FMT – IPM

Lecture 3

Ms. Thi Van Anh Nguyen, PhD Candidate

Part 1
Chapter 6: Risk aversion and capital allocation
1 Risk and risk
aversion
 Risk Aversion of investors

• Risk aversion (tolerance) is the investor’s degree

of reluctance to accept risk
• Investor’s view of risk (risk tolerance)
– Risk Averse
– Risk Neutral
– Risk Seeking
• Risk-averse investors consider only risk-free or
risky prospects with positive risk premiums, i.e.,
provide higher return than the risk free rate of
return.
– Risk aversion experiment
Investment Investor

Risk
Risk
Aversion
Risk aversion

 Risk-averse investors only consider risk-free or risky

investments with positive risk premiums, i.e., provide
higher return than the risk-free rate of return.

 In a market dominated by risk-averse investors, other

things held constant, the higher a security’s risk, the
higher its required return.
 Factors affecting risk
aversion/tolerance

• Investment circumstances and conditions

• Investment experience
• Emotional aspects
– Emotional time line (mainly hope and fear)
– Fear: leads to a desire for security
– Hope: leads to a desire for potential upside
• Overconfidence
– May lead to overtrading.
Risk and risk aversion

Stock A B
Return (%) 20 18 A dominates B
Risk (%) 25 30

Stock A C
Return (%) 20 18
Risk (%) 25 20
 Risk and risk aversion

• Mean-Variance (M-V) Criterion

– Portfolio A dominates portfolio B if:

E rA   E rB 
and
A B
• Portfolio attractiveness increases with expected
return and decreases with risk
• What happens when return increases with risk?
 Risk and Risk Aversion
• Utility Values
• Score to competing portfolios on the basis of the expected returns and risk of
those portfolios. how much return compensate per unit of risk

• Higher utility values  more attractive risk – return profiles (higher return and
lower risk)
• Investors are willing to consider:
• Risk-free assets
• Speculative positions with positive risk premiums
• Now consider the following portfolios: read table 6.2 in textbook
 Risk Aversion and Utility
Values
• Utility Function
• U = Utility
• E(r) = Expected return on the asset or portfolio
• A = Coefficient of risk aversion
• σ2 = Variance of returns
• ½ = A scaling factor

U  E r   1 A 2
2
 Risk Aversion and Utility
Values

fear risk more => A higher

• Risk adverse: A > 0
• Risk neutral: A = 0
• Risk taking: A < 0

U  E r   1 A 2
2
 Utility Scores of Portfolios with
Varying Degrees of Risk Aversion

Each portfolio receives a utility score to assess the

investor’s risk/return trade off.
 Utility Scores of Portfolios with
Varying Degrees of Risk Aversion

Investor Risk aversion = 4

 Which Portfolio will he choose?

Utility L = 0.07 - 1/2 x 4 x 0.052 = 0.065

Utility M = 0.09 - 1/2 x 4 x 0.12 = 0.070
Utility H = 0.13 - 1/2 x 4 x 0.22 = 0.050
2 Capital allocation
Across Risky and Risk-Free Portfolios
 Capital Allocation Across
Risky & Risk-Free Portfolios

• Asset Allocation
• The choice among broad asset classes that
represents a very important part of portfolio
construction
• The simplest way to control risk is to
manipulate the fraction of the portfolio
invested in risk-free assets versus the
portion invested in the risky assets
 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

Bonds
Risky Portfolio (P)
Complete Portfolio (C) Equities
Risk-free assets
 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 (C)
– (1-y) = Weight of risk-free assets

$210,000 $90,000
y  0.7 1 y   0 .3
$300,000 $300,000

$113,400 $96,600
E:  .378 B:  .322
$300,000 $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
 One Risky Asset and a
Risk-Free Asset: Example
rf = 7% rf = 0%
E(rp) = 15% p = 22% risky

• The expected return on the complete portfolio:

E(r C) = yE(r P) + (1 - y)r f
= rf + y[E(r P) - rf] = 7 + y(15 - 7)
• The risk of the complete portfolio:
C  y P  22y
 p 2  W12 12  2W1W 2 Cov(r1, r2 )  W 2 2  2 2
cov(r1, r2)= p*sigma1*sigma2
 One Risky Asset and a
Risk-Free Asset: Example
• Rearrange and substitute y = σC/σP:
C 8
E rC   rf 
P
E rP   rf   7   C
22
E  rP   rf 8
Slope  
P 22
 One Risky Asset and a
Risk-Free Asset: Example
• The next step is to plot the portfolio characteristics (with various
choices for y) in the expected return–standard deviation plane
• The risk-free asset, F, appears on the vertical axis because its
standard deviation is zero.
• The risky asset, P, is plotted with a standard deviation of 22%, and
expected return of 15%.
• If an investor chooses to invest solely in the risky asset, then y = 1.0,
and the complete portfolio is P.
• If the chosen position is y = 0, then 1 − y = 1.0, and the complete
portfolio is the risk-free portfolio, F.
• What about the more interesting midrange portfolios where y lies
between 0 and 1? These portfolios will graph on the straight line
connecting points F and P. The slope of that line is in this case
equals 8/22.
One Risky Asset & a Risk-Free Asset:
The Investment Opportunity Set
 One Risky Asset & a Risk-Free Asset:
The Investment Opportunity Set

