68 views

Uploaded by Vishwak Subramaniam

CAPM

- 11-09-12 Model Portfolio Customized
- The Absolute Return Letter 0613
- BKM+Chapter+6+Solutions
- Money Manager 7
- Aviva UK: Balance Sheet July 2010
- Microsoft Word - 131025 - Convention Center Hotel Press Release - FINAL
- Risk, Return, and Utility
- SDA 3E Chapter 10
- Long Term Funding Presentation by KPERS Executive Director Glenn Deck (Jan. 24, 2011)
- 22 Sep 2014 Breakouts
- null
- Collomb Thesis
- Can.doc
- 6 MECO Articlev1
- 545 WYN UDRB Letter of Intent
- ebedcd7a-44a5-432c-8fe0-c42ec567b0ad-150403235113-conversion-gate01
- Introduction to Financial Planning-VK-2015.pptx
- Risk Assessment Questionnaire
- Saving vs Earnings
- HDFC MF Monthly Income Plan_Leaflet_ June 2013

You are on page 1of 38

Capital Allocation

to Risky Assets

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

Allocation to Risky Assets

Investors will avoid risk unless there is a

reward.

between a risky portfolio and a risk-free

asset.

Risk and Risk Aversion

Speculation Gamble

Taking considerable Bet on an uncertain

risk for a outcome for enjoyment

commensurate gain Parties (should) assign

Parties have the same probabilities

heterogeneous to the possible

expectations outcomes

So there are trades Gambling happens

among rational parties because it is fun!

Lets play a game

I will toss a coin and pay you some money X

if heads and nothing if tails

How much are you willing to pay to play this

game?

For X = $1

For X = $2

For X = $10

For larger X?

Lets flip the game

I will toss a coin and you pay me some

money X if heads and nothing if tails

How much are you asking me to play this

game?

For X = $1

For X = $2

For X = $10

For larger X?

Risk Aversion and Utility Values

Investors are willing to consider:

risk-free assets

speculative positions with positive risk premia

Investors will reject fair games or worse

Portfolio attractiveness increases with

expected return and decreases with risk.

What happens when return increases with

risk?

Table 6.1 Available Risky Portfolios

(Risk-free Rate = 5%)

How to compare?

Each portfolio receives a utility score to

assess the investors risk/return trade off

A Utility Function

U E r A

1 2

2

= utility or welfare (a measure of happiness)

[] = expected return on the asset or portfolio

= coefficient of risk aversion

2 = variance of returns

= a scaling factor (well see later why turn useful)

increase with E[r] and decrease with 2

INVESTMENTS | BODIE, KANE, MARCUS 6-8

A Utility Function Meaning of A

U E r A

1 2

2

A = coefficient of risk aversion. Interpretation:

A>0 - Risk Averse. Penalizes risk. Will want a

larger risk premium for riskier investments.

A=0 - Risk Neutral. A pure trader, only

concerned about expectation. Indifferent to a

fair game.

A<0 - Risk Lover. Adjusts utility up for risk

because enjoys the risk. A gambler, bored with

risk-free, will prefer for riskier investments.

INVESTMENTS | BODIE, KANE, MARCUS 6-9

Table 6.2 Utility Scores of Alternative Portfolios for

Investors with Varying Degree of Risk Aversion

U Er A 2

1

2

Q. What portfolio will each choose?

Risk-Return Trade-off

Mean-Variance (M-V) Criterion

Portfolio A dominates portfolio B if:

And E rA E rB

A B

Q. How do you find a family of portfolios

you are indifferent to?

INVESTMENTS | BODIE, KANE, MARCUS 6-12

Utility Indifference Curve

How Do You Estimate Risk Aversion?

Use questionnaires

Observe individuals decisions when

confronted with risk

Observe how much people are willing to pay

to avoid risk

Use common sense

Capital Allocation Across Risky and

Risk-Free Portfolios

Asset Allocation: Controlling Risk:

Is a very important Simplest way: adjust

part of portfolio the fraction of the

construction. portfolio invested in

risk-free assets

Refers to the choice

versus the portion

among broad asset

invested in the risky

classes.

assets

Basic Asset Allocation

Portfolio 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

These weights are within the risky portfolio

Q. What is the risk-free vs risky composition?

INVESTMENTS | BODIE, KANE, MARCUS 6-16

Basic Asset Allocation

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

complete portfolio;

(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: 0.378 B: 0.322

$300,000 $300,000

These weights are within the entire portfolio

The Risk-Free Asset

Only the government can issue default-free

bonds (caveats).

