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Return
X1 X0
X0
Profit: p = X1 X0 = rX0
R =1+r
X1 = (1 + r)X0
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Short Sales
total return =
X1
X0
X1
X0
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The rate of return is
r = rate of return =
X1 (X0 )
X1 X0
=
X0
X0
R =1+r
Profit p = X0 X1 = rX0
In practice, the short selling is supplemented by certain restrictions
and safeguards: To short a stock, you are required to deposit an
amount equal to the initial price X0 . At the end of the time period
(with stock price changing to X1 ), you recover your original position
(liquidate your position) and receive your profit from shorting equal
to X0 X1 .
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Example: John Goes Short
John short sold 100 shares of stock ABC at the price $10/share. The
stock dropped to $9/share after one year.
Question: Evaluate the return of this investment
Solution: X0 = 1000, X1 = 900
R=
900
1000
= 0.9
r = R 1 = 0.1
p = rX0 = 0.1 1000 = 100
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Portfolio Return
X0i = X0
i=1
X
X0i
wi = 1.
wi =
X0
i=1
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Portfolio Return (Contd)
Let Ri and ri be the total return and rate of return of asset i. Then
The total return of the portfolio is
R=
Pn
X
i=1 Ri X0i
=
wi Ri
X0
i=1
n
X
i=1
wi ri
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Portfolio Mean and Variance
Consider n assets with random rate of return r1 , r2 , , rn , and a portfolio using the weights wi , i = 1, 2, , n. Let w = (w1 , , wn ) .
Let ri be the expected return of ri and ij be the covariance between
ri and rj . Let
r = (
r1 , , rn ) and = (ij )nn .
The mean rate of return of the portfolio is
r =
n
X
wi ri = w
r
i=1
n
X
i,j=1
wi wj ij = w w
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Example: A Two-Stock World
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Diversification
Diversification: A process of including additional assets in the portfolio to reduce the variance of its return.
Consider n assets that are mutually uncorrelated. The rate of return
of each asset has mean m and variance 2 . Form a portfolio with
wi = n1 . Then
The mean rate of return of the portfolio is E(r) = m
The variance of the portfolio return is var(r) =
2
n
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Diagram of Portfolios
(1 )
r1 +
r2
q
(1 )2 12 + 2(1 )1 2 + 2 22
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If = 1, then
()
=
=
q
(1 )2 12 + 2(1 )1 2 + 2 22
p
[(1 )1 + 2 ]2 = (1 )1 + 2 .
If = 1, then
()
=
=
=
q
(1 )2 12 2(1 )1 2 + 2 22
p
[(1 )1 2 ]2 =| (1 )1 2 |
1
(1 )1 2 if 1+
2
1
2 (1 )1 if 1 +2
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Feasible Set
Suppose there are n basic assets.
Feasible set or feasible region: The set of points that corresponding
to all possible portfolios forming from the n basic assets
The feasible region must be convex to the left.
Minimum-variance set: The left boundary of a feasible set
Minimum-variance point (MVP): The point on the minimum-variance
set that has minimum variance
Risk-averse investor: An investor who, under the same rate of return,
prefers the portfolio with the smallest standard deviation
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Feasible Set (Contd)
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Formulation of Markowitzs Model
Suppose there are n basic assets with mean rates of return ri (i =
1, 2, , n) and covariances ij (i, j = 1, 2, , n). Given a value r, the
objective of a Markowitzs mean-variance portfolio selection problem is
Minimize 12 w w
subject to w
r = r
1 w = 1,
where 1 = (1 1) .
This classical Markowitzs Model is a convex quadratic optimization
problem.
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Solution to Markowitzs Mean-Variance Model
Introduce the Lagrangian
1
L = w w (w
r r) (1 w 1)
2
where and are two Lagrangian multipliers.
Equations for Efficient Set. The portfolio weights wi (i = 1, 2, , n)
and the two Lagrange multipliers and for an efficient portfolio (with
shorting allowed) having mean rate of return r satisfy
w
r 1 = 0
r w = r
1 w = 1,
where 0 = (0 0) .
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Linearity of Efficient Equations
Let {w1 , 1 , 1 }, and {w2 , 2 , 2 } be two efficient portfolios corresponding to r1 and r2 , respectively.
wj
r 1 = 0
r wj = rj
1 wj = 1, j = 1, 2
Then {w = w1 + (1 )w2 , 1 + (1 )2 , 1 + (1 )2 }
satisfies
w
r 1 = 0
r w =
r 1 + (1 )
r2
1 w = 1
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Two-Fund Theorem
Two efficient funds (portfolios) can be established so that any efficient
portfolio can be duplicated, in terms of mean and variance, as a combination
of these two. In other words, all investors seeking efficient portfolios need
only invest in combinations of these two funds.
Implications:
Two mutual funds could provide a complete investment service.
Individuals do not need to purchase individual stocks separately.
Note the underlying assumptions:
Mean-variance framework
Everyone has the same assessment of means, variances and covariances.
Single period
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Computational Implication
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Example
n = 2;
r=
0.151
0.125
0.023 0.0093
0.0093 0.014
0.0093
1
v=
0.014
1
;=
0.023
Let = 0.
0.0093
0.2554
19.9562
1
and w =
v=
Normalization = 78.1278
0.7446
58.1716
0.023 0.0093
0.151
Let = 0.
v=
0.0093 0.014
0.125
4.04
0.393
1
v=
Normalization = 10.28
and w =
6.24
0.607
All efficient solutions can be expressed as
0.393
0.2554
+ (1 )
,
0.607
0.7446
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M-V Selection: No Shorting
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Inclusion of Riskless Asset
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Calculation of Tangent Fund
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30
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Calculation of Tangent Fund (Cont)
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Example
0.151
0.023 0.0093
;=
; rf = 0.08.
0.125
0.0093 0.014
0.023
0.0093
0.151
0.08
v=
0.0093
0.014
0.08
0.125
2.444
2.444
0.6057
v=
w=
/(2.444 + 1.591) =
1.591
1.591
0.3943
0.6057
All efficient solutions can be expressed by
(1 )
0.3943
with 1.
n = 2;
r=