CHAPTER 5 – CAPITAL ALLOCATION TO RISKY ASSETS

RISK & RISK AVERSION

- Investors are risk averse
- Prospect that has 0-risk premium is called fair game  investors who are risk averse reject
investment portfolios that are fair game or worse
- Risk-averse investors only consider risk-free or prospects with positive risk premium
Utility function
- Choice between expected return & risk, the latter measured by variance or SD
- Utility value viewed as measure of ranking portfolio  higher utility values are assigned to
portfolios with more attractive risk-return profiles
- Portfolios receives higher utility score for higher expected returns & lower scores for higher
vitality
U = E(r) - (½)Aσ2 U = utility value; A = index of investor’s risk aversion
- Utility is enhanced by high expected return and diminished by high risk
- More risk-averse (larger A)
- Risk aversion has major impact on investor’s risk-return tradeoff

Risk free rate in this case is 5%

Can see that high-risk portfolio would be
chosen only by investors with lowest risk
aversion degree

- We compare utility values to the rate offered on risk-free investments when choosing b/w risky
portfolio & safe one  “certainty equivalent” rate of return is utility value
- Certain equivalent rate of portfolio is the rate that risk-free investments would need to offer
with certainty to be considered equally attractive to risky portfolio
- We say that portfolio is desirable only if its certainty equivalent return exceeds that of risk-free
alternatives

- portfolio P is preferred by risk-averse

investor to any portfolio in quadrant IV because
it has higher E(r) and lower SD
- any portfolio in quadrant I is preferable
to portfolio P because higher E(r) and smaller SD

Mean-variance (M-V) criterion:

A dominates B if:
 E(rA) ≥ E(rB) AND σA ≤ σB

Indifference curve
**in previous graph, preferred direction is northwest because
in this direction we simultaneously increase E® and decrease
variance of rate of return
**What about quadrant II and III?  their desirability
compared to P depends on exact nature of investor’s risk
aversion
**Starting at P, increase in SD lowers utility  it must be
compensated by an increase in E(r), thus point Q is equally
desirable as P
**Investors will be equally attracted to portfolios with high
risk and high E(r) compared with other portfolios with lower
risk but lower E(r)
**These equally preferred portfolios line on indifference curve

A=4
All risk/return combinations produce utility
of U = 0.02
Thus rational investors are INDIFFERENT to
either portfolio

How can we estimate levels of risk aversion of individual? Questionaire

CAPITAL ALLOCATION ACROSS RISKY & RISK-FREE PORTFOLIOS

- Possible to split investment funds between safe and risky assets
- Risk free asset: proxy; T-bills
- Risky asset: stock (or a portfolio)
- Examine risk/return tradeoff
- Demonstrate how different degrees of risk aversion will affect allocations between risky and risk
free assets
Example: P = portfolio of risky assets, F = risk-free assets
- Assume risky portfolio comprises of 2 mutual funds: one invested in stocks & in long-term bonds
**When we shift wealth from the risky portfolio to the risk-free asste, we don’t change the relative
proportions of the various risky assets within the risky portfolio  rather we reduce the relative weight
of the risky portfolio as a whole
- Assume that total market value of portfolio is $300,000  $90,000 is invested in risk-free,
remaining $210,000 invested in risky assets ($113,400 in equities & $96,600 in long-term bonds)
- The E and B holding in the risky portfolio:
WE = 113,400/210,000 WB = 96,600/210,000
= 54% = 46%
- The weight of risky portfolio P in the complete portfolio, denoted by y
y = 210,000/300,000 1-y = 90,000/300,000
= 70% = 30%
- The weight of each stock in the complete portfolio:
E: 113,400/300,000 B: 96,600/300,000
 = 37.8% = 32.2%
Suppose the owner wants to decrease risk by reducing the allocation to the risky portfolio from y=70%
to y=56%. The risky portfolio would total only $168,000 (56% * 300,000), requiring sale of $42,000, with
proceeds to purchase more shares in risk-free asset.
- The total holdings in risk-free assets will increase to:
90,000 + 42,000 = $132,000 OR 300,000 (1 - .56) = 132,000
The key point is that we leave the proportions of each stock in the risky portfolio unchanged (54% and
46%), so we sell:
E: 54% * 42,000 B: 46% * 42,000
=22,680 = 19,320
As long as we don’t alter the weights of each stock within the risky portfolio, the probabilty distribution
of the rate of return on the risky portfolio remains unchanged by the asset reallocation  what will
change is the probability distribution of the rate of return on the complete portfolio

