portalloc - Optimal capital allocation to efficient frontier portfolios

Syntax

[RiskyRisk, RiskyReturn, RiskyWts, RiskyFraction, OverallRisk, 
OverallReturn] = portalloc(PortRisk, PortReturn, PortWts, 
RisklessRate, BorrowRate, RiskAversion)

Arguments

PortRisk

Standard deviation of each risky asset efficient frontier portfolio. A number of portfolios (NPORTS) by 1 vector.

PortReturn

Expected return of each risky asset efficient frontier portfolio. An NPORTS-by-1 vector.

PortWts

Weights allocated to each asset. An NPORTS by number of assets (NASSETS) matrix of weights allocated to each asset. Each row represents an efficient frontier portfolio of risky assets. Total of all weights in a portfolio is 1.

RisklessRate

Risk-free lending rate. A decimal number.

BorrowRate

(Optional) Borrowing rate. A decimal number. If borrowing is not desired, or not an option, set to NaN (default).

RiskAversion

(Optional) Coefficient of investor's degree of risk aversion. Higher numbers indicate greater risk aversion. Typical coefficients range between 2.0 and 4.0 (Default = 3).

Note Consider that a less risk-averse investor would be expected to accept much greater risk and, consequently, a more risk-averse investor would accept less risk for a given level of return. Therefore, making the RiskAversionargument higher reflects the risk-return tradeoff in the data.

Description

[RiskyRisk, RiskyReturn, RiskyWts, RiskyFraction, OverallRisk, OverallReturn] = portalloc(PortRisk, PortReturn, PortWts, RisklessRate, BorrowRate, RiskAversion) computes the optimal risky portfolio, and the optimal allocation of funds between the risky portfolio and the risk-free asset.

RiskyRisk is the standard deviation of the optimal risky portfolio.

RiskyReturn is the expected return of the optimal risky portfolio.

RiskyWts is a 1-by-NASSETS vector of weights allocated to the optimal risky portfolio. The total of all weights in the portfolio is 1.

RiskyFraction is the fraction of the complete portfolio allocated to the risky portfolio.

OverallRisk is the standard deviation of the optimal overall portfolio.

OverallReturn is the expected rate of return of the optimal overall portfolio.

portalloc generates a plot of the optimal capital allocation if you invoke it without output arguments.

Examples

Generate the efficient frontier from the asset data.

ExpReturn = [0.1 0.2 0.15]; 

ExpCovariance = [0.005   -0.010    0.004 
                -0.010    0.040   -0.002 
                 0.004   -0.002    0.023];
[PortRisk, PortReturn, PortWts] = portopt(ExpReturn,... 
ExpCovariance);

Find the optimal risky portfolio and allocate capital. The risk free investment return is 8%, and the borrowing rate is 12%.

RisklessRate  = 0.08;
BorrowRate    = 0.12;
RiskAversion  = 3;

[RiskyRisk, RiskyReturn, RiskyWts, RiskyFraction, ... 
OverallRisk, OverallReturn] = portalloc(PortRisk, PortReturn,... 
PortWts, RisklessRate, BorrowRate, RiskAversion)

RiskyRisk =

    0.1283

RiskyReturn =

    0.1788

RiskyWts =

    0.0265    0.6023    0.3712

RiskyFraction =

    1.1898
OverallRisk =

    0.1527

OverallReturn =

    0.1899

References

Bodie, Kane, and Marcus, Investments, Second Edition, Chapters 6 and 7.