Risk-free in real terms only if price indexed and

maturity equal to investors holding period.

T-bills viewed as the risk-free asset

Money market funds also considered risk-free

in practice

(caveat, remember fall 2008?)

Figure 6.3 Spread Between 3-Month

CD and T-bill Rates

Portfolios of One Risky Asset and a Risk-Free

Asset

You can create a complete portfolio by splitting

funds between safe and risky assets. Let:

y = portion allocated to the risky portfolio, P

(1-y) = portion to invest in risk-free asset, F.

Build a complete portfolio C: rC yrp 1 y rf

Take expectations: E rC yE rp 1 y rf

Rearrange terms: E rC rf yE rp rf

risk premium

Q. Whats the porfolios c?

Example Using Chapter 6.4 Numbers

Risky Risk-free

E(rp) = 15% rf = 7%

p = 22% rf = 0%

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

Example (Ctd.)

The expected return on the complete portfolio

is the risk-free rate plus the weight of P times

the risk premium of P

E rC rf yE rp rf

risk premium

E rc 7 y15 7

Example (Ctd.)

The risk of the complete portfolio is the

weight of P times the risk of P because

the risk free asset has zero standard

deviation:

C y P 22 y

Example (Ctd.)

Place the two portfolios P and F on the {r,}

plane. Varying y from 0 to 1 describes a line

between F and P, what is the slope?

Rearrange and substitute y=C / P:

C

E rC rf

P

E rP rf 7 C

8

22

E rP rf 8

Slope Intercept rf 7

P 22

Fig. 6.4 The Investment Opportunity Set

y =1

Q. Whats the

value of y

here?

What does it

mean?

y =0

Capital Allocation Line with Leverage

y>1 means borrow money to lever up your

investment (e.g. buy on margin)

but borrow at rf=9%

Lending range slope = 8/22 = 0.36

Borrowing range slope = 6/22 = 0.27

CAL kinks at P

Figure 6.5 The Opportunity Set with

Differential Borrowing and Lending Rates

You

borrow

You lend

Risk Tolerance and Asset Allocation

The investor must choose one optimal

portfolio, C, from the set of feasible choices

(by changing y)

Expected return of the complete portfolio:

[ ] = + ([ ] )

Variance:

y

2

C

2 2

P

Utility Function depending on y

Express U as a function of y

E rC

1

U A C

2

2

U rf y E rp rf A y P

1

2

2 2

U is a quadratic function of y

U ay yb c

2

Table 6.4 Utility Levels for Various Positions in Risky

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

Example:

rf = 7%

E(rp) = 15%

p = 22%

Figure 6.6 Chart Utility as a Function of

the Allocation to the Risky Asset (y)

Maximize Utility Function w.r.t. y

Express U as a function of y

E rC

1

U A C

2

U rf y E rp rf A y P

1

2

2 2

E rp rf

The maximize w.r.t. y

ymaxU

A 2

P

Utility Indifference curves

Utility Indifference Levels

U E r A const

1 2

2

For example :

U 0.05, 0.09

Table 6.5 Spreadsheet Calculations of

Indifference Curves

Table 6.6 Expected Returns on Four

Indifference Curves and the CAL

Risk aversion coefficient A=4

Put it together and find your optimal allocation 6-36

2. Map your

Utility

3. Find optimal y indifference

to maximize your curves

U along Capital

Alllocation Line

Alllocation Line

by varying y

Passive Strategies:

The Capital Market Line (CML)

Capital allocation line formed investment in

two passive portfolios:

1. risk-free short-term T-bills (or equivalent)

2. asset that mimics a broad market index

indirect security analysis

strategy a reasonable choice for many

investors

INVESTMENTS | BODIE, KANE, MARCUS 6-37

Passive Strategies:

