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Chap 006

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6 views34 pages

Chap 006

Uploaded by

Nguyễn Hồng Hạnh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 6

Risk Aversion and Capital


Allocation to Risky Assets

INVESTMENTS | BODIE, KANE, MARCUS


McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2

Allocation to Risky Assets

• Investors will avoid risk unless there


is a reward.
• How much reward is enough?

• The utility model gives the optimal


allocation between a risky portfolio
and a risk-free asset.

INVESTMENTS | BODIE, KANE, MARCUS


6-3

Risk and Risk Aversion


• Speculation
– Taking considerable risk for a
commensurate gain

– Parties have heterogeneous


expectations

INVESTMENTS | BODIE, KANE, MARCUS


6-4

Risk Aversion and Utility Values


• Investors are willing to consider:
– risk-free assets
– speculative positions with positive risk
premiums

INVESTMENTS | BODIE, KANE, MARCUS


6-5

Mean-Variance (M-V) Criterion

• Portfolio A dominates portfolio B if:

E (rA )  E (rB )
• And
A B
• What happens when return increases
with risk?

INVESTMENTS | BODIE, KANE, MARCUS


6-6

Table 6.1 Available Risky Portfolios (Risk-


free Rate = 5%)

Which one do you prefer?

INVESTMENTS | BODIE, KANE, MARCUS


6-7

Utility Function

U = utility
E ( r ) = expected
return on the asset 1
or portfolio U = E ( r ) − A 2

A = coefficient of risk 2
aversion
2 = variance of
returns
½ = a scaling factor
INVESTMENTS | BODIE, KANE, MARCUS
6-8

Table 6.2 Utility Scores of Alternative Portfolios for


Investors with Varying Degree of Risk Aversion

INVESTMENTS | BODIE, KANE, MARCUS


6-9

Estimating Risk Aversion

• Use questionnaires

• Observe individuals’ decisions when


confronted with risk

• Observe how much people are willing to


pay to avoid risk

INVESTMENTS | BODIE, KANE, MARCUS


6-10

Capital Allocation Across Risky and Risk-


Free Portfolios
Asset Allocation: Controlling Risk:

• Is a very important • Simplest way:


part of portfolio Manipulate the
construction. fraction of the
portfolio invested in
• Refers to the choice risk-free assets
among broad asset versus the portion
classes. invested in the risky
assets

INVESTMENTS | BODIE, KANE, MARCUS


6-11

Basic Asset Allocation


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

INVESTMENTS | BODIE, KANE, MARCUS


6-12

Basic Asset Allocation

• Let y = weight of the risky portfolio, P,


in the complete portfolio; (1-y) = weight
of risk-free assets:

INVESTMENTS | BODIE, KANE, MARCUS


6-13

The Risk-Free Asset


• Only the government can issue
default-free bonds.
– Risk-free in real terms only if price
indexed and maturity equal to investor’s
holding period.
• T-bills viewed as “the” risk-free asset
• Money market funds also considered
risk-free in practice

INVESTMENTS | BODIE, KANE, MARCUS


6-14

Figure 6.3 Spread Between 3-Month


CD and T-bill Rates

INVESTMENTS | BODIE, KANE, MARCUS


6-15

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.

INVESTMENTS | BODIE, KANE, MARCUS


6-16

Example Using Chapter 6.4 Numbers

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf

INVESTMENTS | BODIE, KANE, MARCUS


6-17

Example (Ctd.)
The expected
return on the
complete E ( rc ) = r f + y  E ( rP ) − r f 
portfolio is the
risk-free rate

E(rc ) = 7 + y(15 − 7)
plus the weight
of P times the
risk premium of
P
INVESTMENTS | BODIE, KANE, MARCUS
6-18

Example (Ctd.)

• The risk of the complete portfolio is


the weight of P times the risk of P:
 C = y P = 22 y
C
y=
P
INVESTMENTS | BODIE, KANE, MARCUS
6-19

Example (Ctd.)
• Rearrange and substitute y=C/P:
C
E (rC ) = rf +
P
E (rP ) − rf  = 7 +  C
8
22
• This equation presents the relation between
Exp. Return and
Risk of the Complete Portfolio!
E (rP ) − rf 8
Slope = =
P 22

INVESTMENTS | BODIE, KANE, MARCUS


6-20

Figure 6.4 The Investment


Opportunity Set

INVESTMENTS | BODIE, KANE, MARCUS


6-21

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

INVESTMENTS | BODIE, KANE, MARCUS


6-22

Figure 6.5 The Opportunity Set with


Differential Borrowing and Lending Rates

INVESTMENTS | BODIE, KANE, MARCUS


6-23

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 ) − r f 
– Variance:
 =y
2
C
2 2
P

INVESTMENTS | BODIE, KANE, MARCUS


6-24

Table 6.4 Utility Levels for Various Positions in Risky


Assets (y) for an Investor with Risk Aversion A = 4

INVESTMENTS | BODIE, KANE, MARCUS


6-25

Figure 6.6 Utility as a Function of


Allocation to the Risky Asset, y

INVESTMENTS | BODIE, KANE, MARCUS


6-26

Indifference Curves and Assets Allocation

• Different combinations of risk and return


that yield the same level of utility to
investors.

INVESTMENTS | BODIE, KANE, MARCUS


6-27

Table 6.5 Spreadsheet Calculations of Exp.


Return for Indifference Curves

INVESTMENTS | BODIE, KANE, MARCUS


6-28

Figure 6.7 Indifference Curves for


U = .05 and U = .09 with A = 2 and A = 4

INVESTMENTS | BODIE, KANE, MARCUS


6-29

Figure 6.8 Finding the Optimal Complete


Portfolio Using Indifference Curves

INVESTMENTS | BODIE, KANE, MARCUS


6-30

Table 6.6 Expected Returns on Four


Indifference Curves and the CAL

INVESTMENTS | BODIE, KANE, MARCUS


6-31

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

INVESTMENTS | BODIE, KANE, MARCUS


6-32

Passive Strategies:
The Capital Market Line
• A natural candidate for a passively held
risky asset would be a well-diversified
portfolio of common stocks such as the
S&P 500.
• The capital market line (CML) is the capital
allocation line formed from 1-month T-bills
and a broad index of common stocks (e.g.
the S&P 500).

INVESTMENTS | BODIE, KANE, MARCUS


6-33

Passive Strategies:
The Capital Market Line

• The CML is given by a strategy that


involves investment in two passive
portfolios:

1. virtually risk-free short-term T-bills (or


a money market fund)
2. a fund of common stocks that mimics
a broad market index.
INVESTMENTS | BODIE, KANE, MARCUS
6-34

Passive Strategies:
The Capital Market Line

• From 1926 to 2009, the passive risky


portfolio offered an average risk premium
of 7.9% with a standard deviation of
20.8%, resulting in a reward-to-volatility
ratio of .38.

INVESTMENTS | BODIE, KANE, MARCUS

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