2ND MODULE OF INVESTMENTS

WEEK 8

8.1 – Mean-Variance: Capital Allocation

How to optimal organize the assets available in the market into a portfolio?

➔ We can be able to reduce risk without sacrifice return

Capital Allocation-How to allocate wealth to different assets categories: risky assets and risk-
free assets

Simple situation: there is only one risky asset and one risk-free asset. The problem of the
investor is to combine these two assets. So, the investor has to compare portfolios.

High return and low risk is obviously the better choice but when risk increase along with
return is not so obvious anymore what is the optimal portfolio. So, we assume that investors
can assign scores -utilities to different portfolios. It corresponds to the following formula:

It fully depends on expected return and variance. Investors only care about that two. The
assumption of normality (class week 7) is the one who allows to make this simplification.

E[r]- expected return

Delta – variante

A- Coefficient of risk aversion→ Price that investor attach to risk. Scaling factor applied to
variance to reduce the score/utility. Investor that are more risk averse will attach a higher
price to risk.

Graphical representation of the utility: Indifference curve

The curve is plotting all portfolios that are giving investors the same utility. For example, P1
and P2 give investor the same utility score. But portfolio P3 is clearly less attractive than the
portfolios in the utility curve, because for example it has the same return of P2 but higher risk.
However, P4 for example is more attractive because it has the same return but lower risk.

Investor has to choose how to allocate the wealth between risky assets and risk-free assets.

Y: proportion of the investors wealth that is invested on risky assets

(1-y): the remaining proportion invested in the risk free

The return of the combine portfolio can be written like this:

After some manipulation we get to: Risk free plus y time the axis return of the risky asset
We want to plot the possible portfolios in the same expected return/standard deviation space
that we used for the indifference curve. For that we will need the expected return and the
variance.

Expected return- We are not taking the expectation of risk free because by definition that is a
certain asset that will give you certain cash flows.

Variance- Again there is no need to consider risk free because risk free is riskless

The standard deviation of the combine portfolio is obtained by taking the square root of the
variance that is obtained by the second formula of the above image.

The last step is to combine the formula for standard deviation solving for y in the formula for
expected return. And with that step we obtain the CAL formula:

This represents the equation of a line with a expected return/standard deviation space. This
line will have a intercept equal to the risk free rate. The slop is the term (E[r] – rf/ Delta p ) and
that corresponds to the sharp ratio of the risky asset. X return on the numerator and standard
deviation in the denominator. The graphical representation of this line is:

P: point where we full invest in the risky asset

So the different points in the line will have different y (proportion that the investors invest in
the risky asset). In the intercept the investor is investing zero. If we are at any point between
risk free and p then the proportion is between 0 and 1. When we go beyond p what is
happening is that the investor is borrowing money at the risk free to invest more the 100% of
his wealth in the risky asset.

Complication (Explaining the red part of the graph): Beyond point p investors are borrowing
money to invest more money in the risky asset. But for that we are assuming that investor can
borrow at the risk-free rate. But usually, investors are not able to borrow at a risk free rate, are
not free from the risk of defaulting. So, they will probably borrow at a higher rate than the risk-
free rate. If we consider this, beyond point p the CAL, the slop of this line, will be lower
because the sharp ratio using a higher risk free rate will be lower.

Now we can find a solution for an optimal portfolio. Where are the investors position them
self in the CAL?

Using the concept of utility, the solution is to maximize the utility function of the investment:

This the expected return and the variance for the combine portfolio. We can then substitute
the previously formulas of expected return and variance of the portfolio in this new one and
we will get to the second line formula. Solving this maximation problem (1st order condition)
gives us this optimal solution → The optimal allocation of the investors to the risk-free asset.
In this formula all the terms are equal to all investors apart from the A (risk aversion) varies
according to the investors profile. Higher coefficient of risk aversion mean the investor will
prefer less risky portfolio. Lower coefficient the inventor will prefer portfolio with higher risk.

This optimal solution has also a graphical representation that will combine the indifference
curve with the CAL line:

So, we have the CAL and then we plug a lot of different indifference curves. If we move to the
left, investors are selecting portfolios that are more attractive. So, investors would like to
position themselves to the most left indifference curve. At the same time the CAL line is
indicating the set of available combinations in the market. So combining this two concepts
we find that the optimal solution is the point that an indifference curve touches the CAL. So
the indifference curve needs to be tangent to the CAL in one point. This point here is the same
that we found with the optimal solution.