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Topic 1 (Ch. 6) Capital Allocation to Risky Assets

- Risk with simple prospects
- Investor’s view of risk
- Risk aversion and utility
- Trade-off between risk and return
- Asset risk versus portfolio risk
- Capital allocation across risky and risk-free portfolios

- The presence of risk means that more than one outcome is possible.
- A simple prospect is an investment opportunity in which a certain initial wealth is placed at risk, and there are only two possible outcomes.
- Take as an example initial wealth, W, of $100,000, and assume two possible results in one year.

The variance of end-of-year wealth:

(the expected value of the squared deviation of each possible outcome from the mean)

- The standard deviation of end-of-year wealth:

(the square root of the variance)

Suppose that at the time of the decision, a one- year T-bill offers a risk-free rate of return of 5%; $100,000 can be invested to yield a sure profit of $5,000.

The expected marginal, or incremental,

profit of the risky investment over investing

in safe T-bills is:

$22,000 - $5,000 = $17,000

- One can earn a risk premium of $17,000 as

compensation for the risk of the investment.

- One of the central concerns of finance theory is the measurement of risk and the determination of the risk premiums that investors can expect of risky assets in well-functioning capital markets.

Investor’s View of Risk

- Risk averse:Considers only risk-free or risky prospects with positive risk premia.
- Risk neutral:Finds the level of risk irrelevant and considers only the expected return of risky prospects.
- Risk lover:Accepts lower expected returns on prospects with higher amounts of risk.

Risk Aversion and Utility

- Assume that each investor can assign a welfare, or utility, score to competing investment portfolios (collections of assets) based on the expected return and risk of those portfolios.
- The utility score may be viewed as a means of ranking portfolios. Higher utility values are assigned to portfolios with more attractive risk-return profiles. Portfolios receive higher utility scores for higher expected returns and lower scores for higher volatility.

One utility function that is commonly used:

- where U: utility valueE(r): expected return2: variance of returns A: index of the investor’s risk aversion

Consistent with the notion that utility is enhanced by high expected returns and diminished by high risk.

Example 1:

Choose between:

(1) T-bills providing a risk-free return of 5%.

(2) A risky portfolio with E(r)= 22% and

= 34% .

A = 3:

T-bills: U = 0.05 – 0 = 0.05.

Risky portfolio: U = 0.22 – 0.5 3 (0.34)2

= 0.0466.

Choose T-bills.

Example 2:

Risk-free rate = 5%

The extent to which variance lowers utility depends on A, the investor’s degree of risk aversion. More risk-averse investors (who have the larger As) penalize risky investments more severely.

- Investors choosing among competing investment portfolios will select the one providing the highest utility level.

Trade-off between Risk and Return

- Portfolio P has expected return E(rP)and standard deviation P.

P is preferred by risk-averse investors to any portfolio in quadrant IV because it has an expected return any portfolio in that quadrant and a standard deviation any portfolio in that quadrant.

- Conversely, any portfolio in quadrant I is preferable to portfolio P because its expected return P’s and its standard deviation P’s.

The mean-standard deviation or mean-variance (M-V) criterion:

- A dominates B if

and

and at least one inequality is strict (rules out the equality).

The indifference curve:

A curve connecting all portfolios that are equally desirable to the investor (i.e. with the same utility) according to their means and standard deviations.

To determine some of the points that appear on the indifference curve, examine the utility values of several possible portfolios for an investor with A = 4:

The expected return of an asset is a probability-weighted average of its return in all scenarios:

where Pr(s): the probability of scenario s

r(s): the return in scenario s

The variance of an asset’s returns is the expected value of the squared deviations from the expected return:

- The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with portfolio proportions as weights.
- The expected rate of return on a portfolio is a weighted average of the expected rate of return on each component asset.

Consider a portfolio when it splits its investment evenly between Best Candy and SugarKane:

- Covariance:
- Measures how much the returns on two risky assets move in tandem.
- A positive covariance means that asset returns move together.
- A negative covariance means that they vary inversely.

