0522 Financial Investment UNIT 5

FINANCIAL INVESTMENTS MBF301
UNIT 5 – Capital Allocation to risky assets
1. Risk and risk aversion

2. Capital allocation across risky and risk free
asset portfolios
3. The risk-free assets
4. Relationship between risk and return
5. Portfolios of one risky asset and a risk-free
asset
6. Risk tolerance and asset allocation
7. Passive strategies: The Capital Market Line
1

Let’s focus on a 3 different portfolios:
I. A portfolio of T-bills US Govt < 2 years
II. A portfolio of U.S. government bonds
III. A portfolio of U.S. common stocks
These investments offer different degrees of risk
and real rate of return: there is still some
uncertainty about inflation 2

How a $1 investment at the start of 1900 would have
by end of 2008, Acc. all dividend and interest payment
In real terms
3
• 2. Risk and risk aversion

• Compare and note how inflation has eroded
the purchasing power of returns to investors
• By switching to LT government bonds, the
investor acquires an asset whose price
fluctuates as interest rates vary
• Bond prices fall when interest rates rise and
vice versa 4

• An investment in LT Treasury bonds would
have produced $242. Common stocks were in
a class by themselves. An investor who placed
a dollar in the stocks of large U.S. firms would
have received $14,276
• Investment performance coincides with our
intuitive risk ranking 5

Common stocks offered a risk premium of 7.1%
(11.1 - 4.0), over the return on Treasury bills
The reason is that annual rates of return for
common stocks fluctuate so much that averages
taken over short periods are meaningless
6
The ranking reveals a significant fall in overall

optimism about the global economy since pre- and
early-pandemic levels last year
7
8
Range of the marginal effect of risk aversion on the
bank lending rate
(ECB)
9
2. Capital Allocation Line CAL

• CAL is a line that graphically depicts the risk-
and-reward profile of assets, and can be used
to find the optimal portfolio
• Portfolio expected return and variance
• The portfolio’s expected return is a weighted
average of its individual assets’ expected
returns, and is calculated as:
10
E(Rp) = w1E(R1) + w2E(R2)

w1, w2 : respective weights for the 2 assets
E(R1), E(R2), respective expected returns
Higher variance means higher levels of risk and
vice versa
A portfolio variance also depends on the
covariance and correlation of the 2 assets
The formula for portfolio variance is given as:
11
Var(Rp) =
w21Var(R1) + w22Var(R2) + 2w1w2Cov(R1, R2)
Cov(R1, R2): covariance of the 2 asset returns
Alternatively, the formula can be written as:
σ2p = w21σ21 + w22σ22 + 2ρ(R1, R2) w1w2σ1σ2
ρ(R1, R2): the correlation of R1 and R2
ρ(R1, R2) = Cov(R1, R2)/ σ1σ2: conversion between
correlation and covariance 12
2. Capital Allocation Line and Optimal Portfolio:

ØDiversification is a technique that minimizes
portfolio risk by investing in assets with
negative covariance
ØIn practice, we do not know the returns and
standard deviations of individual assets, but
we can estimate these values based on these
assets’ historical values
13
2. The efficient/ portfolio frontier

• Graph that maps out all possible portfolios
with different asset weight combinations and
with x-axis: levels of portfolio standard dev
y-axis: portfolio expected return
To construct a portfolio frontier, first assign
values for E(R1), E(R2), stdev(R1), stdev(R2), and
ρ(R1, R2..)
14
2. The efficient frontier

Calculation of the
portfolio expected
return and variance for
each possible asset
weight combinations
15

Use the scatter chart with smooth lines to plot
the portfolio’s expected return and standard
deviation
16

• To know which portfolios are attractive to
investors > mean-variance criterion:
• Portfolio A dominates Portfolio B if E(RA) ≥
E(RB) and σA ≤ σB , hence investors would
prefer A
• Any investor would optimally select a portfolio
on the upward-sloping portion of the portfolio
frontier, called the efficient frontier,
or minimum variance frontier 17
• Investors often combine risky assets with risk-

free assets (such as govies) to reduce risks
• The expected return of a complete portfolio is
given as: E(Rc) = wpE(Rp) + (1 − wp)Rf
• And the variance and standard deviation of
the complete portfolio return is given as:
• Var(Rc) = w2pVar(Rp), σ(Rc) = wpσ(Rp),
• where wp is the fraction invested in the risky
asset portfolio 18

• While the expected excess return of a
complete portfolio is calculated as
• E(Rc) – Rf, if we substitute E(Rc) with the
previous formula, we get wp(E(Rp) − Rf
• The standard deviation of the complete
portfolio is σ(Rc) = wpσ(Rp), which gives us:
• wp = σ(Rc)/σ(Rp)
• Therefore, for each complete portfolio: 19
Or E(Rc) = Rf + Spσ(Rc), where Sp =

• The line E(Rc) = Rf + Spσ(Rc) is the capital
allocation line (CAL)
• The slope of the line, Sp, is the Sharpe ratio, or
reward-to-risk ratio. The Sharpe ratio
measures the increase in expected return per
unit of additional standard deviation
20
• The optimal portfolio consists of a risk-free

asset and an optimal risky asset portfolio
• The optimal risky asset portfolio is at the point
where the CAL is tangent to the efficient
frontier
• The slope of CAL is the highest mean we
achieve the highest returns per additional unit
of risk 21
s:
22
s:

The tangent portfolio weights are calculated as
follows:
This asset weight combination gives the best

risk-to-reward ratio, as it has the highest slope
for CAL
23
BCO222 BUSINESS FINANCE II (4 ECTS)
UNIT 1 and 2 – Rate of return, don´t get confused
Required rate of return: CAPM
Cost of capital: necessary return on a project to

make it worthwhile
Discount rate: rate used to discount future cash

flows of an investment / project
24
BCO222 BUSINESS FINANCE II (4 ECTS)
UNIT 1 and 2 – Rate of return, don´t get confused

