Capital Allocation Across Risky

Capital Allocation Across Risky
and Risk-Free Portfolios

Capital Allocation Across Risky and Risk-
Free Portfolios
Asset Allocation: Controlling Risk:
• Is a very important
part of portfolio • Simplest way:
construction. Manipulate the
fraction of the
• Refers to the choice
among broad asset portfolio invested in
classes. risk-free assets
versus the portion
invested in the risky
assets
Basic Asset Allocation
Portfolio Total Market Value $300,000
Risk-free money market fund $90,000
Equities $113,400
Bonds (long-term) $96,600
Total risk assets $210,000
$113,400 $96,600
WE   0.54 WB   0.46
$210,000 $210,00
These weights are within the risky portfolio
Q. What is the risk-free vs risky composition?
Basic Asset Allocation Example
Total market value $300,000
Risk-free money market fund $90,000
Equities $113,400
Bonds (long-term) $96,600
Total risk assets $210,000
$113,400 $96,600
WE   0.54 WB   0.46
$210,000 $210,00
Basic Asset Allocation Example
Let
y = Weight of the risky portfolio, P, in the complete
portfolio
(1-y) = Weight of risk-free assets
$210,000 $90,000
y  0.7 1 y   0.3
$300,000 $300,000
Proportion In Equity: Proportion in Bond:

$113,400
E:  .378 $96,600
$300,000 B:  .322
$300,000
The Risk-Free Asset
• 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
• (caveat, remember fall 2008?)
Portfolios of One Risky Asset and a 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
6-21
Portfolios of One Risky Asset and a Risk-Free

Asset
You can create a complete portfolio by splitting
funds between safe and risky assets. Let:
• y = portion allocated to the risky portfolio, p
• (1-y) = portion to invest in risk-free asset, f.
Build a complete portfolio C: rC  yrp  1 y rf
Take expectations: ErC  yErp  1 yr f
Rearrange terms: E rC  r f  yE rp  r f 

p
 
risk premium
Q. What’s the porfolio’s c?
Capital Allocation Line
• CAL depicts all the risk-return combinations
available to investors.
• The Slope of CAL, denoted by S, equals the
increase in the expected return of the
complete portfolio per unit of additional
standard deviation – in other words,
incremental return per incremental risk.
• Slope is also called reward-to-volatility ratio.
• Its also called Sharpe’s ratio.
Capital Allocation Formula
CAL Contd.
• Capital allocation line (CAL) is a graph created
by investors to measure the risk of risky and
risk-free assets.
• The graph displays the return to be made by
taking on a certain level of risk.
• Its slope is known as the "reward-to-
variability ratio“
CAL
Note On : Slope and y-intercept
• Every straight line can be represented by an equation: y =
mx + b.
• The coordinates of every point on the line will solve the
equation if you substitute them in the equation for x and y.
• The slope m of this line - its steepness, or slant - can be
calculated like this:
m = change in y-value
change in x-value
• The equation of any straight line, called a linear equation,
can be written as: y = mx + b, where m is the slope of the
line and b is the y-intercept
• The y-intercept of this line is the value of y at the point
where the line crosses the y axis
Slope and Intercept contd.
Example
Risky Risk-free
E(rp) = 15% rf = 7%
p = 22% rf = 0%
y = % in p (1-y) = % in rf
6-23
Example (Ctd.)
The expected
return on the ErC  r f  yE rp-rf 
complete
risk premium
portfolio is the
risk-free rate plus
the weight of P E rc  7  y 15  7 
times the risk
premium of P
One Risky Asset and a Risk-Free Asset:
Example
rf = 7% rf = 0%
E(rp) = 15% p = 22%
• The expected return on the complete portfolio:

E rc   7  y15  7
• The risk of the complete portfolio:
 C  y P  22 y
6-24
Example (Ctd.)
• The risk of the complete portfolio is
the weight of P times the risk of P
because the risk free asset has
zero standard deviation:
C  y P 22y
y=C / P
6-25
Example (Ctd.)
Place the two portfolios P and F on the {r,}
plane. Varying y from 0 to 1 describes a line
between F and P, what is the slope?
Rearrange and substitute y=C / P:
C
E rC  r f 
P
 
ErP  r f 7   C
8
22
E rP  rf
Slope   8 Intercept  rf  7
P 22
The Investment Opportunity Set
Figure 6.4 The Investment
Opportunity Set
y =1
Q. What’s the
value of y
here?
What does it
mean?
y =0
Capital Allocation Line with Leverage
• y>1 means borrow money to lever up
your investment (e.g. buy on margin)
• There is asymmetry: lend (or invest) 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
• 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   rf 
Variance of the overall portfolio:
 y
2
c
2 2
p

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Capital Allocation Across Risky

and Risk-Free Portfolios

Proportion In Equity: Proportion in Bond:

• Only the government can issue default-free

Portfolios of One Risky Asset and a Risk-Free

• The expected return on the complete portfolio:

• The investor must choose one optimal

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