CHAPTER5

RISKAVERSIONANDCAPITALALLOCATIONTORISKY
ASSETS

1. a. Theexpectedcashflowis:(0.5x$70,000)+(0.5x200,000)=$135,000
Withariskpremiumof8%overtheriskfreerateof6%,therequiredrateofreturnis
14%.Therefore,thepresentvalueoftheportfoliois:

$135,000/1.14=$118,421

b. Iftheportfolioispurchasedfor$118,421,andprovidesanexpectedcashinflowof
$135,000,thentheexpectedrateofreturn[E(r)]isderivedasfollows:

$118,421x[1+E(r)]=$135,000
Therefore,E(r)=14%.Theportfoliopriceissettoequatetheexpectedrateorreturn
withtherequiredrateofreturn.

c. IftheriskpremiumoverTbillsisnow12%,thentherequiredreturnis:
6%+12%=18%
Thepresentvalueoftheportfolioisnow:
$135,000/1.18=$114,407

d. Foragivenexpectedcashflow,portfoliosthatcommandgreaterriskpremiamustsell
atlowerprices.Theextradiscountfromexpectedvalueisapenaltyforrisk.

2. WhenwespecifyutilitybyU=E(r).005A2, theutilityfrombillsis7%,whilethat
fromtheriskyportfolioisU=12.005Ax182 =121.62A.Fortheportfoliotobe
preferredtobills,thefollowinginequalitymusthold:121.62A>7,or,
A<5/1.62=3.09.Amustbelessthan3.09fortheriskyportfoliotobepreferredtobills.

3. Pointsonthecurvearederivedasfollows:

U=5=E(r).005A2 =E(r).0152
ThenecessaryvalueofE(r),giventhevalueof2, istherefore:

2
E(r)
0% 0 5.0%
5 25 5.375

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 10 100 6.5
15 225 8.375
20 400 11.0
25 625 14.375

Theindifferencecurveisdepictedbytheboldlineinthefollowinggraph(labeled
Q3,forQuestion3).

4. RepeatingtheanalysisinProblem3,utilityis:

U = E(r) .005A2 = E(r) .022 = 4

leadingtotheequalutilitycombinationsofexpectedreturnandstandarddeviation
presentedinthetablebelow.Theindifferencecurveistheupwardslopinglineappearing
inthegraphofProblem
3,labeledQ4(for
Question4).
E(r) U(Q4,A=4)
U(Q3,A=3)
2
E(r)
0%
0
4.00%
5
25
5
4.50 U(Q5,A=0)
10
4
100
6.00
15
225
8.50
20 U(Q6,A<0)
400
12.00
25
625 16.50

TheindifferencecurveinProblem4differsfromthatinProblem3inbothslopeand

52
 intercept.WhenAincreasesfrom3to4,thehigherriskaversionresultsinagreater
slopefortheindifferencecurvesincemoreexpectedreturnisneededtocompensatefor
additional . ThelowerlevelofutilityassumedforProblem4(4%ratherthan5%),
shiftstheverticalinterceptdownby1%.

5. Thecoefficientofriskaversionofariskneutralinvestoriszero.Thecorresponding
utilityissimplyequaltotheportfolio'sexpectedreturn.Thecorrespondingindifference
curveintheexpectedreturnstandarddeviationplaneisahorizontalline,drawninthe
graphofProblem3,andlabeledQ5.

6. Arisklover,ratherthanpenalizingportfolioutilitytoaccountforrisk,derivesgreater
utilityasvarianceincreases.Thisamountstoanegativecoefficientofriskaversion.The
correspondingindifferencecurveisdownwardsloping,asdrawninthegraphofProblem
3,andlabeledQ6.

7. 3.[Utilityforeachportfolio=E(r).005x4x 2. Wechoosetheportfoliowiththe
highestutilityvalue.)

8. 4.[Wheninvestorsareriskneutral,A=0,andtheportfoliowiththehighestutilityisthe
onewiththehighestexpectedreturn.]

