Estratégia Financeira

Part 3 - ch.11 Optimal Portfolio Choice and the Capital Asset Pricing Model

Henrique C. Martins


Chapter Outline

11.1 The Expected Return of a Portfolio

11.2 The Volatility of a Two-Stock Portfolio

11.3 The Volatility of a Large Portfolio

11.4 Risk Versus Return: Choosing an Efficient Portfolio

11.5 Risk-Free Saving and Borrowing

11.6 The Efficient Portfolio and Required Returns

11.7 The Capital Asset Pricing Model

11.8 Determining the Risk Premium

11.1 Expected return of a portfolio

11.1 Expected return of a portfolio

Suppose you have two stocks:

Amazon: \(x_1\): 40%, Return: 10%, Risk: 26.6%

Southwest: \(x_2\): 60%, Return: 15%, Risk: 27.9%

If your portfolio is 40% Amazon + 60% Southwest, then your return is:

\[(0.4 \times 10\%) +(0.6 \times 15\%) = 13\%\]

There is no secret here, the return of a portfolio is the weighted average of returns.

The weights are selected by the investors and, obviously, if prices change, the weights change over time.

11.2 Volatility of a 2-stock portfolio

11.2 Volatility of a 2-stock portfolio

To compute the standard deviation of a portfolio, we cannot rely on the weighted average. We have to look to the covariances.

  • \(\sigma^2_1\) = variance of asset 1.
  • \(\sigma^2_2\) = variance of asset 2
  • \(\sigma_{12}\) = covariance between assets 1 and 2

11.2 Volatility of a 2-stock portfolio

Covariance is the product of the assets’ Sd and their correlation.

\[\sigma_{12} = \sigma_1 \times \sigma_2 \times \rho_{12}\]

Covariance is the expected product of the deviations of two returns from their means.

\[Cov(R_i,R_j) = E[(R_i-E[R_i]) \times (R_j-E[R_j]) ]\]

When using historical data:

\[Cov(R_i,R_j) = \frac{1}{T-1} (R_i-\tilde{R_i} ) \times (R_j-\tilde{R_j} )\]


\[Corr(R_i,R_j) = \frac{Cov(R_i,R_j)}{Sd(R_i)\times Sd(R_j) }\]

11.2 Volatility of a 2-stock portfolio

Therefore, the portfolio variance is:

\[var = (x_1^2 \times \sigma_1^2) + (x_2^2 \times \sigma_2^2) + 2(x_1 \times x_2 \times \sigma_1 \times \sigma_2 \times \rho_{12})\]

If \(\rho_{12} = 0.26\)

\[(0.4^2 \times 26.6^2) + (0.6^2 \times 27.9^2) + 2(0.4 \times 0.6 \times 26.6 \times 27.9 \times 0.26) = 486.1\]

The standard deviation of the portfolio is \(\sqrt{486.1}= 22\%\), which is lower than 26.6% and 27.9%.

11.2 Volatility of a 2-stock portfolio

Covariance and Correlation

Let’s remember the basics about correlation.

11.2 Volatility of a 2-stock portfolio

Covariance and Correlation

These assets have the same historical return and volatility, but they ‘move’ very differently:

  • For example, when North Air performed well, Text Oil tended to do poorly, and when North Air did poorly, Text oil tended to do well

  • North Air is not positively correlated with Text Oil.

  • Consider the portfolio which consists of equal investments in West Air and Tex Oil. The average return of the portfolio is equal to the average return of the two stocks…

  • However, the volatility of 5.1% is much less than the volatility of the two individual stocks.

The amount of risk that is eliminated in a portfolio depends on the degree to which the stocks face common risks and their prices move together.

11.2 Volatility of a 2-stock portfolio

stocks <-c('BBDC3.SA', 'PETR3.SA') 
start <-'2010-01-01' 
end   <-Sys.Date()  
data <- yf_get(tickers = stocks, 
                         first_date = start,
                         last_date = end)
p<-ggplot(data, aes(ref_date , price_close, group=ticker , color=ticker))+
        geom_line() +
        labs(x = "",
             y='Closing prices', 
             title="Two assets returns", 
             subtitle = "Begin 01/01/2010") +   theme_solarized()
import yfinance as yf
import pandas as pd
import matplotlib.pyplot as plt
import numpy as np
import seaborn as sns
from scipy.stats import norm
stocks = ['BBDC3.SA', 'PETR3.SA']
start = '2010-01-01'
end ='%Y-%m-%d')
data =, start=start, end=end)['Close']
data = data.dropna()
# plot the data
plt.plot(data.index, data['BBDC3.SA'], label='BBDC3.SA')
plt.plot(data.index, data['PETR3.SA'], label='PETR3.SA')
# add title and axis labels
plt.title('Two assets returns')
plt.ylabel('Closing prices')
# add legend
# display the plot

Same graph using prices in day 1 = $100.

stock1 <- subset(data, ticker == stocks[1])
stock2 <- subset(data, ticker == stocks[2])
stock1$price_close2 <- stock1$price_close  / stock1$price_close[1] * 100
stock2$price_close2 <- stock2$price_close  / stock2$price_close[1] * 100
p<-ggplot(stock1, aes(ref_date , price_close2, color=ticker))+
        geom_line() +
        geom_line(data=stock2) +
        labs(x = "",
             y='Closing prices', 
             title="Two assets returns, Initial price = 100", 
             subtitle = "Begin 01/01/2010") +   theme_solarized()