FINM7008 Applied Investments

Week 3

Capital Allocation and Optimal Risky Portfolios

Kun Li
RSFAS, Australian National University

page 1 of 18
 3.3 Capital Allocation across Risky and Risk-Free Portfolios
Capital Allocation

• The choice among broad asset classes that represents a very important
part of portfolio construction.
• ’Top-down’ approach to investment:
– An asset allocation decision.
– A security selection decision.
• The simplest way to control risk is to manipulate the fraction of the
portfolio invested in risk-free assets versus the portion invested in the
risky assets.
• This is called Capital allocation decision.

page 2 of 18
Capital Allocation

• Imagine an investment portfolio (herein called the complete portfolio)

comprising two parts
– Risky assets p.
– Risk-free assets f .
• The proportion of the funding invested in p is y , meaning the propor-
tion invested in f is 1 − y .
• The expected return on p is E(rp) and the rate of return on the risk-free
asset is rf .

page 3 of 18
Capital Allocation

• The expected rate of return on the complete portfolio is

( )
E(rc) = yE(rp) + (1 − y)rf = rf + y E(rp) − rf
As investors are risk averse, they will only assume a risky position if
they are promised a positive risk premium.
• The standard deviation of the complete portfolio is
σc = yσp
which implies
( ) σc ( )
E(rc) = rf + y E(rp) − rf = rf +
σp
E(rp) − rf

page 4 of 18
 Basic Asset Allocation Example

• Total market value $300, 000.

• Risk-free money market fund $90, 000.
• Equity $113, 400.
• Bonds (long-term) $96, 600.
• Total risky assets $210, 000.

$113, 400 $96, 600

ωE = = 0.54, ωB = = 0.46
$210, 000 $210, 000
$210, 000 $90, 000
y= = 0.7, 1 − y = = 0.3
$300, 000 $300, 000

page 5 of 18
 3.4 Portfolio of One Risky Asset and a Risk-Free Asset
The Capital Allocation Line

• The capital allocation line (”CAL”)

– represents the risk and return characteristics of all possible combi-
nations of the risk-free and risk assets.
• The slope of the line is
– The increase in the complete portfolio’s expected return for each
additional unit of standard deviation:
Slope =
E (rp) − rf
σp
– Often referred to as the reward-to-variability ratio.

page 6 of 18
Example of One Risky Asset and a Risk-Free Asset
• We have
rf = 7%, E(rp) = 15%, σp = 22%
• The expected return on the complete portfolio
E(rc) = 7 + y × (15 − 7)
• The risk of the complete portfolio is
σc = yσp = 22y
• Rearrange terms

E(rc) = 7 + σ × (15 − 7) = 7 + 22 σc
σc 8
p

• The slope is
Slope =
E(rp) − rf
=
8
.
σp 22

page 7 of 18
The Investment Opportunity Set

page 8 of 18
The Investment Opportunity Set

• Why does the CAL extend beyond P ?

• What happens given to the shape of the CAL given differential bor-
rowing and lending rates?

page 9 of 18
Example 6.3: Leverage
Suppose the investment budget is $300, 000 and our investor borrows
an additional $120, 000, investing the total available funds in the risky
asset. This is a levered position in the risky asset, financed in part by
borrowing. In that case
$420, 000
y= = 1.4, 1 − y = −0.4.
$300, 000
Rather than lending at a 7% interest rate, the investor borrows at 7%.
The slop is
E(rc) = 7% + (1.4 × 8%) = 18.2%
σc = 1.4 × 22% = 30.8%

S=
E (rc) − rf 18.2 − 7
= = 0.36.
σC 30.8
The levered portfolio has a higher standard deviation that does an
unlevered position in the risky asset.

page 10 of 18
Differential Borrowing Rates
• Suppose the borrowing rate is rfB = 9% instead of 7%. The slope
would be
S=
E (rc) − rf
=
6
= 0.27.
σC 22

page 11 of 18
• Only the government can issue default-free securities.
– A security is risk-free in real terms only if its price is indexed and
maturity is equal to investor’s holding period.
• T-bills viewed as ”the” risk-free asset.
• Money market funds also considered risk-free in practice.

Figure 3.1: Spread between 3-month CD and T-bill rates

page 12 of 18
 3.5 Risk Tolerance and Asset Allocation
• The investor uses the CAL to identify the optimal portfolio.
• Formally, chooses y that maximize their utility

max U = E(rc) − Aσc

1 2
y 2
• Rewrite the problem in terms of the risky asset

max U = rf + y(E(rp) − rf ) − Ay σp
1 2 2
y 2
• The optimal weight
y ∗
=
E(rp) − rf
Aσp2
– proportional to the asset’s risk premium.
– inversely proportional to both the assets risk and investor’s risk aver-
sion.

page 13 of 18
Risk Tolerance and Asset Allocation

• Indifference curve analysis can be used to determine the optimal port-

folio graphically.
– Indifference curves connect portfolios investors are indifferent be-
tween given their risk and return characteristics.
– Higher utility curves represent higher utility and describe situations
where investors receive a higher expected return for a given level of
risk.
– Investors will choose the available investment with the highest util-
ity, that is, the optimal portfolio will be where the highest possible
indifference curve is at a tangent to the CAL.

page 14 of 18
Risk Tolerance and Asset Allocation

Figure 3.2: Finding the optimal complete portfolio by using indifference curves

page 15 of 18
The Investment Opportunity Set

page 16 of 18
The Investment Opportunity Set

page 17 of 18
 Optimal Portfolio
max U = E(rc) − Aσc
1 2
y 2
subject to
E(r) = 0.07 + 22 σc
8

A=4
This leads to
8 1 2
max U = 0.07 + σc − Aσc
y 22 2
so that
8 1
σc = × = 9.09%
22 4
E(rc) = 0.07 + 22 × 0.0909 = 10.28%
8

σc 0.0909
y= = = 0.41
σP 0.22
1 − y = 1 − 0.41 = 0.59
page 18 of 18