The Capital Market Line

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 0.40

- 11-09-12 Model Portfolio CustomizedUploaded bymupdate
- The Absolute Return Letter 0613Uploaded byZerohedge
- BKM+Chapter+6+SolutionsUploaded byAhtsham Ahmad
- Money Manager 7Uploaded byTaniya Jain
- Aviva UK: Balance Sheet July 2010Uploaded byAviva Group
- Microsoft Word - 131025 - Convention Center Hotel Press Release - FINALUploaded byeric_roper
- Risk, Return, and UtilityUploaded bySusana
- SDA 3E Chapter 10Uploaded byxinearpinger
- Long Term Funding Presentation by KPERS Executive Director Glenn Deck (Jan. 24, 2011)Uploaded byProtectKPERS
- 22 Sep 2014 BreakoutsUploaded byAjith Chand Bhandaari
- nullUploaded byapi-26004644
- Collomb ThesisUploaded byBader Dahmani
- 6 MECO Articlev1Uploaded byJomel Maroma
- Can.docUploaded byChhaya
- 545 WYN UDRB Letter of IntentUploaded byNone None None
- ebedcd7a-44a5-432c-8fe0-c42ec567b0ad-150403235113-conversion-gate01Uploaded byNikita Sharma
- Introduction to Financial Planning-VK-2015.pptxUploaded byVinod Krishna Makkimane
- Risk Assessment QuestionnaireUploaded byamitnpatel1
- Saving vs EarningsUploaded bybaladtm
- HDFC MF Monthly Income Plan_Leaflet_ June 2013Uploaded byprabhuarunkumar
- WDB UK Alpha Newsletter - V001 _07Uploaded bybrucepackard3948
- Save WiseUploaded byJacobina The-Dynamitess Mwale
- Class 10Uploaded bySamrat Chowdhury
- บัวหลวงเฟล็กซิเบิ้ลเพื่อการเลี้ยงชีพUploaded byTonmok Son
- Chap 010Uploaded byAnonymous sZLcBAg
- c-2158-KVl2ocXgpMUY-2845396007569904564Uploaded byAlex Soneji
- Annexure1Uploaded byAayush Choudhury
- FP Calculator (1)Uploaded byNarendra Bhole
- atul autoUploaded byMohit Kanjwani
- GoodWillUploaded byAyan Noor

- A1_Tablet Computer Sales_ Moving AveragesUploaded byVishwak Subramaniam
- FAQ (1)Uploaded byVishwak Subramaniam
- Affidavit MBA I&EUploaded byVishwak Subramaniam
- Family Business Information FormUploaded byVishwak Subramaniam
- Books at JSTOR Open AccessUploaded byVishwak Subramaniam
- Risk Aversion and Capital AllocationUploaded byVishwak Subramaniam
- Training SheetsUploaded byVishwak Subramaniam
- 40125 Alindip Datta FA 2Uploaded byVishwak Subramaniam
- Financial Accounting QuestionsUploaded byVishwak Subramaniam
- SEED Preparatory Kit - FinanceUploaded byVishwak Subramaniam

- What House? Property and Mortgage Magazine - May 2012Uploaded bySonya Brucciani
- Role of the Insurance Regulatory and Development AuthorityUploaded bygoyal_divya18
- nyeb18-43971Uploaded byAnonymous HiB16AfCa
- Ch.7_8_notesf2012Uploaded byDiep Ngo
- Current Affairs February 2014Uploaded byHeather Cunningham
- SFM Assignment STM Dec 09Uploaded byenginiboeer
- Francisco vs TRBUploaded byFranz Kafka
- 2(1)Uploaded bymershaas
- Albert Saiz ImportantUploaded byFawaz M Kha
- Unctad MauritiusUploaded bytejasvi_ravi
- Alternative Marketing Techniques for EntrepreneursUploaded bybrokencyder
- General Trade License in Dubai and the UAEUploaded byZak alba
- CEO Overconfidence and Corporate InvestmentUploaded byShito Ryu
- Fr Sbr Examinable Documents S18 J19Uploaded bymarc a
- Cfr Tmb Insolvency Request to Remove Borza and Audit 35760-3-2006 28 Nov 2014Uploaded byHassan Awdi
- PLENITU-AnnualReport2011 (1.4MB)Uploaded byFoo Wen
- Reliance the life story of a giantUploaded byjames thottan
- Power Sector Circular DebtUploaded byikram
- Chapter 6: Non Profit OrganizationUploaded bymariyam_aziz_1
- 2017 IAS 07 AmendmentsUploaded byJona Thea Francisco
- Indian Law Firm Awards.pdfUploaded byKuldeep Indeevar
- Project MistakesUploaded byuravashi
- 2016112614502600012845_PPT5_Capacity Planning_R0 1Uploaded byFaizal Akbar
- How Do I Identify Obsolete Inventory_ - Questions & Answers - AccountingToolsUploaded byMd Rakibul Hasan
- MO week 16, RTSUploaded bysserifund
- Corporate ValuationUploaded byshahsam17
- Fixing the ‘Brain Damage’ Caused by the I.P.OUploaded byTara Sinha
- Comprehensive Examinations 2 (Part I)Uploaded byYander Marl Bautista
- Merger Case StudyUploaded byAniket Lakhe
- Day Count ConventionUploaded byDiego Gonzáles