Risk and

Return
Week 4
Investments FNCE30001

Dr Patrick Kelly
Finance
 Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act.

Any further copying or communication of this material by you

may be the subject of copyright protection under the Act.

Do not remove this notice

How do we optimally
allocate wealth
between a risky and
risk-free asset?
 Lecture Overview
Statistics & Probability
State-Dependent Returns
Risk Aversion
Capital Allocation
 Reading
5.3 Risk and Risk Premiums
5.4 Learning from Historical Returns
6.1 to 6.5 Risk and Risk Aversion to Risk Tolerance and Asset Allocation (up to
“Non-Normal Returns”)

5
Statistics &
Probability

6
 Statistics vs. Probability
What is the difference between statistics and probability?

Why do we study statistics and probability together?

Roulette (“Little Wheel”)
 Wheel A Wheel B
What if you 40 20
couldn’t see the 41 5
wheel… 41 0
40 30
42 25
but you could see
42 10
the outcomes?
40 15
41 35
 Summarizing Past Returns
Arithmetic mean:
$
1
𝑟̄ = & 𝑟!
𝑛
!"#

Variance:
'
1
𝜎% = & 𝑟& − 𝑟̅ %
𝑇−1
&"#

Standard Deviation:
𝜎 𝑟 = 𝜎% 𝑟 = 𝑣𝑎𝑟 𝑟
State-
Dependent
Returns
(“Scenario”-based Returns)
 States of the World (“Scenarios”)
• Idea: there are several potential “states” of the economy/world at a fixed
point in the future (say, 1 month or 1 year from today)
• Each state has an associated probability of occurring

State Probability
Good 20%
Normal 35%
Bad 45%
 State-Dependent Returns
Most (all?) assets are risky
We’ll model their returns as state-dependent random variables

State Probability rRio

Good 20% 12%
Normal 35% 5%
Bad 45% -3%
 Expectation, Variance,
Standard Deviation
Since the return is a random variable, it has an expectation (mean) and a
variance:
𝐸 𝑟̃ = ∑𝑝𝑟𝑜𝑏 𝑠 𝑟 𝑠

𝑣𝑎𝑟 𝑟̃ = 𝜎 % 𝑟̃ = ∑𝑝𝑟𝑜𝑏 𝑠 𝑟 𝑠 − 𝐸 𝑟̃ %

where
• prob(s) is the probability of state s occurring
• r(s) is the return in state s

Standard deviation is often used instead of variance:

𝜎 𝑟̃ = 𝑣𝑎𝑟 𝑟̃
 E[𝑟!"#
̃ ] & var(𝑟!"#
̃ )
State Probability rRio
Good 20% 12%
Normal 35% 5%
Bad 45% -3%

𝐸 𝑟()*
̃ = .20 .12 + .35 .05 + .45 −.03 = .028

𝑣𝑎𝑟 𝑟()*
̃ =.20 .12 − .028 % +.35 .05 − .028 % + .45 −.03 − .028 %

= .003376
𝜎()* = .003376 = .0581
From Bloomberg.com: “Wall Street
Trading Desks Map Out Game Plans for
CPI Scenarios” (14 Feb 2023)

16
Risk
Aversion

17
 What is Risk?
Generally speaking: “risk” in finance = “uncertain outcomes”

𝕊
𝑣𝑎𝑟 𝑟̃ = 𝜎 % 𝑟̃ = & 𝑝𝑟𝑜𝑏 𝑠 𝑟 𝑠 − 𝐸 𝑟̃ %

+"#

We assume we can estimate the probabilities of these uncertain outcomes

We will often – though not always – quantify risk as the standard deviation of
an asset’s returns (σ)
 Risk Preferences
Standard assumption: investors are “risk averse”
• For a given level of expected returns, investors prefer the least risk possible

What factors might affect an investor’s level of risk aversion?

• Age, health, wealth, marital status, children
• But the big things are probably innate personality and personal experiences
 Risk Aversion: Example
Consider the following game:
I flip a coin
• If it comes up “heads”, I pay you $100
• If it comes up “tails”, you pay me $100

Would you want to play this game?

 How to quantify risk preferences?
Utility functions are used to rank a person’s preferences over combinations of
goods (desired) and bads (undesired)

For example, if (a,b) represents combinations of apples and bananas:

U(a,b) > U(aʹ,bʹ)
implies that this person prefers the bundle (a,b) over (a’,b’)

U(4,10) > U(5,8) means that this person would rather have 4 apples and 10
bananas than 5 apples and 8 bananas
 Mean-Variance Criterion
For our purposes, the “good” will be mean (or expected) return and the “bad”
will be standard deviation or variance
 What about other moments?
The Mean-Variance Criterion implies that we will assume investors don’t care
about other moments (characteristics) of an asset’s distribution
 What utility function should we
use?
There are no formal restrictions…

But presumably we want a utility function that captures risk aversion:

