Chapter 6 Risk Aversion and Capital Allocation to Risky Assets

6.1 Risk and Risk Aversion

Risk-averse investors
They are willing to consider risk-free investments and risky investments with
positive risk premium.

Risk-neutral investors
Judge risky investments only by expected rates of return (the level of risk is
irrelevant).

Risk-loving investors
Happy to engage in investments with zero risk premium such as fair games and
gambles (prefer uncertainty to certainty).

Utility Function: risk aversion here I

↓
↑ ↑
U is the utility level {A0
2

U =L ( R )
-
=

A > 0 when investors are risk-averse

u E ( R ↑ EAT
"

A = 0 when investors are risk-neutral

-
=

% ↑ 2

A < 0 when investors are risk-loving U =L ( R )

_

±A
Different investor has different risk aversion level
Investors always choose the portfolio with the highest utility
Certainty Equivalent Rate is the rate of a risk-free investment needs to offer to
provide the same utility as the risky portfolio.

Indifference Curve
Connects all portfolios with different expected returns and standard deviations
with the same utility level.

> > > 0

Same

Utitty

A :O

A< 0
6.2 Capital Allocation across Risky and Risk-Free Portfolios

Weight of Equity Fund in the Complete Portfolio:

Weight of Bond Fund in the Complete Portfolio:

6.4 Portfolios of One Risky Asset and a Risk-Free Asset

Expected Return Risk

where

Covariance measures the expected tendency for two securities to co-vary.

Covariance is positive (negative) when the rates move in the same (opposite) direction,
the product of the deviations is positive (negative).
Covariance of returns is 0 if returns on the assets are unrelated.
Covariance of a return with itself is its own variance. Cor / Re .Rf ) =0

=E[ Re ECR :D ] / Rf ECRFI]

- -

=D

covCR-e.BE )
=
[ [ Re ECR :c) ][ Re ECR :c)]
-
-

'
=
[ [ Re ECR :c)]
-

=%
 Expected Return Risk

0
↑ ↑ Tfo

Substitute for 2 into 1:

Ratio
Sharpe

margin
Slope of
CAL on

E(R) buying )
invest
:
=
rf
to of loan
borrowing ( rate

#
1 ;
y> Capital Allocation
Line (CAL)

g-
-
i

y=o✓
< \
<
☐ y P = C

C =

0
However, nongovernment investors cannot borrow at risk-free rate. In other words, a typical
-free rate.

E(R)

Capital Allocation
Line (CAL)

P
6.5 Risk Tolerance and Asset Allocation
Given that there is a risky portfolio and a risk-free asset, any investor can construct any
complete portfolio (C).

Individual investor differences in risk aversion imply that different investors will
choose different positions in the risky portfolio (P) and risk-free asset (f).

"
Given the risk aversion level of each investor, different indifference curves with
different utility level can be generated.

Any investor will always prefer portfolios on higher indifference curve.

Higher indifference curves correspond to higher levels of utility.
The more risk-averse the investor, the steeper the indifference curves.

The indifference curve that is tangent to the CAL and the tangency point corresponds
to the standard deviation and expected return of the complete portfolio (C).

The more (less) the risk-averse the investor, the less (more) the weight will be given to
the risky portfolio (P) and the more (less) the weight will be given to the risk-free asset
(f).

CAL

.
IN-CLASS EXERCISE 1
Assuming the borrowing rate equals to the risk-free rate. An investor with a higher degree
of risk aversion, compared to one with a lower degree, will prefer complete portfolios
a. with higher risk premiums.
b. with higher standard deviations. ×
c. with lower Sharpe ratios.
d. with higher Sharpe ratios. *
◦
e. None of the above is true.

IN-CLASS EXERCISE 2
IMI uses the capital allocation line to make asset allocation recommendations. IMI derives
the following forecasts:
Expected return on the risky portfolio: 12%
Standard deviation on the risky portfolio: 20%
T-bill rate: 5%

A client seeks IMI s advice for a portfolio asset allocation and informs IMI that for every $4
he invests in the risky portfolio, he would borrow $2 further to invest. A bank is willing to
lend to the client with a premium of 2.5% on the T-bill rate. What expected return and
standard deviation should the client expect for his/her portfolio?

y= 4¥ = 1.5

yE(Rp ) +
( 1- g) ECRB )
ECR )
=
.

=
1.5112%7+(-0.5715-12.52)
=
14.25%
% =

gop
= 1.540% )
=
36%
 SELF-STUDY PROBLEM SET 1
Which of the following statements must be true?
a. A lower allocation to the risky portfolio reduces the Sharpe (reward-to-volatility) ratio. ×
@b. The higher the borrowing rate, the lower the Sharpe ratios of levered portfolios.
c. With a fixed risk-free rate, doubling the expected return and standard deviation of the
risky portfolio will double the Sharpe ratio.
d. Holding constant the risk premium of the risky portfolio, a higher risk-free rate will
increase the Sharpe ratio of investments with a positive allocation to the risky asset.

