Economics 122

F I N A NCI AL ECON OMI CS ( R I S K AV ERSION A N D CA P I TAL A L LOCATI ON)

M. DE BUQUE - GONZAL ES
1 ST S E MESTER, 2 0 1 4 -2015

SOURCE: BODIE ET AL. (2009)

Risk and Risk Aversion
Gamble
 Take risks. Bet or wager on an uncertain outcome for
enjoyment.
 “Fair  game”:  A  risky  investment  with  a  risk  premium  of  
zero.
 Parties have homogenous expectations (same probabilities
to outcomes).
Risk and Risk Aversion
Speculation
 Taking considerable risk for a commensurate gain.
 Parties have heterogeneous expectations (different
probabilities assigned to outcomes).
Risk Aversion and Utility Values
 Risk-averse investors are willing to consider:
 Risk-free assets
 Speculative positions with positive risk premiums
 Portfolio attractiveness increases with expected return and
decreases with risk.
 But return increases with risk!
Available Risky Portfolios
(Risk-free Rate = 5%)

Each  portfolio  receives  a  utility  score  to  assess  the  investor’s  

risk/return trade off.
Utility Function
 Utility function:
1
𝑈 = 𝐸 𝑟 − 𝐴𝜎
2
where
𝑈 = utility
𝐸(𝑟) = expected return on the asset or portfolio
𝐴 = coefficient of risk aversion (higher, more risk averse)
𝜎 = variance of returns
= a scaling factor
Risk Aversion Parameter
 Risk averse (𝐴 > 0)
Will accept only risk-free bets or speculative prospects with
positive risk premium.
Will reject fair games or worse.
 Risk neutral (𝐴 = 0)
 Risk lover (𝐴 < 0)
Adjusts the expected return upward to take into account the
“fun”  of  confronting  the  prospect’s  risk.

6-7
Utility Scores of Alternative Portfolios for
Investors with Varying Degree of Risk Aversion
Mean-Variance (M-V) Criterion
 Portfolio A dominates portfolio B if:

𝐸 𝑅 ≥𝐸 𝑅
and
𝜎 ≤𝜎
Estimating Risk Aversion
 Use questionnaires.
 Observe individuals’  decisions  when  confronted  with  risk.
 Observe how much people are willing to pay to avoid risk.
Basic Asset Allocation
Total market $300,000
Risk-free $90,000
Risky assets (denote by P) $210,000
Equities $113,400
Bonds $96,600

$113,400 $96,600
𝑊 = = .54, 𝑊 = = .46
$210,000 $210,000
Basic Asset Allocation
Let
𝑦 = weight of the risky portfolio, P, in the complete
portfolio,
(1 − 𝑦) = weight of risk-free assets.

Then
$ , $ ,
𝑦= = .70 1−𝑦 = = .30
$ , $ ,
$ , $ ,
𝐸 = = .378 𝐵= = .322
$ , $ ,
The Risk-free Asset
 Only the government can issue default-free bonds.
Risk-free in real terms only if price-indexed and if the maturity is
equal to the investor’s  holding  period.
 T-bills  viewed  as  “the”  risk-free asset.
 Money market funds also considered risk-free in practice.
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
It’s  possible  to  create  a  complete portfolio by splitting
investment funds between safe and risky assets.
Again, let
𝑦 = portion allocated to the risky portfolio, P
(1 − 𝑦) = portion to be invested in risk-free asset, F
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
Let
𝑟 = risk-free rate
𝑟 = ROR on risky assets
The ROR on the complete portfolio is:
𝑟 = 1 − 𝑦 𝑟 + 𝑦𝑟
=𝑟 +𝑦 𝑟 −𝑟
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
 We take the expectations of this to get the expected return
on the complete portfolio.
 The expected return on the complete portfolio is the risk-
free rate plus the weight of P times the risk premium of P.
𝐸 𝑟 = 𝐸 𝑟 + 𝑦𝐸 𝑟 − 𝑟
=𝑟 +𝑦 𝐸 𝑟 −𝑟
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
 To measure the risk of the complete portfolio, first get the
variance of its rate of return.
𝜎 = 𝑣𝑎𝑟 𝑟 = 𝑣𝑎𝑟 1 − 𝑦 𝑟 + 𝑣𝑎𝑟 𝑦𝑟
𝜎 =𝑦 𝜎
 The risk of the complete portfolio (the standard deviation of
𝑟 ) is then the weight of P times the risk of P:
𝜎 = 𝑦𝜎
 Also,
𝜎
𝑦=
𝜎
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
 We can then rearrange and substitute 𝑦 = into the
expected return equation:
𝐸 𝑟 =𝑟 +𝑦 𝐸 𝑟 −𝑟
𝜎
=𝑟 + 𝐸 𝑟 −𝑟
𝜎
𝐸 𝑟 −𝑟
=𝑟 + 𝜎
𝜎
Portfolio:
1 Risky Asset and 1 Risk-Free Asset
 Note that the slope is the reward-to-volatility (Sharpe) ratio:
𝐸 𝑟 −𝑟 𝑟 +𝑦 𝐸 𝑟 −𝑟 −𝑟
𝑆 = =
𝜎 𝑦𝜎
𝑦 𝐸 𝑟 −𝑟
=
𝑦𝜎
𝐸 𝑟 −𝑟
=
𝜎
=𝑆
 The expected return equation can then be written as:
𝐸 𝑟 = 𝑟 + 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 𝜎
Capital Allocation Line
 Plotting the expected returns equation of the complete portfolio,
you get the capital allocation line (CAL) :
𝐸 𝑟 −𝑟
𝐸 𝑟 =𝑟 + 𝜎
𝜎
 The CAL depicts all the risk-return combinations available to
investors. It is also known as the investment opportunity set (IOS).
 In the expected return–standard deviation plane, all portfolios that
are constructed from the same risky and risk-free funds (with
various proportions) lie on a line from the risk-free rate through the
risky fund.
The Investment Opportunity Set

