Investor’s Utility and Capital Allocation

Line

PREPARED BY:
DR. HANAN AMIN
The Efficient Frontier
 The efficient frontier represents that set of optimal portfolios that
offers the maximum rate of return for every given level of risk, or
the minimum risk for every level of return.
Minimum-Variance Portfolios The investment opportunity set consisting
of all available investable sets is shown in Exhibit 25. There are a large
number of portfolios available for investment, but we must choose a single
optimal portfolio.
Efficient Frontier of Risky Assets

 The curve that lies above and to the right of the global minimum-
variance portfolio is referred to as the Markowitz efficient frontier
because it contains all portfolios of risky assets that rational, risk-averse
investors will choose. The increase in return with every unit increase in
risk, however, keeps decreasing as we move from left to the right
because the slope continues to decrease.
Efficient Frontier
 Risk-averse investors seek to minimize risk for a given return. Consider Points A, B,
and X in Exhibit 25 and assume that they are on the same horizontal line by
construction. Thus, the three points have the same expected return, E(R1), as do all
other points on the imaginary line connecting A, B, and X. Given a choice, an
investor will choose the point with the minimum risk, which is Point X. Point X,
however, is unattainable because it does not lie within the investment opportunity set.
 Thus, the minimum risk that we can attain for E(R1) is at Point A. Point B and all
points to the right of Point A are feasible but they have higher risk. Therefore, a risk-
averse investor will choose only Point A in preference to any other portfolio with the
same return. Similarly, Point C is the minimum variance point for the return earned at
C. Points to the right of C have higher risk.
Utility Theory and Indifference Curves
 A risk-averse investor is simply one that dislikes risk (i.e., prefers
less risk to more risk). Given two investments that have equal
expected returns, a risk-averse investor will choose the one with
less risk (standard deviation, ς).
A simple implementation of utility theory allows us to quantify the
rankings of investment choices using risk and return.
Risk Aversion For Different types on investors
Utility and Indifference Curves
 Utility is a measure of relative satisfaction that an investor derives from different portfolios. We can
generate a mathematical function to represent this utility that is a function of the portfolio expected
return, the portfolio variance and a measure of risk aversion.

 U = E(r) – ½Aσ2
 Where:
 where, U is the utility of an investment, E(r) is the expected return, and ς2 is the variance of the investment.
 •The risk aversion coefficient, A, is greater than zero for a risk-averse investor. So any increase in risk
reduces his/her utility.
 • The risk aversion coefficient for a risk-neutral investor is 0, and changes in risk do not affect his/her utility.
 • For a risk lover, the risk aversion coefficient is negative, creating an inverse situation so that additional risk
contributes to an increase in his/her utility.
 • Note that a risk-free asset (ς2 = 0) generates the same utility for all individuals
An indifference curve plots the combinations of risk-return pairs that an investor would
accept to maintain a given level of utility. Indifference curves are thus defined in terms of
a trade-off between the expected rate of return and variance of the rate of return .
Indifference Curve
 An indifference curve plots combinations of risk and expected return that provide the same
expected utility. Indifference curves for risk and return slope upward “run northeast”
because risk-averse investors will only take on more risk if they are compensated with
greater expected returns. It has the steepest slope. An investor who is more risk-seeking
has an indifference curve that is much flatter as their demand for increased returns as risk
increases is much less acute. In other words, the indifference curves of a more risk-averse
investor will be steeper than those of a less risk-averse investor, reflecting a higher risk
aversion coefficient.
 The investor’s expected utility is the same for all points (portfolios) along any single
indifference curve. Portfolios along indifference curve I1 in Exhibit 13 are preferred to all
portfolios along I2, which are preferred to all portfolios along I3.
 N.B Highest Utility I1,Moderate Utility I2,Low Utility I3.
According to Markowitz, An investor’s optimal risky portfolio is
determined where the investor’s highest utility curve is tangent to
the efficient frontier.
The Two-fund Separation Theorem
 The two-fund separation theorem states that all investors, regardless of taste,
risk preference, and initial wealth, will hold a combination of two portfolios
or funds: a risk-free asset and an optimal portfolio of risky assets. This
allows us to break the portfolio construction problem into two distinct steps:
an investment decision and a financing decision.
 To start with, the optimal risky asset portfolio using the risk, return and
correlation characteristics of the underlying assets dictate the investment
decision. Besides, considering an investor’s risk preference, a determination
is made on the allocation to the risk-free asset. Plotting the risk-free asset
with the risky portfolio on a graph creates the capital allocation line (CAL).
Financing decision involves whether you will lend or borrow your money.
Capital Allocation Line: The line of possible portfolio risk
and return combinations given the risk-free rate and the risk and return of a
portfolio of risky assets is referred to as the capital allocation line (CAL). For
an individual investor, the best CAL is the one that offers the most-preferred
set of possible portfolios in terms of their risk and returns
A Risk-Free Asset and Many Risky Assets Capital
Allocation Line and Optimal Risky Portfolio
 The two-fund separation theorem states that all investors regardless of taste, risk preferences,
and initial wealth will hold a combination of two portfolios or funds: a risk-free asset and an
optimal portfolio of risky assets.
 The separation theorem allows us to divide an investor’s investment problem into two distinct
steps: the investment decision and the financing decision. In the first step, as in the previous
analysis, the investor identifies the optimal risky portfolio.
 the individual investor’s risk preference determines the amount of financing (i.e., lending to
the government instead of investing in the optimal risky portfolio or borrowing to purchase
additional amounts of the optimal risky portfolio).
 The optimal portfolio is determined by the intersection between the CAL and indifference
curve .
 CAL has a higher return than efficient frontier as investors can borrow at risk-free rate.
Capital Allocation Line (CAL)

