Determining the Minimum Variance Portfolio

Consider the two risky securities listed below.

Expected Standard
Return Deviation
Stocks (S) 15.0% 21.0%
Bonds (B) 6.0% 11.0%

1) If the correlation between these two securities is 0.15, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

The general formula for the portfolio weight that gives the minimum variance
portfolio is:

σ B2 − Cov S , B
wSMVP = =
σ S2 + σ B2 − 2Cov S , B

Here the covariance equals ρ·σS·σB = 0.15(0.21)(0.11) = 0.003465, so the formula

gives:

(0.11) 2 − 0.003465
w MVP
= = 0.1753 = 17.53%
(0.21) 2 + (0.11) 2 − 2(0.003465)
S

w BMVP = 1 − wSMVP = 1 − 0.1753 = 0.8247 = 82.47%

Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation
2) If the correlation between these two securities is 0.0, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

With a correlation of zero, the formula for the portfolio weights in the minimum
variance portfolio simplifies to:

σ B2 (0.11) 2 0.0121
wSMVP = = = = 21.53%
σ S + σ B (0.21) + (0.11)
2 2 2 2
0.0441 + 0.0121

w BMVP = 1 − wSMVP = 1 − 0.2153 = 0.7847 = 78.47%

Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation

3)
 If the correlation between these two securities is -1.0, what are the portfolio weights
for the minimum variance portfolio created by combining these two securities?

With a correlation of -1.0, the formula for the portfolio weights in the minimum
variance portfolio simplifies to:

σB 0.11
wSMVP = = = 0.3438 = 34.38%
σ S + σ B 0.21 + 0.11

w BMVP = 1 − wSMVP = 1 − 0.3438 = 0.6562 = 65.62%

Note that this represents a perfect hedge portfolio. If you plug these weights into
Rule 2*, you will find that the resulting standard deviation is zero.

Stock/Bond Portfolios

18.0%

17.0%

16.0%

15.0%

14.0%

13.0%

12.0%

11.0%
Expected Return

10.0%

9.0%

8.0%

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation