 1 and 1 = 1 wg = 0 1 11
2 2
hence
11
wg = T
(independent of ).
1 11

2. When 0, w = 1 + 11.
2
T T T 1 1 11
1 = 1 w = 1 1 + 1 1 so that = T .
2 2 1 11
T T

w= 1+
1 1 1 1
1 = 1
1 1 11+w .
T T 1 g
1 11 1 1
We obtain
T 1
1 1
z = T
1 T
1 and 1 z = 0.
1 11
Observe that cov(Rwg , Rz) = z T wg = 0.
Financial interpretation

wg leads to a minimum risk position. This position is modified

by investing in the self-financing portfolio z so as to maximize
2 T w wT 1w.

Efficient frontier

Consider

P = T (wg + z ) = g + P,z
2 = 2 + 2 cov(R
P , R ) + 2 2 .
g |
w g z
{z

} z
z T wg =0
!2
2 2 P g 2 . Hence, the frontier is
By eliminating , P = g + z
P,z
2 )-diagram and hyperbolic in the ( , )-
parabolic in the (P , P P P
diagram.
Inclusion of riskfree asset (deterministic rate of return R0 = r)

N
X
Let w = (w0 wN )T and wi = 1.
i=0

Lagrangian formulation becomes

c
bTw
L = 2 cT w
cw cT 1 1) + 2 w0r + w0
c + (w
T
b = (1 N )T RN , 1 = (1 1)T
c = (w1 wn)T RN ,
where w
RN .

The optimality conditions become

2 r + = 0 (i)
2 c + 1 = 0
b 2w (ii)
N
X
wi = 1 (iii)
i=0
Estimation of risk tolerance (inverse problem)

Reverse optimization: given an efficient portfolio w, it is possible

) and . Taking the inner product
to express in terms of var(RP P
of w
c with (ii), we obtain
T
2 (rw0 +
bTw
c) 2w
c w
c + = 0.

By eliminating using (i), we obtain the implied risk tolerance as

follows:
var(RP)
= .
P r
Marginal utilities

c
With w0 = 1 1 w
c, we obtain the objective function

c
F (w b r 1)T w
c) = 2 [r + ( cT w
c] w c
c
b r 1) 2w
F = 2 ( c

so that

(F )i = 2 [i r] 2cov(RP , Ri), i = 1, 2, , N.
An increase of amount dwi in the weight of asset i and a corre-
sponding reduction of the riskless asset leads to a marginal change
(F )i dwi of the objective function. By increasing (decreasing) the
positions with high (low) marginal utilities, an efficient portfolio w
can be considerably improved.
Summary

1. The objective function 2 T w wT w represents a balance of

maximizing return 2 T w against risk wT w, where the weigh-
ing factor is related to the reciprocal of relative risk aversion
coefficient RR .

2. The optimal solution takes the form

w = wg + z
where wg is the portfolio weight of the global minimum variance
portfolio and the weights in z are summed to zero.
3. The additional variance above g2 is given by

2z
2 .

This is obvious since cov(Rwg , Rz ) = 0, that is, Rwg and Rz

are uncorrelated

4. With the inclusion of riskfree asset, the marginal utility (F )i

of the ith asset can be increased by

(i) higher value of , 0,

(ii) higher positive value of i r
(iii) higher negative correlation between portfolios rate of return
RP and assets rate of return Ri.
Asset-Liability Model

Liabilities of a pension fund = future benefits future contributions

Market value can hardly be determined since liabilities are not readily
marketable. Assume that some specific accounting rules are used to
calculate an initial value L0. If the same rule is applied one period
later, a value L1 results.

L1 L0
Growth rate of the liabilities = RL = , where RL is expected
L0
to depend on the changes of interest rate structure, mortality and
other stochastic factors. Let A0 be the initial value of assets. The
investment strategy of the pension fund is given by the portfolio
choice w.
Surplus optimization

Depending on the portfolio choice w, the surplus gain after one

period

S1 S0 = A0Rw L0RL, where S0 = A0 L0.

