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COURSE MATERIAL

Capital Allocation

Asset Allocation

Security selection

Diversification portfolio into different kind of line

of business stock

Insurance principle to reduce risk

The risk that remains even after extensive

diversification is called market risk called

systematic risk or non diversifiable risk

The risk that can be eliminated by diversification

is called unique risk, firm specific risk, non

systematic risk or diversifiable risk

Suppose : D = bond portfolio specializing in long term debt securities

E = equity securities

wD = proportion invested in the bond fund

1- wD = wE = proportion invested in the stock fund

Then our portfolios model is

rP wD rD wE rE

(1)

Expected return on component securities with portfolio proportion as weight s:

(2)

Cov(rD , rE ) DE D E

(4)

P wD D wE E

(DE =-1 ), P = 0

P wD D wE E

(5)

E

wD

D E

D

wE

1 wD

D E

(6)

either of the individual component assets.

work with the capital allocation line (CAL)

To objective is to find the weight wD and wE that result in the highest slope of

the CAL. Thus our objective function is the Sharpe ratio

SP

E (rP ) rf

8wD 13wE

solve an optimization problem formally

max S

wi

E (rp ) rf

, wi 1

E ( RD ) E2 E ( RE )Cov( RD , RE )

wD

E ( RD ) E2 E ( RE ) D2 [ E ( RD ) E ( RE )]Cov ( RD , RE )

wE 1 wD

Once we have reached this point, generalizing to the case of many risky assets is

straightforward. Before we move on, let us briefly summarize the steps we followed to

arrive at the complete portfolio.

1. Specify the return characteristics of all securities (expected returns, variances,

covariances ).

2. Establish the risky portfolio (asset allocation):

a) Calculate the optimal risky portfolio, P

b) Calculate the properties of portfolio P using the weights determined in step ( a )

3. Allocate funds between the risky portfolio and the risk-free asset (capital

allocation):

Calculate the fraction of the complete portfolio allocated to portfolio P (the

risky portfolio) and to T-bills (the risk-free asset)

Calculate the share of the complete portfolio invested in each asset and in T-bills

MODEL

Security Selection

As in the two risky assets example, the problem

has three parts. First, we identify the riskreturn

combinations available from the set of risky

assets. Next, we identify the optimal portfolio of

risky assets by finding the portfolio weights that

result in the steepest CAL. Finally, we choose

an appropriate complete portfolio by mixing the

risk-free asset with the optimal risky portfolio

port-folio with weights in each security, wi ,

can be calculated from the bordered

covariance matrix or, equivalently, from the

following extensions of Equations

n

E (rp ) wi E (ri )

i 1

p2 wi w j Cov(ri , rj )

i 1 j 1

identification of the efficient set of portfolios, or the efficient frontier of

risky assets

Separation property the only difference between clients choices is that the

more risk-averse client will invest more in the risk-free asset and less in

the optimal risky portfolio than will a less risk-averse client

The portfolio choice problem may be separated into two independent tasks.

The first task, determination of the optimal risky portfolio, is purely

technical. the second task, capital allocation, depends on personal

preference

Different managers will estimate different input lists, thus deriv-ing different

efficient frontiers, and offer different optimal portfolios to their clients.

The source of the disparity lies in the security analysis

The general formula for the variance of a portfolio is

n

wi w j Cov(ri , rj )

2

p

i 1 j 1

n

n

n

1

1

1

2

2

p i 2 Cov (ri , rj )

n i 1 n

j 1 i 1 n

j i

2

i

average variance and average covariance

1 n 2

i

n i 1

2

n

n

1

Cov

Cov(ri , rj )

n(n 1) j 1 i 1

j i

Portfolio variance as

1 2 n 1

Cov

n

n

2

p

When the average covariance among

security return to zero, as it is when all risk is

firm specific, portfolio variance can be driven

to zero

The theories of security selection and asset

allocation are identical. Both activities call for

the construction of an efficient frontier, and

the choice of a particular portfolio from along

that frontier

RETURNS

Potential nonnormality of returns requires us

to pay attention as well to risk measures that

focus on worst-case losses such as value at

risk (VaR) or expected shortfall (ES)

OF LONG-TERM INVESTMENTS

Diversification means that we spread our

investment budget across a variety of assets

and thus limit overall risk

Risk pooling means merging

uncorrelated, risky projects as a means to

reduce risk. Applied to the insurance

business, risk pooling entails selling many

uncorrelated insurance policies

RISK SHARING

Risk sharing, the act of selling shares in

an attractive risky portfolio to limit risk and

yet maintain the Sharpe ratio (profitability) of

the resultant position. Suppose that every

time a new risky asset is added to the

portfolio

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