Point X on the capital allocation line in this Figure represents a portfolio that is 40% invested in the risky
asset portfolio and 60% invested in the risk-free asset.
Investor Preferences
 A highly risk-averse investor may choose to invest only in the risk-free asset. A
less risk-averse investor may, on the contrary, have a small portion of their
wealth invested in the risk-free asset and a large portion invested in the risky
portfolio. Investors with a high-risk tolerance may, in fact, choose to borrow
and invest in a risky portfolio. This enables the investor to invest more than
100% of their assets and create a leveraged portfolio.
We can overlay an investor’s indifference curve with the capital
allocation line to determine their optimal portfolio .
Risk-Averse Investor’s Indifference Curves
Risk-Averse Investor’s Indifference
Curves
 Now that we have constructed a set of the possible efficient portfolios
(the capital allocation line), we can combine this with indifference curves
representing an individual’s preferences for risk and return to illustrate
the logic of selecting an optimal portfolio (i.e., one that maximizes the
investor’s expected utility).
 In the previous figure, we can see that Investor A, with preference
represented by indifference curves I1, I2, and I3, can reach the level of
expected utility on I2 by selecting Portfolio X. This is the optimal
portfolio for this investor, as any portfolio that lies on I2 is preferred to all
portfolios that lie on I3 (and in fact to any portfolios that lie between I2
and I3). Portfolios on I1 are preferred to those on I2, but none of the
portfolios that lie on I1 are available in the market.
Example on Utility function
 Using the utility function U = E (r) – ½Aσ2 and assuming A = -4, which of
the following statements best describes the investor’s attitude to risk?
 A. The investor is risk-neutral.
 B. The investor is risk-averse.
 C. The investor is risk-seeking.
Solution

 The correct answer is C.

 A negative risk aversion coefficient (A = -4) means the investor
receives a higher utility (more satisfaction) for taking more portfolio
risk. A risk-averse investor would have a risk aversion coefficient
greater than 0 while a risk neutral investor would have a risk
aversion coefficient equal to 0.
Indifference curves with higher utility than this one lie above the capital allocation line, so
their portfolios are not achievable. Indifference curves that lie below this one are not
preferred because they have lower utility. Thus, the optimal portfolio for the investor with
this indifference curve is portfolio C on CAL(P), which is tangent to the indifference curve
Solution:
Assignment on Utility