The return on surplus is defined by
S1 S0 1
RS = = Rw RL
A0 f0
where f0 = A0/L0 is the initial funding ratio.

Maximization formulation:-
( " # !)
1 1
max 2 E Rw RL var Rw RL
w RN f0 f0
N
X 1
subject to wi = 1. Note that RL and var(RL) are independent
i=1 f0
of w so that they do not enter into the objective function.
 ( )
2
max 2 E[Rw ] var(Rw ) + cov(Rw , RL)
w RN f0
N
X
subject to wi = 1. Recall that
i=1

N
X N
X
cov(Rw , RL) = cov wiRi, RL = wicov(Ri, RL).
i=1 i=1

max {2 T w + 2 T w wT w} subject to 1T w = 1,
w RN

1
where T = (1 N ) with i = cov(Ri, RL),
f0

T = (1 N ) with i = E[Ri], ij = cov(Ri, Rj ).

Remarks

1. The additional term 2 T w in the objective function arises from

the correlation cov(Ri, RL) between return of risky asset i and
return of liability multiplied by the factor L0/A0.

2. Compared to the earlier model, we just need to replace T by

1
T + T . The efficient portfolios are of the form

w = wg + z L + z , 0,
T 1
1
where z L = 1 T

11 with
N
X
ziL = 0.
1 11 i=1
The occurrence of liabilities leads only to parallel shifts of the
set of efficient portfolios.
The mean-variance criterion can be reconciled with the expected
utility approach in either of two ways: (1) using a quadratic utility
function, or (2) making the assumption that the random returns are
normal variables.

Quadratic utility

b 2
The quadratic utility function can be defined as U (x) = ax x ,
2
where a > 0 and b > 0. This utility function is really meaningful
only in the range x a/b, for it is in this range that the function is
increasing. Note also that for b > 0 the function is strictly concave
everywhere and thus exhibits risk aversion.
 mean-variance analysis maximum expected utility criterion
based on quadratic utility

Suppose that a portfolio has a random wealth value of y. Using the

expected utility criterion, we evaluate the portfolio using

b 2
E[U (y)] = E ay y
2
b
= aE[y] E[y 2]
2
b 2 b
= aE[y] (E[y]) var(y).
2 2

The optimal portfolio is the one that maximizes this value with
respect to all feasible choices of the random wealth variable y.
Normal Returns

When all returns are normal random variables, the mean-variance

criterion is also equivalent to the expected utility approach for any
risk-averse utility function.

To deduce this, select a utility function U . Consider a random

wealth variable y that is a normal random variable with mean value
M and standard deviation . Since the probability distribution is
completely defined by M and , it follows that the expected utility
is a function of M and . If U is risk averse, then
f f
E[U (y)] = f (M, ), with >0 and < 0.
M
 Now suppose that the returns of all assets are normal random
variables. Then any linear combination of these asset is a normal
random variable. Hence any portfolio problem is therefore equiv-
alent to the selection of combination of assets that maximizes
the function f (M, ) with respect to all feasible combinations.

For a risky-averse utility, this again implies that the variance

should be minimized for any given value of the mean. In other
words, the solution must be mean-variance efficient.

Portfolio problem is to find w such that f (M, ) is maximized

with respect to all feasible combinations.
 Two fund monetary separation

Consider a financial market with the riskfree asset and several risky
assets, suppose the utility function satisfies
u0(z)
00 = a + bz, valid for all z,
u (z)
then the optimal portfolio at different wealth levels is given by the
combination of the riskfree asset and market fund consisting of the
risky assets. The relative proportions of risky assets in the market
fund remain the same, irrespective of W0.

Remark

The class of utility functions include

(i) quadratic utility
(ii) log utility: a = 0
(iii) exponential utility: b = 0
(iv) power utility: a = 0.
Let W0 be the initial wealth, then the wealth amount aj (W0) of
risky asset j in the optimal portfolio satisfies

aj (W0) = j h(W0) j = 1, 2, , n, and j is independent of W0,

so that the relative proportion bj is given by
aj (W0) j
bj = n = n , independent of W0.
X X
ak (W0) k
k=1 k=1
Lemma

1. Suppose the utility function satisfies

u0(W1)
00 = a + bW1, for all W1,
u (W1)
then the optimal portfolio is given by

aj (W0) = j (a + bRW0), j = 1, 2, , n, (A)

e = 1 + re , j = 1, 2, , n.
where R = 1 + rf and R j j

2. Define V (W0) = max{aj }n f )],

E[u(W
j=1
1

m
X n
X n
X
f = W
where W aj R + e = RW +
aj R e R),
aj (R
1 0 j 0 j
j=1 j=1 j=1
then
V 0(W0) a
00 = + bW0, for all initial wealth W0. (B)
V (W0) R
Proof

Assume that
aj (W0) = j (W0)(a + bRW0)
where j (W0), j = 1, , n, is a differentiable function.

For any value of W0, from the optimality property of aj (W0), we

deduce that
f )]
E[u(W 1
ak


N

X
0 e R)
e R) (W )(a + bRW ) (R
= E u RW0 + (Rj j 0 0 k = 0,

j=1
| {z }
f1
W
(1)
k = 1, 2, , N.
Next, we differentiate eq (1) with respect to W0. First, we observe
that

f N
X
dW 1 e R) (W )b
= R 1 + (R j j 0
dW0 j=1
N d (W )
X j 0 e R)(a + bRW ).
+ (Rj 0
j=1 dW 0

Hence, for the kth component, we obtain

N
X dj (W0)
E[u00(W
f )(R
1
e
j
e
R)(Rk R)(a + bRW0)]
j=1 dW0

N
X
00 f
= E u (W1)(Rk R)R 1 + e R) (W )b ,
(R j j 0
j=1
k = 1, 2, , N.
In matrix form, we have
d1 (W0 )

e1 R)
(R 2 (R e1 R)(R eN R) dW0
(R e2 R)(R e1 R) (R e2 R)(R eN R) 00
d2 (W0 )

E
... ... ...
u ( f
W 1 )(a + bRW 0 )

dW0
...

eN R)(R
(R e1 R) (ReN R)2 dN (W0 )
dW0
n h PN io
E u (W00 f1)(R e1 R)R 1 + e
j=1 (Rj R)j (W0 )b
n h PN io
00 f1)(R e2 R)R 1 + ej R)j (W0)b
E u (W j=1 ( R
=
...
n h PN io
00
E u (W f1)(R eN R)R 1 + e
j=1 (Rj R)j (W0 )b
(2)
From the assumption
u0(W1)
00 = a + bW1,
u (W1)
we obtain
u0 (W
f )
1
u00(W
f )
1 = h PN i
e
a + b RW0 + j=1(Rj R)j (W0)(a + bRW0)
u0 (W
f )
1
= h PN i. (3)
e
(a + bRW0) 1 + j=1(Rj R)j (W0)b
observe that

N
X
u00(W
f )(R
1
e R)R 1 +
k
e R) (W )b
(R j j 0
j=1
R
= u0 (W
f )(R
1
e
k R) , k = 1, 2, N. (4)
a + bRW0
Recall the first order condition:

E[u0(W
f )(R
1
e R)] = 0
k k = 1, 2, , N.
Combining eqs (1) and (4), and knowing that the column vector on
the right hand side of eq (2) is a zero vector, we deduce that
dj
(W0) = 0, j = 1, 2, , n,
dW0
provided that the matrix in eq (2) is non-singular. We then have

j (W0) = j , independent of W0.