SELF-STUDY PROBLEM SET 2

The change from a straight to kinked capital allocation line is a result of the:
a. Reward-to-volatility ration increasing.

:
b. Borrowing rate exceeding the lending rate.
c.
d. Increase in the portfolio proportion of the risk-free asset.

SELF-STUDY PROBLEM SET 3

Use the following graph to answer the following questions.

a. Which indifference curve represents the greatest level of utility that can be achieved by
the investor?

b. Which point designates the optimal complete portfolio (C)?

F
SELF-STUDY PROBLEM SET 4

a. Based on the utility formula above, which investment would you select if you were risk
averse with A = 4? U -0.06
,
=
Uz= 0.1588 Investment } as Ttgwes the
'

'
highest
Uc, -0.1518
•

Ui -0.35
-

U .

b. Based on the utility formula above, which investment would you select if you were risk
neutral?
Investment 4 .

SELF-STUDY PROBLEM SET 5

Consider a risky portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of
risk aversion for which the risky portfolio is still preferred to bills?
12%-1-1748%5 > 7%
A- < 3.086
SELF-STUDY PROBLEM SET 6
The average annual rate of return on the S&P 500 portfolio over the past 80 years has
averaged roughly 8% more than the Treasury bill return and that the S&P 500 standard
deviation has been about 20% per year. Assume these values
expectations for future performance and that the current T-bill rate is 5%.
a. Calculate the expected return and standard deviation of portfolios invested in T-bills and
the S&P 500 index with weights as follows:
E( Rp ) Op "
P(A=2) Up( A- =3 )
13% 20% 0.09 0-07
11.4% 16% 0.0884 0.0756
9.8% 12% 0.0836 0.0764
8.2% 8% 0.0756 0.0724
6.6% 4% 0.0644 0.0636
5% 0% 0.05 0.05

b. Calculate the utility levels of each portfolio for an investor with A =2 and A = 3. What
do you conclude?
SELF-STUDY PROBLEM SET 7
You manage a risky portfolio with expected rate of return of 18% and standard deviation of
28%. The T-bill rate is 8%.
a. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money
market fund. What is the expected value and standard deviation of the rate of return on
his portfolio? E( Rc )
-0.748%7+0.318%7=15%9--0.7128%7
-

-19.6%
b. Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 25%, Stock B 32%, Stock C 43%

position in T-bills? 0.7428% __

17.5% wseodoc -_
0.7×43%-30 / %
wstock.is
.
=

Wstockp
=
0.7 ✗ 32% =
30%
22.4% We -
bills
=

c. What is the reward-to-volatility ratio (S) of your risky portfolio?

18% -8% 15%-8%0=0.3571
Sp =

28%
0.3571 "
So =

19.6%
d. Draw the CAL of your portfolio on an expected return standard deviation diagram.
What is the

e. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
i. What is the proportion y? yCl8% > + ( 1- g) ( 8%7=162
9=0.8
ii. -bill
fund? WA 0.865%7=0-2 We
=
-0.8143%7--0.344
-

WB 0.8 (32%0)=0.256 WT bills

=
0.2 -
=

iii. What is the standard deviation

G. =
0.8128%7=22 4% .

f. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete
deviation will not exceed 18%.
18% __y(zt% )
i. What is the investment proportion, y?
y= 64.29%
ii. What is the expected rate of return on the complete portfolio?
E(Rc)= 64.29%118%1+4 -64.29% ) @ %)
g. Your client s risk aversion is A = 3.5 14.43% 18% -8%
=

i. What is the investment proportion, y, should be invested in your fund??

9= 3.5128%5
ii. What is the expected rate of return and the standard deviation on the client s
optimized complete portfolio? g- 36.44%
8%-10.3644118%-8%7
-
11.64%
ECR )= .

% =
0.3644 ( 28%7=10.20 %
 ECR )

d) 0 3571
slope
=
.

CAL

18% - - - - -
•
-

15%
- - - - -

•
i
Ip
i

%
8% ' '

l I

%
19.6%28 % 6
SELF-STUDY PROBLEM SET 8
You manage an equity fund with risk premium of 10% with standard deviation of 14%. The
rate on Treasury bills is 6%. Your client chooses to invest $60,000 of her portfolio in your
equity fund and $40,000 in Treasury bills. What is the expected return and standard

toooo
0.6
y
= =

40000+6 oooo

ECR c) =
6%+0.6110%7
= 12%

% =
0.644% )

=
8.4%