9. b

10. Theportfolioexpectedreturncanbecomputedasfollows:

Portfolio Portfolio
Wbills x + Wmarket x = standard deviation
_______________________________________________________________(=w x17.12%)___
market

0.0 5% 1.0 9.20% 9.20% 17.12%

.2 5 .8 9.20 8.36 13.70
.4 5 .6 9.20 7.52 10.27
.6 5 .4 9.20 6.68 6.85
.8 5 .2 9.20 5.84 3.42
1.0 5 0.0 9.20 5.00 0

11. ComputingtheutilityfromU=E(r).005xA2 = E(r) .0152 (becauseA=3),we

arriveatthefollowingtable.

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 Wbills Wmarket E(r) 2 U(A=3)

U(A=5)
___________________________________________________________________

0. 1.0 9.20% 17.12 293.09 4.80 1.87

.2 .8 8.36 13.7 187.69 5.54 3.67
.4 .6 7.52 10.27 105.47 5.93 4.88
.6 .4 6.68 6.85 46.92 5.97 5.51
.8 .2 5.84 3.42 11.70 5.66 5.55
1.00 5.0 0 0 5.0 5.0

TheutilitycolumnimpliesthatinvestorswithA=3willpreferapositionof60%in
themarketand40%inbillsoveranyoftheotherpositionsinthetable;thosewith
A=5willprefer20%inthemarketand80%inbills.

12. ThecolumnlabeledU(A=5)inthetableaboveiscomputedfromU=E(r).005 A2 =
E(r) .0252 (sinceA=5).Itshowsthatthemoreriskaverseinvestorswillpreferthe
positionwith20%inthemarketindexportfolio,ratherthanthe40%marketweight
preferredbyinvestorswithA=3.

13. Expectedreturn= .38% + .718% = 15%peryear.
Standarddeviation = .728% = 19.6%

14. Investment proportions: 30.0% in T-bills

.7 27% = 18.9% in stock A
.733% = 23.1% in stock B
.740% = 28.0% in stock C

15. Yourrewardtovariabilityratio = = .3571

Client'srewardtovariabilityratio = = .3571

16.

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 30

25
CA L (Slope = .3571)
20

E(r) P
15
% Client
10

0
0 10 20 30 40

17. a. E(rC) = rf + [E(rP) rf] y =8+l0y

Iftheexpectedreturnoftheportfolioisequalto16%,thensolvingforyweget:

16 = 8 + l0y, and y = = .8

Therefore,togetanexpectedreturnof16%theclientmustinvest80%oftotalfundsin
theriskyportfolioand20%inTbills.

b. Investmentproportionsoftheclient'sfunds:
20%inTbills,
.827% = 21.6% in stock A
.8 33% = 26.4% in stock B
.8 40% = 32.0% in stock C

c. C= .8P= .828% = 22.4% per year

18. a. C= y28%. Ifyourclientwantsastandarddeviationofatmost18%,then

y=18/28=.6429=64.29%intheriskyportfolio.

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 b. E(rC) = 8 + 10y = 8 + .642910 = 8 + 6.429 = 14.429%

19. a.
y* = = = = .3644

Sotheclient'soptimalproportionsare36.44%intheriskyportfolioand63.56%inT
bills.

b. E(rC) = 8 + 10y* = 8 + .364410 = 11.644%

C= .364428 = 10.20%

20.a. SlopeoftheCML = = .20

Thediagramisonthefollowingpage.

b. Myfundallowsaninvestortoachieveahighermeanforanygivenstandarddeviationthanwoulda
passivestrategy,i.e.,ahigherexpectedreturnforanygivenlevelofrisk.

CML and CAL

18
16 CA L: Slope = .3571
14
Expected Retrun

12
10
CML: Slope = .20
8
6
4
2
0
0 10 20 30
Standard Deviation

21.a. With70%ofhismoneyinmyfund'sportfoliotheclientgetsameanreturnof15%per

56
 yearandastandarddeviationof19.6%peryear.Ifheshiftsthatmoneytothepassive
portfolio(whichhasanexpectedreturnof13%andstandarddeviationof25%),his
overallexpectedreturnandstandarddeviationbecome:

E(rC) = rf + .7[E(r M)rf]

Inthiscase,rf=8%andE(rM)=13%.Therefore,
E(rC) = 8 + .7(13 8) = 11.5%

Thestandarddeviationofthecompleteportfoliousingthepassiveportfoliowouldbe:

C= .7M= .725% = 17.5%

Therefore,theshiftentailsadeclineinthemeanfrom14%to11.5%andadeclineinthe
standarddeviationfrom19.6%to17.5%.Sincebothmeanreturnandstandarddeviation
fall,itisnotyetclearwhetherthemoveisbeneficialorharmful.Thedisadvantageofthe
shiftisthatifmyclientiswillingtoacceptameanreturnonhistotalportfolioof11.5%,
hecanachieveitwithalowerstandarddeviationusingmyfundportfolio,ratherthanthe
passiveportfolio.Toachieveatargetmeanof11.5%,wefirstwritethemeanofthe
completeportfolioasafunctionoftheproportionsinvestedinmyfundportfolio,y:

E(rC) = 8 + y(18 8) = 8 + 10y

Becauseourtargetis:E(rC)=11.5%,theproportionthatmustbeinvestedinmyfundis
determinedasfollows:

11.5 = 8 + 10y, y = = .35

Thestandarddeviationoftheportfoliowouldbe:C= y28% = .3528% = 9.8%.

Thus,byusingmyportfolio,thesame11.5%expectedreturncanbeachievedwitha
standarddeviationofonly9.8%asopposedtothestandarddeviationof17.5%usingthe
passiveportfolio.

b. Thefeewouldreducetherewardtovariabilityratio,i.e.,theslopeoftheCAL.Clients
willbeindifferentbetweenmyfundandthepassiveportfolioiftheslopeoftheafterfee
CALandtheCMLareequal.Letfdenotethefee.

Slope of CAL with fee = =

SlopeofCML(whichrequiresnofee) = = .20. Settingtheseslopesequalweget:

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 = .20

10f = 28.20 = 5.6

f = 105.6 = 4.4% per year

22.a. Theformulafortheoptimalproportiontoinvestinthepassiveportfoliois:

y* =

With E(rM) = 13%; rf = 8%;M=25%; A = 3.5, we get

y*==.2286

b. Theanswerhereisthesameasin9b.Thefeethatyoucanchargeaclientisthesame
regardlessoftheassetallocationmixofyourclient'sportfolio.Youcanchargeafeethat
will equalizetherewardtovariability ratio ofyourportfoliowiththatofyour
competition.

23. Ifrf = 5% but r= 9%, thentheCMLandindifferencecurvesareasfollows:

E(r)

borrow

lend CAL
CML
P
13

25

24. Forytobelessthan1.0(sothattheinvestorisalender),riskaversionmustbelarge
enoughthat:

58
 y= < 1

= 1.28

Forytobegreaterthan1.0(sothattheinvestorisaborrower),riskaversionmustbe
smallenoughthat:

y= > 1

= .64

Forvaluesofriskaversionwithinthisrange,theinvestorneitherborrowsnorlends,but
insteadholdsacompleteportfoliocomprisedonlyoftheoptimalriskyportfolio:

y = 1 for .64 1.28

25. a. Thegraphofproblem23hastoberedrawnherewithE(r)=11%and= 15%

b. For a lending position, = 2.67

For a borrowing position, = .89

In between, y = 1 for .89 A 2.67

59
E(r)

CML
M
13 F CAL
11
9

15 25

26. The maximum feasible fee, denoted f, depends on the reward-to-variability ratio.

For y < 1, the lending rate, 5%, is viewed as the relevant risk-free rate, and we solve for f
from:
=

f = 6 = 1.2%

For y > 1, the borrowing rate, 9%, is the relevant risk-free rate. Then we notice that even
without a fee, the active fund is inferior to the passive fund because:

= .13 <= .16

More risk tolerant investors (who are more inclined to borrow) therefore will not be
clients of the fund even without a fee. (If you solved for the fee that would make
investors who borrow indifferent between the active and passive portfolio, as we did
above for lending investors, you would find that f is negative: that is, you would need to
pay them to choose your active fund.) The reason is that these investors desire higher
risk-higher returncompleteportfoliosandthusareintheborrowingrangeoftherelevant
CAL.Inthisrangetherewardtovariabilityratiooftheindex(thepassivefund)isbetter

510
 thanthatofthemanagedfund.

