Chapter Six

Capital Allocation to Risky Assets

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 Examples

• In last lecture, we learned expected return

and standard deviation (SD).
• Q: which portfolio would you prefer?
Portfolio Expected Risk
Return (SD)
A 10% 15%
B 14% 15%

Portfolio Expected Risk

Return (SD)
A 12% 15%
B 12% 25%

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 Table 6.1 An Example

• Q: Which portfolio would you choose?

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 Utility

• Utility
• In economics, utility is a measure of a person’s
preferences over some set of goods and services;
• Here we use utility as a measure of attractiveness
of portfolios to an investor:
U  E  r   1 A 2
2
• Portfolio attractiveness increases with expected
return and decreases with risk;

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 Risk Aversion and Utility Values

• Utility Function

U  E  r   1 A 2
2
• U = Utility
• E(r) = Expected return on the asset or portfolio
• A = Coefficient of risk aversion (of an investor)
• σ2 = Variance of returns
• ½ = A scaling factor

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 Risk Aversion and Utility Values

• Utility Function

U  E  r   1 A 2
2
• A>0 risk averse investor
• A=0 risk-neutral investor
• A<0 risk lover

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 Table 6.2 Utility Scores of Portfolios with
Varying Degrees of Risk Aversion
• Investor #1, risk aversion A = 2.0
• Investor #2, risk aversion A = 3.5 U  E  r   1 A 2
2
• Investor #3, risk aversion A = 5.0

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 Risk Aversion and Utility Values

• An investor has $1,000,000 to invest

A Probability outcome Return Expected Stdev
return
50% 2,000,000 1
50% 0 -1 0 1

B Probability outcome Return Expected Stdev

return
100% 1,100,000 0.1 0.1 0

• An example of risk lover:

• A life-saving surgery would cost $1,500,000
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 Risk Aversion and Utility

• Mean-SD plane:

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 Risk Aversion and Utility
• Equally preferred portfolios lie on a curve: indifference
curve

U  E  r   1 A 2
2

1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
2
A constant

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 Risk Aversion and Utility

∙T

∙O
∙S

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 Risk Aversion and Utility
• For each investor, there is only one indifference curve
crossing the point P

1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
2

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 Risk Aversion and Utility
• For each Investor, there are countless indifference curves
on the plane

1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
P1
2

P2

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 Risk Aversion and Utility

• Different Investors may have different indifference curves

Investor B

1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
Investor C
2

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 Portfolios of One Risky Asset and a
Risk-Free Asset
• Assume a world has only two assets: safe asset (F) and risky
asset (P).
rf = 7% E(rp) = 15%
rf = 0% p = 22%
An investor (with risk averse A=4) splits investment fund
between safe and risky assets.

• Q: How to split?
• y = Portion allocated to risky asset P
• (1 - y) = Portion to be invested in risk-free asset F
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 Portfolios of One Risky Asset and a
Risk-Free Asset

P P

• We solve this question in two steps:

1. We figure out all possible combinations of P and F;
2. We find the optimal combination among all possible
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6-16
 One Risky Asset and a Risk-Free
Asset: Example
• The expected return on the entire portfolio:
𝐸 𝑟𝑐 = 𝑦𝐸 𝑟𝑝 + 1 − 𝑦 𝑟𝑓 = 𝑟𝑓 + 𝑦[𝐸 𝑟𝑝 − 𝑟𝑓 ]
𝑛

*Note: Portfolio return: 𝐸 𝑟𝑐 = 𝑤𝑖 𝐸(𝑟𝑖 )

𝑖=1

• The risk of the entire portfolio:

2 2
𝜎𝑐 = 𝑦 𝜎𝑝 + (1 − 𝑦)2 𝜎𝑟𝑓 2 + 2𝑦 1 − 𝑦 𝜎𝑝 𝑟𝑓 = 𝑦𝜎𝑃
𝑛 𝑛

*Note: Portfolio variance: 𝜎𝑐 2 = 𝑤𝑖 𝑤𝑗 𝜎(𝑖, 𝑗)

𝑖=1 𝑗=1

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 One Risky Asset and a Risk-Free
Asset: Example
𝐸 𝑟𝑐 = 𝑟𝑓 + 𝑦[𝐸 𝑟𝑝 − 𝑟𝑓 ]

𝜎𝑐 = 𝑦𝜎𝑃
• Rearrange and substitute 𝑦 = σC/σP:
C
E  rC   rf   E  rP   rf 
P

Given: rf = 7% E(rp) = 15%

rf = 0% p = 22%
8
E  rC   0.07   C
22
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 Figure 6.4 The Investment Opportunity Set

8
E  rC   0.07  C
22

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 Optimal Portfolio

Indifference
curve

Optimal Portfolio

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 Optimal Portfolio
Another investor:

Indifference
curve

Optimal Portfolio

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 Optimal Portfolio

1
Max 𝑈 = 𝐸 𝑟𝑐 − 𝐴𝜎𝑐 2
2
8
where E  rC   0.07  C 𝐴=4
22

8
Max 𝑈 = 0.07 + 𝜎𝑐 − 2𝜎𝑐 2
22

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 Optimal Portfolio

8
Max 𝑈 = 0.07 + 𝜎𝑐 − 2𝜎𝑐 2
22

𝑑𝑈 𝑑𝑈 8
1st derivative: =0 = − 4𝜎𝑐 = 0
𝑑𝜎𝑐 𝑑𝜎𝑐 22

𝑑2𝑈 𝑑2 𝑈
2nd derivative: <0? = −4 yes
𝑑𝜎𝑐 2 𝑑𝜎𝑐 2

∗
8 1
𝜎𝑐 = × = 9.09%;
22 4
∗
𝜎 0.0909 8
𝑦∗ =
𝑐
= = 0.41; 1 − 𝑦 ∗ = 0.59; E *  rC   0.07   0.0909  10.31%
𝜎𝑃 0.22 22

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 Capital Allocation Across Risky
and Risk-Free Portfolios
• The simplest way to control risk: choose the
fraction of the portfolio invested in risk-free
assets versus the portion invested in the risky
assets.
• Recall: Asset Allocation - The choice among
asset classes;

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 Finding the
Optimal Portfolio
Homework:
1. Draw an indifference curve if A=0.
2. Redo the question (page 14) with A=1, A=0.
3. We further assume that the investor can’t short
the risk-free asset. Would your above answers be
different?

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 Chapter 6

• Chapter 6:
• 6.1, 6.2, 6.3, 6.4, 6.5, 6.6

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