IOS is higher past point "P"

Rate at which you can
borrow is higher than the
Risk Free Rate
Capital Allocation Line
 Again, the slope of the CAL, denoted 𝑆 , is the reward-to-
volatility ratio or the Sharpe ratio.
𝐸 𝑟 −𝑟
𝑆 =
𝜎
 𝑆 equals the increase in the expected return of the complete
portfolio per unit of additional standard deviation (that is, the
incremental return per incremental risk).
 Notice that 𝑆 is independent of the proportion 𝑦, the position
on the risky fund. It is the same for all portfolios constructed
from the same risky fund and risk-free fund (but in various
proportions) that lie on the CAL.
Example of CAL with numbers
𝑟 = 7% 𝜎 = 0%
𝐸 𝑟 = 15% 𝜎 = 22%

𝐸 𝑟 =𝑟 +𝑦 𝐸 𝑟 − 𝑟 = 7 + 𝑦 15 − 7 = 7 + 8𝑦
𝜎 = 𝑦𝜎 = 22𝑦
𝐸 𝑟 =7+ 𝜎

𝑆 = = .36
The Investment Opportunity Set
CAL with Leverage
 If investors can borrow at the (risk-free) rate (𝑟 = 7% in
our example), they can construct portfolios that may be
plotted on the CAL to the right of P on the graph.
 But only government can borrow at the default-free rate.
Nongovernment investors  can’t  borrow  at  that rate.
 This causes lenders to nongovernment borrowers to
demand higher interest rates on loans (i.e., borrowing cost
greater than 𝑟 ).
CAL with Leverage
 Suppose the borrowing rate is 𝑟 = 9%. In the borrowing
range, the slope of the CAL will be:
𝐸(𝑟 ) − 𝑟 15 − 9 6
= = = .27
𝜎 22 22

 The slopes will therefore differ across the different ranges:

 Lending range slope = 8/22 = .36
 Borrowing range slope = 6/22 = .27
CAL with Leverage
Therefore, the CAL “kinks”  at  point P.
To the left of P, the investor is lending at 7%.
The slope of the CAL is .36.
To the right of P, where 𝑦 > 1, the investor is
borrowing at 9% to finance extra investments in the
risky asset (e.g., through a margin account).
The slope of the CAL is .27.
The Opportunity Set with Differential
Borrowing and Lending Rates
Risk Tolerance and Asset Allocation
 The investor confronting the CAL now must choose one optimal
portfolio, C, from the set of feasible choices (choice entails trade-off
between risk and return).
 Individual investor differences in risk aversion imply that, given an
identical opportunity set (that is, a risk-free rate and a reward-to-
volatility ratio), different investors will choose different positions in
the risky asset.
 An investor who faces a risk-free rate, 𝑟 , and a risky portfolio with
expected return 𝐸 𝑟 and standard deviation 𝜎 will find that, for
any choice of 𝑦, the following hold:
Expected return of the complete portfolio: 𝐸 𝑟 = 𝑟 + 𝑦 𝐸 𝑟 −𝑟
Standard deviation: 𝜎 = 𝑦𝜎
Risk Tolerance and Asset Allocation
 An investor will attempt to maximize utility by choosing the
best allocation to the risky asset, 𝑦.
 Recall the utility function: 𝑈 = 𝐸 𝑟 − 𝐴𝜎
 As the allocation to the risky asset increases (higher 𝑦),
expected return increases, but so does volatility, so utility can
increase or decrease.
 Initially, utility increases as 𝑦 increases (investors willing to
assume more risk to increase expected return), but eventually
it declines (as increases in risk dominate the increase in
expected return).
Utility as a Function of Allocation to the
Risky Asset, y
Risk Tolerance and Asset Allocation
 Utility maximization problem :
1
max 𝑈 = 𝐸 𝑟 − 𝐴𝜎
2
= 𝑟 + 𝑦 𝐸(𝑟 ) − 𝑟 − 𝐴𝑦 𝜎
Solving this, the optimal position for risk-averse investors
in the risky asset, 𝑦*, is:
∗
𝐸(𝑟 ) − 𝑟
𝑦 =
𝐴𝜎
Risk Tolerance and Asset Allocation
 Solving this, the optimal position for risk-averse investors in the
risky asset, 𝑦*, is:
∗
𝐸(𝑟 ) − 𝑟
𝑦 =
𝐴𝜎
 This solution shows that the optimal position in the risky asset is, as
one would expect:
 inversely proportional to the level of risk aversion and the level of
risk (as measured by the variance of the risky asset), and
 directly proportional to the risk premium offered by the risky asset.
Numerical example
 Recall 𝐸(𝑟 ) = 15%, 𝜎 = 22%, and 𝑟 = 7%. Suppose the risk
aversion parameter 𝐴 = 4.
 Express returns as decimals.
 The optimal solution for an investor is:
( ) . .
𝑦∗ = = = .41
∗.
1 − 𝑦 ∗ = .59

The investor will invest 41% of the investment budget to the

risky asset and 59% in the risk-free asset.
Numerical example
 With 41% invested in the risky portfolio, the expected return and SD of
the complete portfolio are:
𝐸(𝑟 ) = 𝑟 + 𝑦 𝐸(𝑟 ) − 𝑟
= 7 + .41(15 − 7)
= 10.28%
𝜎 = 𝑦𝜎 = .41 ∗ 22 = 9.02%
 The risk premium of the complete portfolio is
𝐸(𝑟 ) − 𝑟 = 10.28 − 7 = 3.28%.
.
 The reward-to-volatility (Sharpe) ratio is = .36 as assumed for this
.
example.
Risk Tolerance and Asset Allocation
 A graphical way of presenting this decision problem is to use
indifference curve (IC) analysis.
 From 𝑈 = 𝐸 𝑟 − 𝐴𝜎 , the IC curve is:
1
𝐸 𝑟 = 𝑈 + 𝐴𝜎
2
 Slope of IC: 𝑆 = = 𝐴𝜎

 Slope of CAL: 𝑆 =
Risk Tolerance and Asset Allocation
Tangency point of IC and CAL (where 𝑆 = 𝑆 ):
𝐸 𝑟 −𝑟
𝐴𝜎 =
𝜎
𝐸 𝑟 −𝑟
𝐴𝑦𝜎 =
𝜎

𝐸(𝑟 ) − 𝑟
𝑦∗ =
𝐴𝜎
Utility Levels for Various Positions in Risky Assets
(y) for an Investor with Risk Aversion A = 4
The Investment Opportunity Set
Utility as a Function of Allocation to the
Risky Asset, y
Spreadsheet Calculations of Indifference
Curves
Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4
Expected Returns on Four Indifference
Curves and the CAL
Finding the Optimal Complete Portfolio
Using Indifference Curves
Passive Strategies
 A passive strategy avoids any direct or indirect security
analysis.
 Supply and demand forces may make such a strategy a
reasonable choice for many investors.
Passive Strategies:
The Capital Market Line
 A natural candidate for a passively held risky asset would
be a well-diversified portfolio of common stocks such as
the S&P 500.
 The capital market line (CML) is the capital allocation line
formed from 1-month T-bills and a broad index of common
stocks (e.g. the S&P 500).
Passive Strategies:
The Capital Market Line
 In summary, the CML is given by a strategy that involves
investment in two passive portfolios:
Virtually risk-free short-term T-bills (or a money market
fund).
A fund of common stocks that mimics a broad market
index.