• Higher expected return à greater utility (happiness)
• Higher standard deviation à less utility
 We will focus on utility functions
of this form:
1
𝑈 = 𝐸 𝑟̃ − 𝐴𝜎 !
2
• 𝐸 𝑟̃ = expected return of an investment
• σ = standard deviation
• A = investor-specific term measuring her preference toward risk

• if A > 0, the investor is risk-averse

• if A = 0, the investor is risk-neutral
• if A < 0, the investor is risk-loving
 Why Utility Function?
Suppose the investor is choosing between the following three investments:

Investment Expected Return SD

Low Risk 8% 6%

Medium Risk 10% 12%

High Risk 14% 19%

A utility function allows us to rank every possible risk-return combination

 Investment Expected Return SD
Low Risk 8% 6%
Utility
Medium Risk 10% 12%

High Risk 14% 19%

Suppose we estimate the investor has A=2
1
𝑈 = 𝐸 𝑟̃ − 𝐴𝜎 %
2

We can calculate the investor’s utility of holding each portfolio:

1
𝑈 Low Risk = .08 − 2 .06% = .0764
2
1
𝑈 Medium Risk = .10 − 2 .12% = .0856
2
1
𝑈 High Risk = .14 − 2 .19% = .1039
2
 Indifference Curves
Indifference curve: the set of standard deviation and expected return
combinations that provide the investor with the same amount of utility

For example, an indifference curve for U = .04 corresponds to all investments i

such that
U(𝐸 𝑟!̃ ,σi) = .04
 Drawing an Indifference Curve
For an investor with A = 2, how can we compute the indifference curve for U =
.04?
• Pick some arbitrary 𝐸 𝑟!̃
• Find the σi such that 𝐸 𝑟!̃ −(1/2) 2 σi2 = .04

𝐸 𝑟!̃ σi U

.04 0 .04 − 02 = .04

.05 .10 .05 − .12 = .04

.06 .141 .06 − .141 ≈ .04

... ... ...

 Risk-Aversion, Graphically
1 % E[r]
𝑈 = 𝐸 𝑟̃ − 𝐴𝜎 Indifference Curve
2
𝐴>0

Higher Q
S
Return

P σ
R

More
Risk
 Risk-Averse Preferences
1 % E[r]
𝑈 = 𝐸 𝑟̃ − 𝐴𝜎
2
𝐴>0

P σ
 Risk-Loving Preferences
1 % E[r]
𝑈 = 𝐸 𝑟̃ − 𝐴𝜎
2
𝐴<0

P σ

Q
 Risk-Neutral Preferences
𝑈 = 𝐸 𝑟̃ E[r]
𝐴=0

Q
P σ
Risk-Aversion and Indifference
Curves
Capital
Allocation
 Definition of “Portfolio”
A portfolio is a collection of assets.
The fraction of our investment in each asset is called its “portfolio weight”

Asset Weight

Risky Asset 25%

Risk-Free Asset 75%

The weights must sum to 100%

 Portfolio of Portfolios
The components of a portfolio may themselves be portfolios
Consider a portfolio with a value of $300,000:
• $90,000 is invested in risk-free securities
• the rest is invested in a risky portfolio P
• P: 60% stock A and 40% stock B

Let w denote the weight of the risky securities in the overall portfolio:

%#-,---
𝑤= = 70%
/--,---
0-,---
1−𝑤 = = 30%
/--,---
 Rebalancing a Portfolio
The investor would like to reduce her allocation of risky securities from 70% to
40%
Assuming she does not want to change the composition of portfolio P, how does
she accomplish this?

1. Sell 30% of her wealth in P: .30 * $300 = $90

• Since P is 60% A and 40% B, this means she sells
• .6 * $90 = $54 of A
• .4 * $90 = $36 of B
2. Use proceeds ($90) to buy the risk-free asset
 Capital Allocation
How do we optimally allocate wealth (capital)
between a risky portfolio P and a risk-free asset?

We need to consider two things:

1. The risk-return combination available to the investor
2. Personal risk-return preferences of the investor
 Capital Allocation
Consider a portfolio C (a complete portfolio):
• w invested in a risky asset P
• 1 − w invested in the risk-free asset

C has the following properties:

𝐸 𝑟1̃ = 𝑤𝐸 𝑟2̃ + 1 − 𝑤 𝑟3

𝜎1% = 𝜎 % 𝑟1̃ = 𝑤 % 𝜎2% + 1 − 𝑤 % 𝜎3% + 2𝑤 1 − 𝑤 𝑐𝑜𝑣 𝑟2̃ , 𝑟3̃

𝜎1% = 𝑤 % 𝜎2%
𝜎4 = 𝑤𝜎2
 Example
Suppose:
• 𝐸 𝑟5̃ = 15%
• σP = 22%
• rf = 7%
We can construct the following table:

w 𝐸 𝑟!̃ σC

0 7% 0%

0.5 11% 11%

1 15% 22%
 What about borrowing?
If we allow borrowing at the risk-free rate (i.e., buying on margin), we can
extend the previous table:

w 𝑬 𝒓& 𝑪 σC
0 7% 0%

0.5 11% 11%

1 15% 22%

1.5 19% 33%

On a graph: The plot of all 𝐸 𝑟1̃ & σC combinations available to the investor =
Capital Allocation Line (CAL)
What are the investor’s feasible
investment opportunities?
 Capital Allocation Line (CAL)
Increasing the fraction of the overall portfolio (w) invested in the risky asset
from 0% to 100%
• increases expected return by 8%
• increases standard deviation by 22%