RISK-FREE ASSET
- Only gov’t can issue default-free bonds bc of their power to tax and control money supply
- Only risk-free asset in real terms is perfectly price-indexed bond
o Offers guaranteed real rate to investor only if maturity of bond = investor’s desired
holding period
- But T-bills are commonly viewed as “the” risk-free asset because their short-term nature makes
their value insensitive to interest rate fluctuations
- In practice, most investors use broader range of money market instruments as risk-free asset 
all the money market instruments are virtually free of interest rate risk because of their short
maturities & are fairly safe in terms of default or credit risk
- Money market funds – the most accesible risk-free asset for most investors
o For the most part holds 3 types: T-bills, bearer deposit notes (BDN), commercial paper
(CP)

PORTFOLIO OF 1 RISKY ASSET & 1 RISK-FREE ASSET

Suppose investor already decided on composition of optimal risky portfolio P. Now concern is with
capital allocation of y to be allocated to P and 1-y to be allocate to risk-free assets F.
Assume E(rp) = 15% and σp = 22%; rf = 7% and σf = 0%
Thus, the risk premium on risk asset = 15 – 7 = 8%
With proportion y in risky portfolio and 1-y in risk-free asset, rate of return on COMPLETE portfolio,
denoted by C, is rC
rC = yrp + (1 – y) rf
Portfolio’s expected return is
E(rc) = yE(rp) + (1 - y)rf
= rf + y[E(rp) – rf)]
Since SD of risk-free = 0, SD of complete portfolio = SD of risky * weight of risky asset
σc = yσp

[𝐸(𝑟𝑃 )−𝑟𝑓]
**Slope of the line is simply
Basically risk premium/ SD of P
*The straight line is capital allocation line
CAL  depicts all risk-return
combinations available
*it’s the set of feasible expected return &
SD pairs of all portfolios resulting from
different values of y
* e.g.: when y = 1, SDp = 22%, when y = 0,
SD p = 0
*Slope of CAL = increase in expected
return of chosen portfolio per unit of
additional SD  measure of extra return
per extra risk  also called reward-to-
volatility ratio or Sharpe ratio
𝜎𝑃
or rise/run

USING LEVERAGE WITH CAL

Suppose investment budget is $300,000, and investor borrows additional 120,000 to invest in risky asset
 this is levered position in risky asset.
y = 420,000/300,000 = 1.4
rc = rf + y[E(rP) – rf
rc = 07 + (1.4) (.15-.07) = 0.182 = 18.2%

Opportunity set with differential borrowing and lending rates

Suppose the borrowing
rate rBf = 9%, then slope of
CAL will be (.15 - .09)/.22 =
.27
CAL will be kinked at point
P  the left of P, investor is
lending at 7% and slope of
CAL is .36  the right of P
where y>1, investor is
borrowing to finance extra
investments in risky asset,
and slope is. 27
RISK TOLERANCE & ASSET ALLOCATION
- Individual differences in risk aversion lead to
different capital allocation choices even when
facing identical opportunity set
- More risk-averse investors will choose to hold
less risky asset & more risk-free
- Investors choose allocation to risky asset y that
maximizes their utility function
- As allocation to risky asset increases (higher y),
expected return increases, but also does
vitality, so utility can increase or decrease

Graph shows utility is highest

when y =.41
When y < .41, investors are
willing to assume more risk
to increase expected return,
but at higher levels of y, risk
is higher, and additional
allocations to risky asset are
undesirable  beyond this point, further increases in risk dominate increase in expected return &
reduce utility

To solve utility maximization problem we write problem as follow:

Max U = E(rC) – ½ Aσ2C
= rf + y[E(rP) – rf] – ½ Ay2σP2

Maximization problem is solved by setting the derivative of this expression to 0  doing so yields
optimal position for risk-averse investors in the risky asset y*
𝐸(𝑟𝑃 )−𝑟𝑓
y* = 𝐴𝜎𝑃2

Using the previous example where rf = 7%, E(rP) = 15%, and σp = 22%. If investors has coefficient of risk
aversion A = 4
.15−.07
y* = 4∗.222 = .41
This means the investor will invest 41% in risky and 59% in risk-free
Investors would prefer a portfolio on the higher
indifference curve with higher certainty equivalent
(utility)  portfolios on higher indifference curves
offer higher expected return for any given level of
risk
More risk-averse investors have steeper indifference
curves than less risk-averse

**The indifference curve is tangent

to CAL and the tangency point
corresponds to the SD & expected
return of the optimal complete
portfolio
**The line that doesn’t intersect
CAL  not realistic, not achievable
expectation
**You want point of tangency
because that’s where the optimal
utility is, the higher the utility line
goes the better, but too high away
from CAL is not realistic  want ≠
achieve