Now, aj = j (a + bW0), a > 0. When b = 0, aj is independent of the
initial wealth W0.

The portfolio (a1(W0) aN (W0)) is said to be partially separated if

aj (W0)/aj 0 (W0) is independent of W0, and it is said to be completely
separated if aj is independent of W0.
To show eq (B), we start from the optimality condition on

aj (W0) = j (a + bRW0)
to obtain

n
X
V (W0) = E u RW0 + e R) (a + bRW )
(R j j 0
j=1

n
X N
X
= E u 1 + (Re R)j b RW0 + e R) a .
(R
j j j
j=1 j=1
Differentiate V (W0) twice with respect to W0

n
X
V 0(W 0) = E u0(W
f )R 1 +
1
e R) b
(R j j
j=1
2
n
X
e R) b
V 00(W0) = E u00(W
f )R2 1 +
1 ( Rj j .
j=1

Relating u00(W
f ) with u0(W
1
f ) using eq (3), we obtain
1
h Pn i
RE u0 (W
f )R
1
e
1 + j=1(Rj R)j b R
V 00(W 0) = = V 0(W0).
a + bRW0 a + bRW0
Combining the results
V 0(W0) a
00 = + bW0.
V (W0) R
Formulation for finding the optimal portfolio

Let be the weight of the riskfree asset so that the wealth invested in risky
assets is W0 (1 ). Let bj be the weight of risky asset j within W0(1 ) so that
Xn
bj = 1. The random wealth W f at the end of the investment period is
j=1

f )]
max E[u(W
{,bj }

where
n
X
f
W = W0 (1 + rf ) + W0 (1 )bj (1 + rej )
j=1

n
X
= W0 1 + rf + (1 ) bj rej
j=1

subject to
n
X
bj = 1.
j=1
Lagrangian formulation

n
X
f )] + 1
max E[u(W bj .
{,bj ,} j=1
First order conditions give

n
X
E u0(W
f )W r
0 f bj rej = 0 (1)
j=1
h i
E 0 f
u (W )W0(1 )rej = , j = 1, 2, , n, (2)
n
X
bj = 1. (3)
j=1

n
X
From eq. (1), E[u0(W
f )r ]
f = E u0(W
f) bj rej ,
j=1

and from eqs (2) and (3), we have

n
X
= E u0(W
f )W
0(1 ) bj rej .
j=1
Substituting into eq (2)

n
X
f )re ] = E u0(W
E[u0(W j
f) bj rej , j = 1, 2, , n,
j=1
and using eq (1), we obtain

E[u0(W
f )(re r )] = 0
j f

or equivalently,

n
X
E u0 W0 1 + rf + (1 ) b`(re` rf ) (rej rf ) = 0,
`=1
j = 1, 2, , n. (4)
Exponential utility

Consider u0(z) = Aeaz , a > 0, substituting into eq. (4)

n
X
E A exp a W0 (1 + rf ) + (1 ) b`(re` rf ) (rej rf ) = 0

`=1
and since A exp(aW0(1 + rf )) is non-random, we have
h Pn i
a e`rf ) e
`=1 W0 (1)b` (r
E e (r j rf ) = 0, j = 1, 2, , n. (5a)
For another initial wealth W00 , we have similar result
Pn
0 0 0 e r )
E ea `=1 W0 (1 )b` (r` f (r
ej rf ) = 0, j = 1, 2, , n. (5b)
Suppose we postulate that the solution to the system of equations
h Pn i
a e`rf ) e
`=1 ` (r
E e (rj rf ) = 0, j = 1, 2, , n,
is unique, then by comparing eqs (5a,b), we obtain

W0(1 )b` = W00 (1 0)b0`.

Summing ` from 1 to n, we obtain

W0(1 ) = W00 (1 0),

hence
b` = b0`, ` = 1, 2, , n.
The total wealth amount W0(1 ) invested in risky assets and the
wealth amount in each asset are independent of W0.