Portfolio Theory

Philippe Henrotte
HEC Paris
Topic 3: Portfolio Theory
Portfolio Return
Short Selling
Risk Free Security
Leverage, Sharpe ratio, Capital Allocation Line
Diversification
Portfolio risk, correlation, equally weighted
portfolios
Efficient Frontier
Risky securities only, risky and risk free securities

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Topic 3: Roadmap
How do you compute the return of a portfolio if you know
the return of the individual securities in the portfolio?
How can I benefit from a falling stock?
What is the effect of leveraging my portfolio by borrowing
to invest more than my initial money?
Is not putting all your eggs in the same basket a good
investment advice?
Is it possible to diversify away all risk in a large portfolio?
How can I best combine risky investments in a portfolio?
What if I can borrow or lend money on top of investing in
risky securities?

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Portfolio Return
Portfolio Return
A portfolio is a collection of securities
We study a portfolio between two periods, 0 and t
Portfolio consists of n securities indexed by i from 1 to n
For each security i in the portfolio we define
Ni Number (quantity) of security i in the portfolio
Pi0 Initial price of security i
Pit Final price of security i
Dit Amount distributed between 0 and t by security i
ri Return of security i from 0 to t given by

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Portfolio Return
For the portfolio we define
V0 Initial value of the portfolio
Vt Final value of the portfolio
Dt Aggregate amount distributed by the portfolio securities
rp Return of the portfolio from 0 to t given by

Simple accounting

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Portfolio Return
We derive

ωi is the initial value weight of security i in the portfolio

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Portfolio Return
Example: consider a portfolio with 200 shares of the
Walt Disney Company worth $30 per share and 100
shares of Coca-Cola worth $40 per share

The one year return on Walt Disney is 15% while it is 5%

on Coca-Cola, the portfolio return is therefore 11%

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Portfolio Return
The return of a portfolio is the value weighted average of
the returns of the securities in the portfolio
Remark 1: the relation holds for net and gross returns

Remark 2: portfolios are associative

A portfolio of portfolios is itself a portfolio of securities
The return of the overall portfolio is the value weighted average of
the returns of the sub-portfolios
The weights are the initial percentage in value of each sub-
portfolio in the overall portfolio

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Portfolio Return
Remark 3: the relation holds for realized and expected
returns

Example: The expected return on Walt Disney is 10%

while it is 8% on Coca-Cola, the expected return of the
portfolio is therefore 9.20%

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Short Selling
Short Selling
Selling a security short means borrowing and selling a
security which you do not own while repurchasing it later,
hopefully at a lower price
The original owner does not mind as long as you give
her any distribution on the security during the period (we
call it a manufactured distribution)
The original owner faces some counterparty risk
she receives a (small) fee from you
she usually asks for some collateral from you (cash or security
you own)
the collateral may increase as the price of the shorted security
rises (margin call)

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Portfolio Return with Short Sales
Portfolio consists of n securities indexed by i from 1 to n
And m securities shorted indexed by j from 1 to m
V0 is your initial wealth. The cash raised by selling the
shorts, added to V0, is invested in the longs

You receive the distributions of the longs but need to pay

the manufactured distributions on the shorts

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Portfolio Return with Short Sales
At the end of the period, you repurchase the shorted
securities in the market and give them back to their
original owners. Your final wealth Vt is

The return rp on your wealth is

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Portfolio Return with Short Sales
We obtain

ωi and ωj are the initial value weights of security i and j

respectively, as a percentage of the initial value V0

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Portfolio Return with Short Sales
Example: you start with $10,000, you short 50 shares of
Coca-Cola at $40 per share generating $2,000. You
invest the total $12,000 in Walt Disney shares worth $30
per share by purchasing 400 shares

The one year return on Walt Disney is 15% while it is 5%

on Coca-Cola, the portfolio return is therefore 17%

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Risk Free Security
Risk Free Security
We assume that one security is special: it offers a return
rf which is certain, we call it the risk free security
The variance of rf is zero
The covariance and correlation of rf with any other return is zero
The risk free security is typically a short term
government security: a Treasury bill in the US for
instance
Any cash position in a portfolio is in fact invested in such
risk free security
Remark: today the risk free rate is zero or negative in
many countries while there may be a risk of government
default: we talk about return free risk!