Scales the covariance to a value between -1

(perfect negative correlation) and +1 (perfect

positive correlation).

- This large negative correlation (close to -1)

confirms the strong tendency of Best and

SugarKane stocks to move inversely.

Portfolio variance (2-asset case):

where

wi: fraction of the portfolio invested in asset i

: variance of the return on asset i

With equal weights in Best and SugarKane:

A positive covariance increases portfolio variance, and a negative covariance acts to reduce portfolio variance.

This makes sense because returns on negatively correlated assets tend to be offsetting, which stabilizes portfolio returns.

- Hedging involves the purchase of an asset that

is negatively correlated with the existing portfolio.

This negative correlation reduces the overall risk of the portfolio.

p = 4.83% is much lower than Best or SugarKane.

- p = 4.83% is lower than the average of Best and SugarKane (16.82%).
- Portfolio provides average expected return but lower risk.
- Reason: negative correlation.

Capital Allocation Across Risky and Risk-free Portfolios

- The choice of the proportion of the overall portfolio to place in risk-free securities versus risky securities.
- Denote the investor’s portfolio of risky assets as P and the risk-free asset as F.
- For now, we take the composition of the risky portfolio as given and focus only on the allocation between it and risk-free securities.

Risk-free assets

- Treasury bills:
- Short-term, highly liquid government securities issued at a discount from the face value and returning the face amount at maturity.
- Their short-term nature makes their values insensitive to interest rate fluctuations. Indeed, an investor can lock in a short-term nominal return by buying a bill and holding it to maturity.
- Inflation uncertainty over the course of a few weeks, or even months, is negligible compared with the uncertainty of stock market returns.

Money market instruments:

- Commercial paper (CP):
- Short-term unsecured debt note issued by large, well-known companies.
- Certificate of deposit (CD):
- Time deposit with a bank.
- Virtually free of interest rate risk because of their short maturities and are fairly safe in terms of default or credit risk.

Capital Allocation Line

- Suppose the investor has already decided on the composition of the risky portfolio.
- Now the concern is with the proportion of the investment budget, y, to be allocated to the risky portfolio, P.
- The remaining proportion, 1 - y, is to be invested in the risk-free asset, F.

Let rP: risky rate of return on P

E(rP) (= 15%): expected rate of return on P

P(= 22%): standard deviation of P

rf(= 7%): risk-free rate of return on F

E(rP) - rf(= 8%): risk premium on P

- With y in the risky portfolio and 1 - y in the risk-free asset, the rate of return on the completeportfolio C:

The base rate of return for any portfolio is the risk-free rate.

In addition, the portfolio is expected to earn a risk premium that depends on the risk premium of the risky portfolio, E(rP) - rf, and the investor’s position in the risky asset, y.

Recall: Portfolio variance (2-asset case):

- The standard deviation of the portfolio is

proportional to both the standard deviation of the

risky asset and the proportion invested in it.

The capital allocation line (CAL):

- shows all feasible risk-return combinations

of a risky and risk-free asset to investors.

- equals the increase in the expected return of
- the complete portfolio per unit of additional standard deviation (i.e. incremental return per incremental risk).
- - also called the reward-to-variability ratio.

- E(rC) = rf + y[E(rP) – rf] = 7% + 1 8% = 15%
- C = yP = 1 22% = 22%.
- y = 0:
- E(rC) = 7% + 0 8% = 7% ;C = yP = 0.
- y = 0.5:
- E(rC) = 7% + 0.5 8% = 11%
- C = yP = 0.5 22% = 11%
- Will plot on the line FP midway between F & P.
- The reward-to-variability ratio is S = 4/11 = .36
- (precisely the same as that of portfolio P, 8/22).

What about points on the CAL to the right of portfolio P?

- If investors can borrow at the risk-free rate of rf= 7%, they can construct portfolios that may be plotted on the CAL to the right of P.
- Suppose the investment budget is $300,000 and our investor borrows an additional $120,000, investing the total available funds in the risky asset.
- This is a leveraged position in the risky asset; it is financed in part by borrowing.

