MSF 504 Valuation and Portfolio Management

Capital Allocation to Risky Assets

Optimal Risky Portfolios
Week3
Risk and Risk Aversion:
Risk, Speculation, and Gambling
• Speculation
• Assuming considerable investment risk to obtain commensurate gain
• Taking considerable risk for a commensurate gain
• Occurs in spite of the risk involved because one perceives a favorable risk-return trade-off
• Parties have heterogeneous expectations

• Gambling
• To bet or wager on an uncertain outcome
• Bet on an uncertain outcome for enjoyment
• Parties assign the same probabilities to the possible outcomes
• Risk is assumed for enjoyment of the risk itself
Risk and Risk Aversion:
Risk Aversion and Utility Values
• Risk-averse investors consider only risk-free or speculative prospects with
positive risk premiums

• Utility Values
• Investors are willing to consider:
• Risk-free assets
• Speculative positions with positive risk premiums

• Portfolio is more attractive when its expected return is higher and its risk is
lower
• What happens when risk increases along with return?
Available Risky Portfolios

Each portfolio receives a utility score to assess the investor’s

risk/return trade off
Risk and Risk Aversion:
Risk Aversion and Utility Values (Continued)
• We assume each investor can assign a welfare, or utility, score to
competing portfolios

U = E (r ) − 1 A 2
2
• Utility function
• U = Utility value
• E(r) = Expected return
• A = Index of the investor’s risk aversion
• σ2 = Variance of returns
• ½ = Scaling factor
Example

Utility scores of alternative portfolios for investors with varying degrees of risk aversion
Investor Types
• Risk-averse investors consider risky portfolios only if they provide
compensation for risk via a risk premium
• A>0
• Risk-neutral investors find the level of risk irrelevant and consider
only the expected return of risk prospects
• A=0
• Risk lovers are willing to accept lower expected returns on prospects
with higher amounts of risk
• A<0
Trade-Off Between Risk and Return
Mean-Variance (M-V) Criterion
• Mean-variance (M-V) criterion
• The selection of portfolios based on the means and variances of their returns
• The choice of the highest expected return portfolio for a given level of
variance or the lowest variance portfolio for a given expected return
• Requirements for Portfolio A to dominate Portfolio B
• 𝐸 𝑟𝐴 ≥ 𝐸(𝑟𝐵 )
• 𝜎𝐴 ≤ 𝜎𝐵
• At least one inequality is strict (to rule out indifference between the two
portfolios)
Indifference Curves
• Equally preferred portfolios lie in the mean–standard deviation plane
on an indifference curve, which connects all portfolio points with the
same utility value
Estimating Risk Aversion
• How can we estimate the levels of risk aversion of individual
investors?
• Questionnaires
• Varying degrees of complexity
• Observe individuals’ decisions when confronted with risk
• Observations of how portfolio composition changes over time
• Observe how much people are willing to pay to avoid risk
• Average degrees of risk aversion from groups of individuals
Estimating Risk Aversion
• Mean-Variance (M-V) Criterion
• Portfolio A dominates portfolio B if:

E (rA )  E (rB )
and

A B
Capital Allocation Across Risky
and Risk-Free Portfolios
• Asset Allocation
• The choice among broad asset classes that represents a very
important part of portfolio construction

• Most basic asset allocation choice is risk-free money market securities

versus other risky asset classes

• Simplest way to control risk is to manipulate the ratio of risky assets

to risk-free assets
Basic Asset Allocation Example
(1 of 2)
Basic Asset Allocation Example
(2 of 2)
The Risk-Free Asset
• Only the government can issue default-free bonds
• A security is risk-free with a guaranteed real return only if
• Its’ price is indexed
• Maturity is equal to investor’s holding period
• T-bills viewed as “the” risk-free asset
• Broad range of money market instruments are considered effectively
risk-free assets
Portfolios:
Risky Asset and Risk-Free Asset
• It’s possible to create a complete portfolio by splitting investment
funds between safe and risky assets

Let
• y = Portion allocated to the risky portfolio, P
• (1 - y) = Portion to be invested in risk-free asset, F
One Risky Asset and a Risk-Free Asset:
Example (1 of 2)
E(rP) = 15%
p = 22%
rf = 7%

• Rearrange and substitute y = σC/σP:

• Expected return on the complete portfolio

C
E (rC ) = rf +
P
E (rP ) − rf  = 7 +  C
8
22
One Risky Asset and a Risk-Free Asset:
Example (2 of 2)
• Risk of the complete portfolio
𝜎𝐶 = 𝑦𝜎𝑃 = 22𝑦

• The slope of the line is:

E ( rP ) − rf 8
Slope = =
P 22

• Expected return-standard deviation tradeoff for the complete portfolio is:

E(rC) = 7% + C
The Investment Opportunity Set
One Risky Asset and a Risk-Free Asset
Portfolios
• Investment opportunity set offers feasible expected return and
standard deviation pairs of all portfolios resulting form different
values of y

• Graph showing all feasible risk-return combination of a risky and risk-

free asset is the capital allocation line (CAL)
REWARD TO VARIABLITY RATIO - SHARPE RATIO
• Reward-to-volatility ratio (aka Sharpe ratio)
• Ratio of excess return to portfolio standard deviation
The Opportunity Set with
Different Borrowing and Lending Rates
Portfolios of One Risky Asset and a Risk-Free
Asset
• Capital allocation line with leverage
• Lend at rf = 7% and borrow at rf = 9%
• Lending range slope = 8/22 = 0.36
• Borrowing range slope = 6/22 = 0.27
• CAL kinks at P
Risk Tolerance and Asset Allocation
• Investor must choose one optimal portfolio, C, from the set of feasible
choices
• Expected return of the complete portfolio:
E ( rc ) = rf + y   E ( rp ) − rf 
• Variance:

 = y 
2
c
2 2
p
Utility Levels for
Various Positions in Risky Assets
Utility as a Function of Allocation to the Risky
Asset, y (1 of 2)
Utility as a Function of Allocation to the Risky
Asset, y (2 of 2)

E (rP ) − rf
y* =
A 2
P
Calculations of Indifference Curves
Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4
Finding the
Optimal Complete Portfolio
Expected Returns on Four Indifference Curves
and the CAL
Non-Normal Returns
• Above analysis implicitly assumes normality by treating standard
deviation as the appropriate measure of risk

• VaR and ES assess exposure to extreme losses

• “Black swan” events should concern investors

A Black Swan event is an extremely rare and unpredictable occurrence
that has a severe impact on financial markets, economies, or society.
Passive Strategies:
The Capital Market Line (1 of 3)
• A passive strategy avoids any direct or indirect security analysis

• Supply/demand forces (in large capital markets) may make this

strategy the best choice for many investors

• A natural candidate for a passively held risky asset would a well-

diversified portfolio of common stocks
Passive Strategies:
The Capital Market Line (2 of 3)
• The Capital Market Line (CML) is a capital allocation line formed investment
in two passive portfolios:
• Virtually risk-free short-term T-bills (or a money market fund)
• Fund of common stocks that mimics a broad market index

• Capital market line (CML) results when using the market index as the risky
portfolio

• How reasonable is it for an investor to pursue a passive strategy?

• Important considerations:
1. Alternative active strategy is not free
2. Free-rider benefit
Passive Strategies:
The Capital Market Line (3 of 3)
• From 1926 to 2018, the passive risky portfolio offered an average risk
premium of 8.34% with a standard deviation of 20.36%, resulting in a
reward-to-volatility ratio of .41
Chapter 6. Efficient Diversification
• The investment decision:
• Capital allocation (risky vs. risk-free)
• Asset allocation (construction of the risky portfolio)
• Security selection
• Optimal risky portfolio
• The Markowitz portfolio optimization model
• Long- vs. short-term investing
The Investment Decision
• Top-down process with 3 steps:
1. Capital allocation between the risky portfolio and risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each asset class
Diversification and Portfolio Risk
• Market risk
• Risk attributable to market-wide risk sources and remains even after
extensive diversification
• Also call systematic or non-diversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic
Figure 7.1 Portfolio Risk and
the Number of Stocks in the Portfolio

Panel A: All risk is firm specific. Panel B: Some risk is systematic or market-wide.
Figure 7.2 Portfolio Diversification
Portfolios of Two Risky Assets
• Portfolio risk (variance) depends on the correlation between the
returns of the assets in the portfolio
• Covariance and the correlation coefficient provide a measure of
the way returns of two assets move together (covary)
Portfolios of Two Risky Assets:
Return
• Portfolio return: rp = wDrD + wErE
• wD = Bond weight
• rD = Bond return
• wE = Equity weight
• rE = Equity return

E(rp) = wD E(rD) + wEE(rE)

Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
 = w  + w  + 2wD wE Cov ( rD , rE )
2
p
2
D
2
D
2
E
2
E

•  2 = Bond variance
D

•  2
E = Equity variance

• Cov ( rD , rE ) = Covariance of returns for bond and equity

Portfolios of Two Risky Assets: Covariance
• Covariance of returns on bond and equity:
Cov(rD,rE) = DEDE

