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Lesson 2
Portfolio Theory &
Risk-Return Models
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Lesson 2 Portfolio Theory & Risk-
Return Models
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Content
Capital allocation across risky and risk
free asset
– Risk aversion and utility value
– Portfolios of a risky asset and one risk free asset
– Risk Tolerance and Asset Allocation
Optimal risky portfolios
– Portfolios of two risky assets
– Optimal risky portfolio (Asset allocation with
stocks, bonds, and bills)
– The Markowitz portfolio optimization model
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Risk aversion
Most investors are risk averse
Risk-averse investors consider only risk-free or
speculative prospects with positive risk
premiums. That is a risk-averse investor “penalizes” the
expected rate of return of a risky portfolio by a certain
percentage to account for the risk involved
The greater the risk, the greater the penalty (risk
premium).
How do investors choose portfolios with varying degrees
of risk?
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Table 6.1 Available Risky Portfolios (Risk-free
Rate = 5%)
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Utility Function
Utility Function:
U = E(r) – ½ Aσ2
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Utility Function
U = E(r) – 1/2 A 2
Where
U = utility (also called certainty
equivalent rate of return)
E(r) = expected return on the asset or
portfolio
A = coefficient of risk aversion
2 = variance of returns
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Utility Function
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Table 6.2 Utility Scores of Alter. Portfolios for
Investors with Varying Risk Aversion
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Utility Function
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Utility Function
− One portfolio can be assigned different scores of utility
by investors with different risk averse degrees.
− If an investor is sufficiently risk averse, he might
assign any risky portfolio a certainty equivalent rate of
return below the risk-free rate and will reject the
portfolio. At the same time, a less risk-averse investor
may assign the same portfolio a certainty equivalent
rate greater than the risk free rate and thus will prefer
it to the risk-free alternative
− Risky portfolios with zero risk premium always have
certainty equivalent rate being below risk free rate for
any risk-averse investor.
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Figure 6.1 The Trade-off Between Risk and
Returns of a Potential Investment Portfolio
Indifference Curve
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Figure 6.7 Indifference Curves for U = .05 and
U = .09 with A = 2 and A = 4
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Table 6.3 Utility Values of Possible Portfolios for
an Investor with Risk Aversion, A = 4
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Portfolios of a risky
asset and one risk free
asset
Capital Allocation Line
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Capital allocation across risky
and risk free portfolios
− Capital Allocation: how much of the
portfolio should be placed in risk-free
asset versus other risky asset classes
− Asset Allocation: how much of the
portfolio should be placed in risk-free
asset, bond portfolio, and stock portfolio.
− Security Selection: Lựa chọn các chứng
khoán cụ thể trong từng danh mục.
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Capital allocation across risky
and risk free portfolios
Risk Bond
Risk
free Risky free
F
P
Stock A F
B
C D E
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Capital allocation across risky
and risk free portfolios
− Examining the risk – return trade-off available to
investors through the capital allocation (fraction of
portfolio invested in risk free asset versus what is
invested in risky assets).
− Risk free asset: proxied asT-bills (F)
− Risky asset: risky component of the investor’s
overall portfolio comprises two mutual funds, one
invested in stocks (E) and the other invested in
long-term bonds (B)
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Capital allocation across risky
and risk free portfolios
− Take the composition of the risky
portfolio (P) as given.
− Focus only on the allocation between it
and risk-free securities
− When shifting wealth from the risky
portfolio to the risk-free asset, relative
proportions of the various risky assets
within the risky portfolio are not changed
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Example
rf = 7% rf = 0%
E(rp) = 15% p = 22%
y = % in P (1-y) = % in F
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Figure 6.4 The Investment Opportunity Set with a Risky Asset and
a Risk-free Asset in the Expected Return-Standard Deviation Plane
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Figure 6.5 The Opportunity Set with Differential
Borrowing and Lending Rates
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Figure 6.6 Utility as a Function of Allocation to
the Risky Asset, y
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Analysis of capital allocation using
the indifference curve
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Table 6.6 Spreadsheet Calculations of
Indifference Curves
A=2 A=4
SD U =0.05 U = 0.09 U =0.05 U = 0.09
0.000 0.050 0.090 0.050 0.090
0.050 0.053 0.093 0.055 0.095
0.100 0.060 0.100 0.070 0.110
0.150 0.073 0.113 0.095 0.135
0.200 0.090 0.130 0.130 0.170
0.250 0.113 0.153 0.175 0.215
0.300 0.140 0.180 0.230 0.270
0.350 0.173 0.213 0.295 0.335
0.400 0.210 0.250 0.370 0.410
0.450 0.253 0.293 0.455 0.495
0.500 0.300 0.340 0.550 0.590
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Figure 6.7 Indifference Curves for U = .05 and
U = .09 with A = 2 and A = 4
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Analysis of capital allocation using
the indifference curve
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Figure 6.8 Finding the Optimal Complete
Portfolio Using Indifference Curves
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Table 6.7 Expected Returns on Four
Indifference Curves and the CAL
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Analysis of capital allocation using
the indifference curve
− with rf = 7%, E(Rp) = 15%, σP = 22% and for an
investor with A = 4
− Figure 6.8 graphs the four indifference curves and
the CAL.
− The graph reveals that the indifference curve with U
= .08653 is tangent to the CAL;
− the tangency point corresponds to the complete
portfolio that maximizes utility.
− The tangency point occurs at σC = 9.02% and E(rC) =
10.28%, the risk–return parameters of the optimal
complete portfolio with y* = 0.41
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Passive Strategies: The Capital
Market Line
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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 “U.S. Market”
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Table 6.8 Average Annual Return on Stocks and 1-Month T-bills; S.
Dev. and Reward to Variability of Stocks Over Time
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