CHAPTER 6:
RISK AVERSION AND
CAPITAL ALLOCATION
TO RISKY ASSETS
Mr.Mohammed Alhato
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Allocation to Risky Assets
■ Speculation is the undertaking of a
risky investment for its risk premium.
■ Investors will avoid risk unless there is
a reward.
■ A fair game is a risky prospect that has
a zero risk premium and will not be
undertaken by a risk-averse investor.
■ The utility model gives the optimal
allocation between a risky portfolio
and a risk-free asset.
6-2
Types of investors
1.Risk-averse: A > 0
2.Risk lover : A < 0
3.Risk neutral : A = 0
2-3
The Risk-Free Asset
■ Only the government can issue default-
free bonds.
– Risk-free in real terms only if price
indexed and maturity equal to
investor’s holding period.
■ T-bills viewed as “the” risk-free asset
■ Money market funds also considered
risk-free in practice
6-4
Utility Function
U = utility
E ( r ) = expected
return on the asset 1
or portfolio U E ( r ) As 2
A = coefficient of risk 2
aversion
s2 = standard
deviation of returns
½ = a scaling factor
6-5
Risk Tolerance and Asset Allocation
■ The investor must choose one optimal
portfolio, C, from the set of feasible choices
– Expected return of the complete
portfolio:
E ( rc ) r f y E ( rP ) r f
6-6
TRUE OR FALSE
(1): Risk-averse investors only care about the rate of return and willing to accept
lower returns and high risk. ( )
False-Risk-averse investors only accept risky investments that offer risk premiums
over the risk-free rate.
(2): Risk-neutral investors look only at expected returns when making an investment
decision.
True
(3): The relevant risk is portfolio risk; thus, the riskiness of an individual security
should be considered in the context of the portfolio as a whole.
True
(4): The first major step in asset allocation is assessing risk tolerance
False- analyzing financial statements, estimating security betas, then identifying
market anomalies
(5): By determining levels of risk tolerance, investors can select the optimum
portfolio for their own needs. True
2-7
Q1:
A portfolio has an expected rate of return that
equals 20% and standard deviation of 30%, with T-
bills offering a safe rate of return of 7%. Having
that in mind, if you are an investor with a risk
aversion of 4.
1. Would you prefer to invest in T-bills or in a risky portfolio?
And Why?
2. What happens if the coefficient of risk aversion equals 2?
2-8
Q2:
Consider a portfolio that offers an expected rate of
return of 12% and a standard deviation of 18%. T-
bills offer a risk-free 7% rate of return. What is
the maximum level of risk aversion for
which the risky portfolio is still preferred
to bills?
2-9
Q3:
Consider historical data showing that the average annual
rate of return on the S&P 500 portfolio over the past 85
years has averaged roughly 8% more than the Treasury
bill return and that the S&P 500 standard deviation has
been about 20% per year. Assume these values are
representative of investors’ expectations for future
performance and that the current T-bill rate is 5%.
1. Calculate the expected return and variance of portfolios invested
in T-bills and the S&P 500 index with weights as follows:
2-10
Q3:
2. Calculate the utility levels of each portfolio of
Problem 10 for an investor with A= 5
3. Repeat Problem 2 for an investor with A= 3.
2-11
Q4:
You manage a risky portfolio with expected rate of return of
18% and standard deviation of 28%. The T-bill rate is 8%.
And your client chooses to invest 70% of a portfolio in your
fund and 30% in a T-bill money market fund.
1. What is the expected value and standard
deviation of the rate of return on your client’s
portfolio?
2-12
Q4:
Suppose that your risky portfolio includes the following
investments in the given proportions:
2. What are the investment proportions of your client’s
overall portfolio, including the position in T-bills?
2-13
Q4:
3. What is the reward-to-
volatility ratio ( S ) of your risky
portfolio? Your client’s?
2-14
Q5:
Consider the following information about a risky
portfolio that you manage, and a risk-free asset:
1. Your client wants to invest a proportion of her total investment
budget in your risky fund to provide an expected rate of return on her
overall or complete portfolio equal to 8%. What proportion should
she invest in the risky portfolio, P, and what proportion in
the risk-free asset?
2-15
Q5:
2. What will be the standard deviation of the rate of
return on her portfolio?
3. Another client wants the highest return possible subject
to the constraint that you limit his standard deviation to be
no more than 12%. Which client is more risk averse?
2-16
Q6:
Using the concepts and equations related to the
maximization of utility, decide how much should you
invest in Risky assets and how much in Risk-free
assets if you know that:
• The total investment = $100,000
• rf = 7%
• E (rp) = 15%
• σp = 22%
• A= 4
1. How much should you invest in Risky assets?
2. Calculate the complete return Rc.
3. Calculate σc.
2-17
Q7:
Given $100,000 to invest, (1) what is the expected risk
premium in dollars of investing in equities versus
risk-free T-bills on the basis of the following table?
2-18
Q7:
You manage an equity fund with an expected risk premium
of 10% and an expected standard deviation of 14%. The rate
on Treasury bills is 6%. Your client chooses to invest
$60,000 of her portfolio in your equity fund and $40,000 in
a T-bill money market fund. (2) What is the expected
return and standard deviation of return on your
client’s portfolio?
2-19
Q7:
(3) What is the reward-to-volatility
ratio for the equity fund in Problem 2?
2-20
Q8:
Investment Expected Standard Utility
Return deviation
A 0.10 0.20
B 0.15 0.255
C 0.20 0.300
D 0.25 0.339
1. On the basis of utility, which investment would you select if
you were risk-averse with A= 4?
2. On the basis of utility, which investment would you select if
you were risk-neutral?
2-21
2-22
2-23
2-24
2-25
2-26
2-27
2-28
