Risk-Return Relationship (B) Case Write-Up

Summary
The chief goal in this case is to find the risk-return scenarios that adhere to Juans personal
investment strategies. There are two distinct investment strategies laid out in the casethe first
is that Juan is happy to short sell any of the stocks and borrow at the risk-free rate of 5%, while
the other strategy mandates that he would like to invest without any short selling or borrowing
whatsoever. Juan has $100,000 to invest and is looking at this investment scenario from a one-
year perspective. In addition, he is looking at a portfolio with just three stocksa gold mining
company (AUCO), a regional bank (BANC), and a power utility (ELEC).

The chief goal in this case is to simulate the game as described below and verify the results

Model:

Objective:
o To determine the composition of the portfolios, composed of 3 stocks with
varying degree of returns, volatility and correlation, with minimum volatility and
varying expected returns
o To compare different portfolios based on their risk-return and match it with Juans
risk appetite to select a portfolio to invest in

Assumptions: Assumptions in our analysis are pertaining to the assumptions in the

Markowitz portfolio optimization model, which are:

o Investors consider each investment alternative as being represented by a

probability distribution of expected returns over some holding period.
o Investors maximize one-period expected utility and their utility curves
demonstrate diminishing marginal utility of wealth.
o Investors estimate risk on basis of variability of expected returns.
o Investors base decisions solely on expected return and risk.
o Investors prefer higher returns to lower risk and lower risk for the same level of
return.

Structure:

o There are two parts to the analysis for constructing various portfolios depending
upon investment scenarios
Shorting allowed: Sell short any stock and borrow at a risk free rate of 5%
No Shorting allowed: No stock can be sold short

o Scenario 1: Shorting allowed

Based on the returns and standard deviation of each stock, a solver
relationship was set up to get desired level of portfolio return
 No constraints applicable in this case on the weights of investment in each
stock, since negative weight will imply shorting
Using Portfolio return = (Wn*Rn), a constraint was set up to get desired
portfolio return
The resulting solution from solver yielded weights for different stock
For portfolio Variance, a covariance table was developed depending upon
the correlations among different stocks
For covariance, Covar (A, B) = Correl x sigma A x sigma B
For varying portfolio returns, portfolio variance was calculated

o Scenario 2: No Shorting allowed

Based on the returns and standard deviation of each stock, a solver
relationship was set up to get desired level of portfolio return
Constraints applicable in this case on the weights (W 0) of investment in
each stock, since negative weight will imply shorting which is not allowed
Using Portfolio return = (Wn*Rn), a constraint was set up to get desired
portfolio return
The resulting solution from solver yielded weights for different stock
For portfolio Variance, a covariance table was developed depending upon
the correlations among different stocks
For covariance, Covar (A, B) = Correl x sigma A x sigma B
For varying portfolio returns, portfolio variance was calculated

Analysis

Scenario 1: Shorting allowed

o When shorting was allowed in the model, we observed a linear risk-return Capital
Allocation Line (refer excel)
o Increasing expected return in the portfolio saw an increased allocation weight to
the equities and subsequently decreased allocation levels to FDIC, which became
negative after E(r) = 11%
o Between, AUCO, BANC and ELEC, the allocation weights were skewed towards
their mean return.
o Minimum return was achieved when total allocation was to FDIC, return = 5%
and Portfolio variance = 0%
o Maximum return was achieved when allocation to AUCO =54%, BANC= 45.4%
and ELEC = 47.5%,while shorting FDIC = 46.8% of portfolio value. This led to a
portfolio return = 15% and Portfolio Std Dev = 10.7%
o In this case, the portfolio composition that Mr. Juan will ise will depend upon his
risk appetite

Scenario 2: No shorting allowed

 o When shorting was not allowed in the model, we observed a linear risk-return
Capital Allocation Line (refer excel) till a portfolio return = 8.9%
o Increasing expected return in the portfolio saw an increased allocation weight to
the equities and subsequently decreased allocation levels to FDIC
o Between, AUCO, BANC and ELEC, the allocation weights were skewed towards
their mean return.
o Minimum return was achieved when total allocation was to FDIC, return = 5%
and Portfolio variance = 0%
o Maximum return was achieved when allocation to AUCO =100%, BANC= 0%
and ELEC = 0%, FDIC = 0% of portfolio value. This led to a portfolio return =
15% and Portfolio Std Dev= 20%
o In this case, the portfolio composition that Mr. Juan will ise will depend upon his
risk appetite

Conclusions
The observed probabilities and the theoretical probabilities are found to be close (with an
error of 4.8% and 8.4 % respectively).
If we increase the sample size, the observed value converges to the theoretical value.
It is always favorable to change the selection for a better probability of winning.