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Capital Allocation Between The Risky and The Risk-Free Asset

The document discusses allocating capital between risky and risk-free assets. It examines how different levels of risk aversion would affect the proportions allocated to each. The risk-free asset has 0% risk and a 7% return while the risky portfolio has 22% risk and a 15% expected return. An individual's utility is determined by their expected return minus their coefficient of risk aversion multiplied by the variance. Those more risk averse would allocate more to risk-free assets while those willing to accept risk would use leverage to allocate more to risky assets. The capital allocation line graphs different combinations of risk and return available from allocating between the two assets.

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Sekhar Sharma
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127 views14 pages

Capital Allocation Between The Risky and The Risk-Free Asset

The document discusses allocating capital between risky and risk-free assets. It examines how different levels of risk aversion would affect the proportions allocated to each. The risk-free asset has 0% risk and a 7% return while the risky portfolio has 22% risk and a 15% expected return. An individual's utility is determined by their expected return minus their coefficient of risk aversion multiplied by the variance. Those more risk averse would allocate more to risk-free assets while those willing to accept risk would use leverage to allocate more to risky assets. The capital allocation line graphs different combinations of risk and return available from allocating between the two assets.

Uploaded by

Sekhar Sharma
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Capital Allocation Between The

Risky And The Risk-Free Asset

Chapter 7
Allocating Capital: Risky & Risk Free Assets

It’s possible to split investment funds


between safe and risky assets.

Risk free asset: proxy; T-bills

Risky asset: stock (or a portfolio)

7-2
1-2
Allocating Capital: Risky & Risk Free Assets

Issues
Examine risk/return tradeoff.
Demonstrate how different degrees
of risk aversion will affect allocations
between risky and risk free assets.

7-3
1-3
Example Using Chapter 7.3 Numbers

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf

7-4
1-4
Expected Returns for Combinations

E(rc) = yE(rp) + (1 - y)rf

rc = complete or combined portfolio

For example, y = .75


E(rc) = .75(.15) + .25(.07)
= .13 or 13%

7-5
1-5
Possible Combinations

E(r)

E(rp) = 15%
P
E(rc) = 13%
C

rf = 7%
F


0 c 22%
7-6
1-6
Variance For Possible Combined Portfolios

Since  r = 0, then
f

 c = y  p*

* Rule 4 in Chapter 6

7-7
1-7
Combinations Without Leverage

If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
7-8
1-8
Capital Allocation Line with Leverage

Borrow at the Risk-Free Rate and invest


in stock.
Using 50% Leverage,
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

7-9
1-9
CAL (Capital Allocation Line)

E(r)

P
E(rp) = 15%

E(rp) - rf = 8%
) S = 8/22
rf = 7%
F


0 p = 22%

7-10
1-10
CAL with Higher Borrowing Rate

E(r)

) S = .27

9%
) S = .36
7%


p = 22%

7-11
1-11
Risk Aversion and Allocation

Greater levels of risk aversion lead to larger


proportions of the risk free rate.

Lower levels of risk aversion lead to larger


proportions of the portfolio of risky assets.

Willingness to accept high levels of risk for


high levels of returns would result in
leveraged combinations.

7-12
1-12
Utility Function

U = E ( r ) - .005 A 2
Where
U = utility
E ( r ) = expected return on the asset or
portfolio
A = coefficient of risk aversion
 = variance of returns

7-13
1-13
CAL with Risk Preferences

E(r) The lender has a larger A when


compared to the borrower

Borrower

7%
Lender


p = 22%
7-14
1-14

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