27.a. If19572009isassumedtoberepresentativeoffutureexpectedperformance,A=2,
E(rM)rf=4.20%,andM=17.74%(weusethestandarddeviationoftheriskpremium
fromthelastcolumnofTable6.8),theny*isgivenby:

y*==4.20/(.01x2x17.742)=.6672

Thatis,66.72%shouldbeallocatedtoequityand33.28%tobills.

b.If19932009isassumedtoberepresentativeoffutureexpectedperformance,A=2,
E(rM)rf=7.56%;andM=18.89%,theny*isgivenby:

y*=7.56/(.01x2x18.892)=1.0593

Therefore,105.93%ofthecompleteportfolioisallocatedtoequityand5.93%tobills.

c. In(a)themarketriskpremiumisexpectedtobelowerwhilethemarketriskisexpected
tobeatalowerlevelthanin(b).Thefactthattherewardtovariabilityratioisexpected
tobemuchlowerin(a)(4.20/17.74=0.2368)versus7.56/18.89=0.40)explainsthemuch
smallerproportioninvestedinequity.

28. Assumingnochangeintastes,thatis,anunchangedriskaversioncoefficient,A,the
denominatoroftheequationfortheoptimalinvestmentintheriskyportfoliowillbe
higher.Theproportioninvestedintheriskyportfoliowilldependontherelativechange
intheexpectedriskpremium(thenumerator)comparedtothechangeintheperceived
marketrisk.Investorsperceivinghigherriskwilldemandahigherriskpremiumtohold
thesameportfoliotheyheldbefore.Ifweassumethattheriskfreerateisunaffected,the
increaseintheriskpremiumwouldrequireahigherexpectedrateofreturnintheequity
market.

29. Theexpectedreturnofyourfund=Tbillrate+riskpremium=6%+10%=16%.
Theexpectedreturnoftheclient'soverallportfoliois.616%+.46%=12%.
Thestandarddeviationoftheclient'soverallportfoliois.614%=8.4%.

30. Rewardtovariabilityratio===.71.

31. [.650,000+.4(30,000)5,000=13,000]

32. b

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33. a)Curve2
b)PointF

Appendix5A

1. Your$50,000investmentwillgrowto$50,000(1.06)=$53,000byyearend.Without
insuranceyourwealthwillthenbe:

Probability Wealth
No fire: .999 $253,000
Fire: .001 $ 53,000

whichgivesexpectedutility

.001xloge(53,000) + .999 x loge(253,000) = 12.439582

andacertaintyequivalentwealthof

exp(12.439582)=$252,604.85

Withfireinsuranceatacostof$P,yourinvestmentintheriskfreeassetwillbeonly
$(50,000P).Youryearendwealthwillbecertain(sinceyouarefullyinsured)andequalto

(50,000P)x1.06+200,000.

Settingthisexpressionequalto$252,604.85(thecertaintyequivalentoftheuninsuredhouse)
resultsinP=$372.78.Thisisthemostyouwillbewillingtopayforinsurance.Notethat
theexpectedlossis"only"$200,meaningthatyouarewillingtopayquiteariskpremium
overtheexpectedvalueoflosses.Themainreasonisthatthevalueofthehouseisalarge
proportionofyourwealth.

2.a. With1/2coverage,yourpremiumis$100,yourinvestmentinthesafeassetis$49,900
whichgrowsbyyearendto$52,894.Ifthereisafire,yourinsuranceproceedsareonly
$100,000.Youroutcomewillbe:

Probability Wealth
Fire .001 $152,894
No fire .999 $252,894

Expectedutilityis

512
 .001xloge(152,894) + .999xloge(252,894) = 12.440222

and WCE = exp(l2.440222) = $252,767

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