Markowitz Optimal Asset Allocation

Dr. Ir. Budhi Arta Surya

Business, Risk and Finance Group School of Business and Management Institut Teknologi Bandung June 28, 2013

The materials of this course are based on the references listed at the end of this slide.

Markowitz Optimal Asset Allocation

Portfolio Structure

Portfolio Loss Function Denote by V (s) the portfolio value at time s. For a given time horizon , the loss of the portfolio over the period [s, s + ] is dened by

L[s,s+] := (V (s + ) V (s)).

(1)

In establishing the portfolio theory, is assumed to be a xed constant. In this case, it is more convenient to use the following denition

Lt+1 := L[t,(t+1)] = (Vt+1 Vt )..

Here, time series notation is adopted where Vt := V (t). Any random variables with t as the subscript are assumed to be deifned in similar way hrom here on.

(2)

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Portfolio Structure

Portfolio Risk Factors In standard practice, Vt is modelled as a function of time t and a d-dimensional random vector Z t = (Zt,1 , . . . , Zt,d ) of risk factors. In this work, they are assumed to follow some discrete stochastic process. Hence, Vt has representation

Vt = f (t, Z t )
for some measurable function f : R+ Rd R.

(3)

The choice of f depends on the assets contained in the considered portfolio, while the risk factors are usually chosen to be the logarithmic price of nancial assets, yields or logarithmic exchange rates. A representation of the portfolio value in the form of (3) is termed a mapping of risks. Hence, the mapping of risks depend on the types of portfolio assets.
Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013 2

Markowitz Optimal Asset Allocation

Portfolio Structure

Dene the increment process (X t ) by X t := Z t Z t1 . Using the mapping (3) the portfolio loss can be written as

Lt+1 := (Vt+1 Vt ) = (f (t + 1, Z t + X t+1 ) f (t, Z t)).

(4)

Remarks 1. (Vt+1 Vt ) is in practice known as prot-and-loss (P&L). We denote the loss by Lt+1 = (Vt+1 Vt ). By this convention, losses will be positive numbers and prots negative. If f is dierentiable, a rst-order approximation L t+1 of (4) can be considered,
d Lt+1

:= (ft (t, Z t ) +
i=1

fZt,i (t, Z t)X t+1,i ),

(5)

where the subscripts to f denote partial derivatives.

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Markowitz Optimal Asset Allocation

Portfolio Structure
Stock Portfolio Consider a xed portfolio of ds stocks and denote by s i the number of shares of stock i in the potfolio at time t. Denote the stock i price process by St,i . The risk factor is

Zt,i := ln St,i .
The risk factor change then assumes the form of stocks log return, i.e.

Xt+1,i = ln
Then,
ds

St+1,i St,i

Vt =
i=1

s i exp(Zt,i )

(6)

and

ds

Lt+1 =
i=1

i St,i (exp (Xt+1,i ) 1) .

(7)

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Portfolio Structure
Using rst order approximation as in (5) on (7), the loss function can be linearized as
ds i=1 ds i=1

L t+1 =
where

s i St,i Xt+1,i = Vt

s t,i ln

St+1,i St,i

(8)

t,i := i St,i /Vt ,

the stock portfolio weight. Equation (8) gives the linearized risk mapping for stock portfolio. The error from such linearization is small as long as the stock log return is generally small. Dene Rt+1,p :=
Vt+1 Vt

and Rt+1,i := ln
ds

St+1,i St,i

We have following (8) that

Rt+1,p =
i=1

t,i Rt+1,i .

(9)

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Markowitz Optimal Portfolio

Markowitz (1959) laid the groundwork for the CAPM. Sharpe (1964) and Lintner (1965) improved the Markowitz model to develop economy-wide implications. Consider a portfolio of N risky assets whose value is given by
N

Rp =
j =1

j Rj := R,

with 1 = 1.

Technical assumptions

Assume that returns are IID through time and jointly multivariate normal. The expected returns of at least two assets dier The covariance matrix := E RR is of full rank - invertible.
Denote := E R and := E RR . Portfolio p has mean return and variance

p := and variance p =

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Markowitz Optimal Portfolio: Continued Denition 1. Portfolio p is the minimum-variance portfolio of all portfolios with mean return p if weights vector p is the solution to the CO problem:

min ,

subject to

= p =1

(10)

To solve the problem, let us consider the Lagrangian function:

L(x, 1, 2 ) := + 1 p + 2 1 1

The rst order Euler condition gives us the following system of equations

2 1 21 1

= = =

0 p 1

(11) (12) (13)

