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CHAPTER 6

Risk Aversion and


Capital Allocation
to Risky Assets

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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.

The utility model allows optimal allocation


between a risky portfolio and a risk-free
asset.

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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!

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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?

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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?

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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?

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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

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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)

There are other utility functions out there: must


increase with E[r] and decrease with 2
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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.
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Table 6.2 Utility Scores of Alternative Portfolios for
Investors with Varying Degree of Risk Aversion

U Er A 2
1
2

Three investors with A= 2.0, 3.5 and 5.0


Q. What portfolio will each choose?

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Risk-Return Trade-off

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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?
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Utility Indifference Curve

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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

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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

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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?
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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

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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?)

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Figure 6.3 Spread Between 3-Month
CD and T-bill Rates

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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?

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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

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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

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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

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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

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Fig. 6.4 The Investment Opportunity Set

y =1
Q. Whats the
value of y
here?
What does it
mean?

y =0

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Capital Allocation Line with Leverage
y>1 means borrow money to lever up your
investment (e.g. buy on margin)

There is asymmetry: lend (invest) at rf=7%


but borrow at rf=9%
Lending range slope = 8/22 = 0.36
Borrowing range slope = 6/22 = 0.27

CAL kinks at P

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Figure 6.5 The Opportunity Set with
Differential Borrowing and Lending Rates

You
borrow

You lend

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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

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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

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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%

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Figure 6.6 Chart Utility as a Function of
the Allocation to the Risky Asset (y)

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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

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Utility Indifference curves
Utility Indifference Levels
U E r A const
1 2

2
For example :
U 0.05, 0.09

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Table 6.5 Spreadsheet Calculations of
Indifference Curves

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Table 6.6 Expected Returns on Four
Indifference Curves and the CAL
Risk aversion coefficient A=4

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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

1. Draw the Capital


Alllocation Line
by varying y

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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

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
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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

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