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Risk Free Security
We consider a portfolio q combining a portfolio p of risky
securities on the one hand and the risk free security on
the other hand
Initial wealth V0
Let ωp be the percentage of V0 invested in the portfolio p
ωf = 1 - ωp is the percentage of V0 invested at the risk free rate

The excess return is the return minus the risk free rate

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Leverage
Borrowing money at the risk free rate can formally be
analysed as shorting the risk free security
You receive cash today by selling the risk free security
You repurchase later in the market the risk free security
at a higher price
The difference between the initial price and the higher
final price corresponds to the risk free interest which you
pay on your borrowing
There is formally a banking vs security equivalence
Investing in the risk free security = lending to a bank
Shorting the risk free security = borrowing from a bank

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Leverage
We consider again our portfolio p of risky securities
Initial wealth V0 to which you add an amount B by borrowing at
the risk free rate (formally shorting the risk free security)
Invest the total sum V0 + B in the portfolio p
ωp = (V0 + B) / V0 is larger than one due to leverage
ωf = Β / V0 is the amount borrowed in relation to the initial wealth
With now

We have again, in terms of excess return

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Leverage
We obtain

Since rf is a constant

With ωp < 1 investing at the risk free rate reduces the

excess return (realized and expected) and the risk
With ωp > 1 leverage amplifies the excess return
(realized and expected) but also the risk

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Sharpe Ratio

The Sharpe ratio SR measures the ratio of reward to

risk provided by a portfolio

Remark: investing at the risk free rate or borrowing does

not change the Sharpe ratio of the initial portfolio

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Capital Allocation Line
For various (non negative) values of ωp the portfolio q
describes a line in the volatility – expected return plane
called the Capital Allocation Line (CAL)

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Diversification
Portfolio Risk
We measure the risk of a portfolio by its volatility, the
standard deviation of its return

Therefore

Fraction of individual
portfolio risk risk common to the
portfolio
individual weight individual risk

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Portfolio Risk
The portfolio risk is lower than the weighted average risk
of the securities within the portfolio

Correlation: the tendency of the returns on two assets

to move together. Imperfect correlation is the key reason
why diversification reduces portfolio risk
Positively correlated assets tend to move up and down
together, while negatively correlated assets tend to move
in opposite directions

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Why Diversification Works

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Why Diversification Works

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Why Diversification Works

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Equally Weighted Portfolios

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Diversification and Portfolio Risk
Efficient Frontier
Two-Stock Portfolio
Consider a portfolio p invested in two stocks only with

We have for the return

And for the risk

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Two-Stock Portfolio
Portfolios (ω1, ω2) mixing Intel and Coca-Cola

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Two-Stock Portfolio
Changing the correlation between Intel and Coca-Cola

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Two-Stock Portfolio with Short Sales
Short selling one stock while investing in the other

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Three-Stock Portfolio
Portfolios mixing Intel, Coca-Cola and Bore Industries

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Mean Variance Analysis
We assume that investors are risk averse. They seek
portfolios:
with the best reward: the expected return
and the minimum risk: the standard deviation of the returns
Two-step solution
Step 1: Find the risk-reward combinations in the set of all feasible
portfolios, the Investment Opportunity Set
Step 2: Find the optimal portfolios within this set
The efficient frontier are the portfolios which achieve the
best risk-reward mix:
They offer the highest expected return for a given level of risk
Or they offer the lowest risk for a given level of expected return

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Efficient Frontier with Three Stocks
Portfolios mixing Intel, Coca-Cola and Bore Industries

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Efficient Frontier
Efficient frontier with three stocks versus ten stocks

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Risk Free and Risky Securities
Combining a risky portfolio with the risk free security

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Efficient Frontier
Efficient portfolios combining risky and risk free securities

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Efficient Frontier

Remark 1: The overall efficient frontier combining risky

securities with the risk free security is the slope with the
highest Sharpe ratio
Remark 2: The tangent portfolio is not obvious to
compute, it depends in particular on the entire
covariance matrix between pairs of stocks
Remark 3: Not clear if the input data must be guessed or
extracted from past data. Investors care about future
performance and a portfolio which was efficient in the
past may not be efficient in the future

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