By multiplying the equation (11) both side by 1 we get

1 1 1 1 1 + 2 1. 2 2

(14)
7

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Portfolio with Risk-Free Asset By imposing the conditions (12) and (13), we have

1 1 1 1 1 1 + 1 1 2 =1 2 2 1 1 1 1 1 + 1 2 =p . 2 2

(15)

Now let us dene the constants: A = 11, B = 1, C = 1 11, and D = BC A2. Solving the equations (15) for 1 and 2 , we obtain from (14):

p = g + hp,
where g and h are (N 1)vectors dened by g h

= =

1 1 1 B 1 A D 1 1 1 C A 1 , D

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Portfolio with No Risk-Free Asset

Figure 1: Minimum-Variance Portfolios Without Risk-free Asset.

g is the minimum variance portfolio. op is the zero-beta portfolio w.r.t the portfolio p, as this portfolio has a zero covariance with the portfolio p, i.e., Rop, Rp = 0.

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

Markowitz Optimal Asset Allocation

Portfolio with Risk-Free Asset Let Rf be the return of risk-free asset. The portfolio optimization amounts to solving

min ,

subject to + 1 1 Rf = p

(16)

The corresponding Lagrangian function is dened by

L(x, ) := + p 1 1 Rf .
Dierentiating L w.r.t x and , we obtain

2x Rf 1

+ 1 1 Rf
Notice that the equation (18) can be rewritten as

= =

0 p

(17) (18)

p Rf = Rf 1 .

(19)

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Markowitz Optimal Asset Allocation

Portfolio with Risk-Free Asset Multiplying both sides of (17) by 1 to get

1 1 Rf 1 . 2

(20)

By inserting (20) in (19), we get

(p Rf ) 1 = Rf 1 , ( Rf 1)
from which we nally have

p =

(p Rf ) ( Rf 1)

Rf 1

1 Rf 1 .

Note that we can express p as a scalar which depends on the mean of p times a portfolio weight vector which does not depend on p, i.e.,

p = Cp .

Workshop Matematika Keuangan ITS Surabaya, 28-29 Juni 2013

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Markowitz Optimal Asset Allocation

Portfolio with No Risk-Free Asset

Figure 2: Minimum-Variance Portfolios Wit Risk-free Asset. With a risk-free asset, all ecient portfolios lie along the line from the risk-free asset to the tangency portfolio, whose slope measures the market price of risk. The tangency portfolio can be characterized as the portfolio with the maximum Sharpe ratio of all portfolios of risky assets.
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Markowitz Optimal Asset Allocation

Portfolio with Risk-Free Asset Thus, with a risk-free asset all minimum-variance portfolios are a combination of a given risky asset portfolio with weights proportional to and the risk-free asset. This portfolio of risky assets is called the tangency portfolio and has weight vector

Rf 1 . q = 1
1

Rf 1

(21)

With a risk-free asset, all ecient portfolios lie along the line from the risk-free asset to the tangency portfolio, whose slope measures the market price of risk. The tangency portfolio can be characterized as the portfolio with the maximum Sharpe ratio of all portfolios of risky assets. In the next section below we will derive the Sharpe-Lintner CAPM model (??).
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Markowitz Optimal Asset Allocation

The Sharpe-Lintner CAPM model The model can be derived as follows. Replace by the tangency portfolio q (21) in the equation (18) so that 1 q = 1 and multiply m to both sides to get

2mm =
from which we obtain

Rf 1 = m Rf

1 =

m Rf 1
2m m

m Rf 1
2 2m

Substituting back to the equation (18), we have

Rf 1 =

m Rf 1
2 m

m .

More specically in terms of individual asset i, for i = 1, 2, ..., N , we have

ip i Rf = 2 Rm Rf = i Rm Rf . m
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Markowitz Optimal Asset Allocation

Main References References

[1] Bjork, T. Arbitrage Theory in Continuous Time, Oxford University Press, 2004. [2] Campbell, J, Y., Lo, A. W and MacKinlay, A. C. The Econometrics of Financial Markets, Princeton University Press, 1997. [3] Hull, J. Options, Futures, And Other Derivatives, Sixth Edition, Pearson Prentice Hall, 2006. [4] Jorion, F. Handbook of Financial Risk Management, Wiley and Son, 2006. [5] Luenberger, D. Investment Science, Oxford University Press, 1998. [6] Van Deventer, D. R., Imai, K., and Mesler, M. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management, Willey, 2005. [7] Martin, J. D., Cox, Jr. S. C., and MacMinn, R. D. The Theory of Finance: Evidence and Application, The Dryden Press, 1988.
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