The extra return per unit of risk is .08/.22 = 0.36

• Slope of the CAL
• Also called the Sharpe ratio of P:

𝐸 𝑟2̃ − 𝑟3
𝑆2 =
𝜎2

The investor wants an investment P with a steep CAL (high Sharpe ratio)
 Personal preferences and asset
allocation
For a given risky portfolio/asset P:
• An investor chooses a complete portfolio (a mix of risk-free asset and P) on
the CAL
• Trade-off between risk and (expected) return
• Different investors may have different levels of risk-aversion → they may
choose different complete portfolios
 w 𝐸 𝑟(̃ σC Utility
0 0.07 0 0.0700
0.1 0.078 0.022 0.0770
Given A = 4,
we can 0.2 0.086 0.044 0.0821
calculate the 0.3 0.094 0.066 0.0853
utility for 0.4 0.102 0.088 0.0865
different 0.5 0.11 0.11 0.0858
values of w 0.6 0.118 0.132 0.0832
0.7 0.126 0.154 0.0786
0.8 0.134 0.176 0.0720
0.9 0.142 0.198 0.0636
1 0.15 0.22 0.0532
Utility versus w

w
 Maximising utility mathematically
1 %
max 𝑈 = max 𝐸 𝑟1̃ − 𝐴𝜎1
2

1 %
= max w ⋅ 𝐸 𝑟2̃ + 1 − 𝑤 ⋅ 𝑟3 − 𝐴 𝑤𝜎2
6 2

𝐸[𝑟2̃ ] − 𝑟3
𝑤∗ =
𝐴𝜎2%

w∗ = equation for the optimal allocation in the risky portfolio for an investor
 Continuing the Example
Recall:
• Risk-free rate = 7%
• 𝐸[𝑟!̃ ] = 15%
• σP = 22%
• A=4
Acc. to the formula, the optimal proportion of funds invested in the risky portfolio is:

𝐸[𝑟!̃ ] − 𝑟# .15 − .07

w∗ = = = 0.413
𝐴𝜎!$ 4 ⋅.22$

Pretty close to our “brute force” solution of 0.4

 Optimal Complete Portfolio
Goal: Find the complete portfolio on the highest indifference curve that still
touches the CAL

• Identify the indifference curve which is tangent to the CAL

• Tangency point corresponds to expected return and standard deviation of

the portfolio that maximises utility
Optimal Complete Portfolio

Indifference Curve

CAL

C
Different Risk Preferences
Different Complete Portfolio

Cless risk averse

C
What if the is an asset with a
higher Sharpe Ratio?

Cless risk averse

C
Cless risk averse
C
 Sharpe Ratio and the Optimal
Risky Portfolio
Regardless of risk preferences (for any A, 0 < 𝐴 ≤ ∞):

All investors will prefer to form complete portfolios, out of risky assets that
provide the highest Sharpe Ratio possible.

𝐸 𝑟2̃ − 𝑟3
𝑆2 =
𝜎2

54
 Different Preferences (A) with age:
Lifecycle Capital Allocation
Reducing the risk of your portfolio as you age.
• Because you might not have time to recover from negative shocks.

55
Illustration of the benefits of life
cycle investing

Nov. ‘07 Sept. ‘13

56
 CAL with Different Borrowing and
Lending Rates
Suppose that the rates for borrowing and lending are different

Specifically: rBorrow > rLend

(Why is the opposite never possible for an individual?)

To draw our CAL, we must draw two segments

• one that corresponds to lending
• one that corresponds to borrowing
 CAL with Different Borrowing and
Lending Rates
Recall our earlier example with 𝐸[𝑟)̃ ] = 15% and σP = 22%
Let the lending rate be rLend = 7% and the borrowing rate be rBorrow = 9%

𝑆 𝑤 > 1 =.27

𝑆 𝑤 ≤ 1 =.36
 CAL with Different Borrowing and
Lending Rates
Consider a levered portfolio with -50% in the risk-free asset and 150% in P

• 𝐸[𝑟]̃ = −0.5(.09) + 1.5(.15) = 18%

• σ = 1.5(.22) = 33%
• Sharpe Ratio =.09/.33 = 0.27
• Smaller than the Sharpe ratio we found earlier (0.36), which corresponds
to the lending rate
 Key Questions
What is the relationship between statistics and probability?
What is the difference between an asset’s expected return and its realized
return?
What does it mean for a stock (return) to have high variance?
What is risk aversion, and how does it affect an investor’s optimal investment
choice?
 COMMONWEALTH OF AUSTRALIA

Copyright Regulations 1969

Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act. Any further copying or communication of this
material by you may be the subject of copyright protection
under the Act.

Do not remove this notice