• This straight line is called the capital

allocation line (CAL). It depicts all the risk–
return combinations available to investors.
• The slope of the CAL, denoted 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. The
slope, the reward to-volatility ratio, is usually
called the Sharpe ratio
S = [E(r ) − r ]/σ
C f C
One Risky Asset & a Risk-Free Asset:
The Investment Opportunity Set
 One Risky Asset & a Risk-Free Asset:
The Investment Opportunity Set

• In fact, borrowing rate should be greater

than lending rate (for market taker)
• Lend at rf = 7% and borrow at rf = 9%
• Lending range slope = (15-7)/22 = 0.36
• Borrowing range slope = (15-9)/22 = 0.27
• CAL kinks at P
One Risky Asset & a Risk-Free Asset:
The Investment Opportunity Set
 One Risky Asset & a Risk-Free Asset:
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 r p   r f 
– Variance:
2 2 2
 c  y  p
One Risky Asset & a Risk-Free Asset:
Utility Levels for Various Positions in
Risky Assets
One Risky Asset & a Risk-Free Asset:
Utility as a Function of Allocation to
the Risky Asset, y
 One Risky Asset & a Risk-Free Asset:
Utility as a Function of Allocation to
the Risky Asset, y
• Investors choose the allocation to the risky asset, y, that maximizes
their utility function as given by Equation: U = E(r) − ½ Aσ
• As the allocation to the risky asset increases (higher y), expected
return increases, but so does volatility, so utility can increase or
decrease. Initially, utility increases as y increases, but eventually it
declines.
• To solve the utility maximization problem more generally, we write the
problem as follows:

• The maximization problem is solved by setting the derivative of this

expression to zero. Doing so and solving for y gives us the optimal
position for risk-averse investors in the risky asset, y*, as follows:
One Risky Asset & a Risk-Free Asset:
The Indifference Curve

Indifference
Curves for
U = 0.05 &
U = .09
with
A = 2 and
A=4
One Risky Asset & a Risk-Free Asset:
Find the Optimal Complete Portfolio
 Passive Strategies:
The Capital Market Line
• The passive strategy avoids any direct or
indirect security analysis
• Supply and demand forces may make
such a strategy a reasonable choice for
many investors
• A natural candidate for a passively held
risky asset would be a well-diversified
portfolio of common stocks such as the
S&P 500
 Passive Strategies:
The Capital Market Line
• The Capital Market Line (CML or CAL)
• Is a capital allocation line formed investment in
two passive portfolios:
1. Virtually risk-free short-term T-bills (or a
money market fund)
2. Fund of common stocks that mimics a broad
market index
• From 1926 to 2012, the passive risky portfolio
offered an average risk premium of 8.1% with a
standard deviation of 20.48%, resulting in a
reward-to-volatility ratio of .40
Part 2
Chapter 7: OPTIMAL RISKY PORTFOLIOS
1 The investment
decision
The top down process
 The investment process

• 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 marketwide risk sources
and remains even after extensive
diversification
• Also call systematic or nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic
 Market risk vs Firm Specific risk?
- Inflation risk
- Business risk
- Default risk
- Interest rate risk
- Financial risk
- Exchange rate risk it depends
 Portfolio Risk and the Number Figure 7.1:
of Stocks

Panel A: All risk is firm specific. Panel B: Some risk is systematic

or marketwide.
market risk is undiviersible risk
Portfolio Diversification

cannot diversify

Figure 7.2
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:
2 2 2 2 2
  w   w   2 wD wE Cov  rD , rE 
p D D E E
2
–  D = Bond variance
2
–  E = Equity variance

– C ov  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) = rDEDE

– rD,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 r1,2

+ 1.0 > r > - 1.0
– If r = 1.0, the securities are perfectly positively
correlated
– If r = - 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
 Portfolios of Two Risky Assets:
Correlation Coefficients

• The amount of possible risk reduction through

diversification depends on the correlation:

• If r = +1.0, no risk reduction is possible

• If r = 0, σP may be less than the standard deviation of

either component asset

• If r = -1.0, a riskless hedge is possible

 Figure 7.3
Portfolio Expected Return
Portfolio Standard Deviation Figure 7.4
Portfolio Expected Return as a Figure 7.5
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 Opportunity Set of the D and E Figure 7.6
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   r f
Sp 
p

• The slope is also the Sharpe ratio

Debt and Equity Funds with Figure 7.7
the Optimal Risky Portfolio
Determination of the Figure 7.8
Optimal Overall Portfolio
The Proportions of the Figure 7.9
Optimal Complete Portfolio
2 Markowitz Portfolio
Optimization Model
Efficient frontier
 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
The Minimum-Variance Figure 7.10
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
The Efficient Frontier of Figure 7.11
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
Capital Allocation Lines with Various Figure 7.13
Portfolios from the Efficient Set