• D,E = Correlation coefficient of returns

• D = Standard deviation of bond returns
• E = Standard deviation of equity returns
Portfolios of Two Risky Assets:
Correlation Coefficients
• Range of values for 1,2
- 1.0 >  > +1.0
• If  = 1.0, the securities are perfectly positively correlated
• If  = - 1.0, the securities are perfectly negatively correlated
Portfolios of Two Risky Assets:
Correlation Coefficients
• When ρDE = 1, there is no diversification

 P = wE E + wD D
• When ρDE = -1, a perfect hedge is possible

D
wE = = 1 − wD
 D + E
Table 7.2 Computation of Portfolio Variance
From the Covariance Matrix
Figure 7.3 Portfolio Expected Return
Figure 7.4 Portfolio Standard Deviation
Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation
The Minimum Variance Portfolio
• The minimum variance portfolio is the portfolio composed of the risky
assets that has the smallest standard deviation; the portfolio with
least risk
• The amount of possible risk reduction through diversification
depends on the correlation:
• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of either
component asset
• If  = -1.0, a riskless hedge is possible
Figure 7.6 The Opportunity Set of the Debt
and Equity Funds and Two Feasible CALs
The Sharpe Ratio
• Maximize the slope of the CAL for any possible portfolio, P
• The objective function is the slope:

E (rp ) − rf
Sp =
p
• The slope is also the Sharpe ratio. The following is the weight of B
and E.
Figure 7.7 Debt and Equity Funds with the
Optimal Risky Portfolio
Figure 7.8 Determination of the Optimal
Overall Portfolio
Figure 7.9 The Proportions of the Optimal
Complete Portfolio
Markowitz Portfolio Optimization Model
• Security selection
• The first step is to determine the risk-return opportunities available
• All portfolios that lie on the minimum-variance frontier from the global
minimum-variance portfolio and upward provide the best risk-return
combinations
Figure 7.10 The Minimum-Variance
Frontier of Risky Assets
Markowitz Portfolio Optimization Model
• Search for the CAL with the highest reward-to-variability ratio
• Everyone invests in P, regardless of their degree of risk aversion
• More risk averse investors put more in the risk-free asset
• Less risk averse investors put more in P
Figure 7.11 The Efficient Frontier of
Risky Assets with the Optimal CAL
Markowitz Portfolio Optimization Model
• Capital Allocation and the Separation Property
• Portfolio choice problem may be separated into two independent tasks
• Determination of the optimal risky portfolio is purely technical
• Allocation of the complete portfolio to risk-free versus the risky
portfolio depends on personal preference
Figure 7.13 Capital Allocation Lines with
Various Portfolios from the Efficient Set
Markowitz Portfolio Optimization Model
• The Power of Diversification
• Remember:
 p2 =  wi w j Cov ( ri , rj )
n n

i =1 j =1
• If we define the average variance and average covariance of the securities as:
1 n 2
 =  i
2

n i =1

Cov ( ri , rj )
n n
1
Cov = 
n ( n − 1) j =1 i =1
j i
Markowitz Portfolio Optimization Model
• The Power of Diversification
• We can then express portfolio variance as
1 2 n −1
 =  +
2
p Cov
n n
• Portfolio variance can be driven to zero if the average
covariance is zero (only firm specific risk)
• The irreducible risk of a diversified portfolio depends on the
covariance of the returns, which is a function of the
systematic factors in the economy
Table 7.4 Risk Reduction of
Equally Weighted Portfolios
Markowitz Portfolio Optimization Model
• Optimal Portfolios and Nonnormal Returns
• Fat-tailed distributions can result in extreme values of VaR and ES and
encourage smaller allocations to the risky portfolio
• If other portfolios provide sufficiently better VaR and ES values than the
mean-variance efficient portfolio, we may prefer these when faced with fat-
tailed distributions
Risk Pooling and
the Insurance Principle
• Risk pooling
• Merging uncorrelated, risky projects as a means to reduce risk
• It increases the scale of the risky investment by adding additional
uncorrelated assets
• The insurance principle
• Risk increases less than proportionally to the number of policies when the
policies are uncorrelated
• Sharpe ratio increases
Risk Sharing
• As risky assets are added to the portfolio, a portion of the pool is sold
to maintain a risky portfolio of fixed size
• Risk sharing combined with risk pooling is the key to the insurance
industry
• True diversification means spreading a portfolio of fixed size across
many assets, not merely adding more risky bets to an ever-growing
risky portfolio
Investment for the Long Run
• Long-Term Strategy
• Invest in the risky portfolio for 2 years
• Long-term strategy is riskier
• Risk can be reduced by selling some of the risky assets in year 2
• “Time diversification” is not true diversification
• Short-Term Strategy
• Invest in the risky portfolio for 1 year and in the risk-free asset for the
second year
Home Assignment 2
• Do problem 11, 12, 23, and CFA 4 and CFA5 of Chapter 5 of Problem
Sets.