1 – y = 1 – 1.4 = -0.4 (short or borrowing

position in the risk-free assets).

- The leveraged portfolio has a higher expected return and standard deviation than does an unleveraged position in the risky asset.
- Exhibits the same reward-to-variability ratio.

Nongovernment investors cannot borrow at the risk-free rate.

- The risk of a borrower’s default causes lenders to demand higher interest rates on loans.
- Therefore, the nongovernment investor’s borrowing cost will exceed the lending rate of rf= 7%.
- Suppose the borrowing rate is:

In the borrowing range, the reward-to-variability ratio (the slope of the CAL) will be:

- The CAL will therefore be kinked at point P.
- To the left of P the investor is lending at 7%, and the slope of the CAL is 0.36.
- To the right of P, where y > 1, the investor is borrowing at 9%to finance extra investments in the risky asset, and the slope is 0.27.

Risk Tolerance and Asset Allocation

- The investor confronting the CAL now must choose one optimal portfolio, C, from the set of feasible choices.
- This choice entails a trade-off between risk and return.
- The more risk-averse investors will choose to hold less of the risky asset and more of the risk-free asset.

The utility that an investor derives from a portfolio with a given expected return and standard deviation can be described by the following utility function:

where U: utility value

E(r): expected return

2: variance of returns

A: index of the investor’s risk aversion

An investor who faces a risk-free rate, rf, and a risky portfolio with expected return E(rP)and standard deviation p will find that, for any choice of y, the expected return of the complete portfolio is:

E(rC) = rf + y[E(rP) – rf].

The variance of the complete portfolio is:

The investor attempts to maximize utility U by choosing the best allocation to the risky asset, y.

e.g.

This particular investor will invest 41% of the investment budget in the risky asset and 59% in the risk-free asset.

- The rate of return of the complete portfolio will have an expected return & standard deviation:
- The risk premium of the complete portfolio:

Another graphical way of presenting this decision problem is to use indifference curve analysis.

- Recall:
- The indifference curve is a graph in the expected return-standard deviation plane of all points that result in a given level of utility.
- The curve displays the investor’s required trade-off between expected return and standard deviation.

Consider an investor with risk aversion A = 4 who currently holds all her wealth in a risk-free portfolio yielding rf = 5%.

Because the variance of such a portfolio is zero, its utility value is U = 0.05.

Now we find the expected return the investor would require to maintain the same level of utility when holding a risky portfolio, say with = 1%.

We can repeat this calculation for many other levels of , each time finding the value of E(r)necessary to maintain U = 0.05.

This process will yield all combinations of expected return and volatility with utility level of .05; plotting these combinations gives us the indifference curve.

Because the utility value of a risk-free portfolio is simply the expected rate of return of that portfolio, the intercept of each indifference curve (at which = 0) is called the certainty equivalent of the portfolios on that curve and in fact is the utility value of that curve.

- Notice that the intercepts of the indifference curves are at 0.05and 0.09, exactly the level of utility corresponding to the two curves.

The more risk-averse investor has steeper indifference curves than the less risk-averse investor.

- Steeper curves mean that the investor requires a greater increase in expected return to compensate for an increase in portfolio risk.
- Given the choice, any investor would prefer a portfolio on the higher indifference curve, the one with a higher certainty equivalent (utility).
- Portfolios on higher indifference curves offer higher expected return for any given level of risk.

The investor thus attempts to find the complete portfolio on the highest possible indifference curve.

- When we superimpose plots of indifference curves on the investment opportunity set represented by the capital allocation line, we can identify the highest possible indifference curve that touches the CAL.
- That indifference curve is tangent to the CAL, and the tangency point corresponds to the standard deviation and expected return of the optimal complete portfolio.

The indifference curve with U = .08653 is tangent to the CAL.

- The tangency point corresponds to the complete portfolio that maximizes utility.
- The tangency point occurs at C = 9.02% and E(rc) = 10.28%, the risk/return parameters of the optimal complete portfolio with y* = 0.41.

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