Topic 6.

Portfolio Optimisation with Matrix Algebra

Questions

Question 6.1. Suppose that the data on two risky assets is

Expected Return
Asset 1 0.2
Asset 2 0.05
12 0.02 , rf 0.01

Variance
0.1
0.025

For the following questions use matrix algebra in the calculations where appropriate.

i.

For the global minimum variance portfolio obtain

a. The portfolio weights.

In order to obtain the portfolio weights, the following expression can be used.

1e
eT 1e

(1)

In order to utilise (1) the inverse of the covariance matrix needs to be obtained. The covariance
matrix is

0.1 0.02

0.02 0.025

The inverse of the covariance matrix is

 11.9 9.52
1

9.52 47.6

Using (1)

11.9 9.52 1

9.52 47.6 1
e

T 1
e e
11.9 9.52 1
1 1

9.52 47.6 1
1

This yields

1MVP , 2 MVP 0.273

0.727

b. The expected return of the portfolio.

rMVP 1MVP r1 2 MVP r1

(0.273)(0.2) (0.727)(0.05)
0.09095

c. The variance of the portfolio.

0.1

0.02 0.273

2
MVP
T 0.273 0.727

0.02 0.025 0.272

0.01272

ii.

For the tangency portfolio without the risk free asset obtain

a. The portfolio weights.

 11.9 9.52 0.2

9.52 47.6 0.05

r
T 1P
e rP
11.9 9.52 0.2
1 1

9.52 47.6 0.05

1

TP

0.4

0.6

b. The expected return of the portfolio.

rP,TP (0.4)(0.2) (0.6)(0.05) 0.11

c. The variance of the portfolio.

0.1

0.02 0.4

P2 ,TP 0.4 0.6

0.0154
0.02 0.025 0.6

iii.

For the tangency portfolio without a risk free asset obtain

a. The portfolio weights.

11.9 9.52 0.2 0.01

rP rf e
9.52 47.6 0.05 0.01
T 1

11.9 9.52 0.2 0.01
e rP rf e
1 1

9.52 47.6 0.05 0.01

1

TPf

0.416

0.584

b. The expected return of the portfolio.

rP,TPf (0.416)(0.2) (0.584)(0.05) 0.1124

3

c. The variance of the portfolio.

0.1

0.02 0.416

P2 ,TPf 0.416 0.584

0.0161
0.02 0.025 0.584

It is noted that

rP,TPf rP,TP rMVP

MVP P ,TP P ,TPf

Can you think why this should be the case?