Net proceeds / transaction or flotation costs:
Cost of issuance of new share for a company
Used in Dividend growth model =

Share price = D1
k-g
k = required rate of return
g = growth rate
25
2. Capital allocation across risky and risk free

asset portfolios
Asset allocation is the proportion of funds
among different types of assets, such as stocks
and bonds, with different expected returns/ risk
Capital allocation is the apportionment of funds
between risk-free investments, such as T-bills,
and risky assets, such as stocks 26
2. Capital allocation across risky assets/ risk free

• Speculation is the undertaking of a risky
investment for its risk premium
• Investors will avoid risk unless there is a
reward
• The utility model gives the optimal allocation
between a risky portfolio and a risk-free asset
– Risk-averse
– Risk lover
– Risk neutral 27
2. Capital allocation across Risky Assets

• Risk and return are trade-offs and follow a
linear relationship
• High-risk investments present a high
probability of an investor losing all
• Having a solid understanding of one’s u of
money can help investors make investment
decisions that are more suited to their risk
attitudes and investment strategies 28
2. Capital allocation: Utility theory

• Difficult to quantify u as individuals have
different u functions
• Marginal utility refers to how much
incremental u an individual derives from
obtaining 1 additional unit of a certain good/
service
• After having a certain amount of a particular
good or service, the u of acquiring one more
unit of the good/service falls 29
2. Capital allocation across Risky Assets

U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
σ2 = standard deviation of returns
1⁄2 = a scaling factor
U= E (r) – 1 x A σ2
2 30
Utility curves
1. Risk Averse: As the investor takes on

more risk (hence possibility of greater
returns), they will start to have a
smaller desire to take on further risk
31
Utility curves
2. Risk neutral
such an investor would
continuously take on more risk
since this will result in more
utility. This type of investing
behavior is quite rare
32
Utility curves
3. Risk loving
This attitude towards risk
would be exponential, meaning
that this investor
experiences increasing
marginal utility
33
34
2. Capital allocation across risky and risk free asset

portfolios: the simplest case of capital allocation
ØThe risk-return profile of a 2-asset portfolio is
determined by the proportion of the risky asset
to the risk-free asset
ØIf this portfolio consists of a risky asset with a
proportion of y, then the proportion of the risk-
free asset must be 1 – y 35
3. The risk-free assets

Monetary policy environment influence risk free
assets - and overall portfolio construction
• The risk-free rate of return concept initially
contributed to the 1960 portfolio theory, now
known as the CAPM, refined independently by
W. Sharpe, J.Treynor, J. Lintner and J. Mossin
• However are Govt rates 100% risk-free ? 36
37
https://www.putnam.com/individual/content/perspectives/8653-how-could-the-yield-curve-impact-risk-assets-in-2022
https://www.frbsf.org/economic-research/publications/economic-letter/2022/may/current-recession-risk-according-to-yield-curve/ 38
https://www.statista.com/statistics/1058454/yield-curve-usa/
39
• Government bonds do hold risk - hence price

fluctuations in the secondary market
• However they are risk free if held to maturity
as governments will not default on their debt
Institutional Retail investors
investors
risk-free assets Risk-free assets are
ensure CF as - less risky than shares and
their liabilities - may dilute the effect on the portfolio of a
fall due stock market sell-off 40
3. Risk-free rate
• Interest rate an investor can expect to earn on
an investment that carries zero risk
• In practice, considered to equal interest paid
on a 3-mth T-bill, “the safest investment”
• The risk-free rate may differ from investor to
investor
41
3. Risk-free rate
• From an investor’s perspective, rising rates are
a good sign since it signals a confident
treasury and the ability to demand higher
returns
• T-bills fell as low as 0.01% during the 1940s
and 2010s, and as high as 16% in the 1980s:
42

High T-bill rates usually signal prosperous
economic times when:
– private sector companies are performing well,
– meeting earnings targets, and
– Increasing stock prices over time
43
3. Risk-free rate: Bond Default Spread

A bond with default risk is riskier than a bond
(same coupon and maturity) issued by a default-
free entity
Price of risk = differences between the 2 bond yields
10-year corporate bond 3% yield and a
10-year govt bond (same ccy + no default risk),
yield of 1.00%
44

3. Risk-free rate: Bond Default Spread
Comparison of the yield to maturity, which is the
IRR on the bond, given how it is priced:
45
46

Spreads on riskiest high yield widens by most YTD
47
https://bondevalue.com/news/spreads-on-riskiest-high-yield-bonds-widen-by-most-ytd/
48
49
https://www.forbes.com/sites/kristinmckenna/2022/03/14/its-been-one-of-the-top-5-worst-starts-to-a-year-for-stocks-and-bonds/
Implied Equity Risk Premium and Risk free rates
50

3. Risk free rates – Yield curve
• Graphical representation of the interest rates on
debt for a range of maturities
• Shows the yield an investor is expecting to earn if
he lends his money for a given period of time
• Typically upward sloping: a rational market will
generally want more compensation for greater
risk
51

3. Risk free rates – INVERTED Yield curve:
Ø Perception of long-term investors that interest
rates will decline in the future
Ø Main reasons is the expectation of a decline in
inflation
Ø Leading indicator of an economic downturn
52

3. Risk free rates – STEEP Yield curve:
Ø When LT yields are rising faster than ST yields
Ø Indicates the start of economic expansion
Ø Reflects larger difference between ST and LT
return expectations
53
3. Risk free rates – FLAT Yield curve:

All maturities have similar yields
When there is a transition between the normal
yield curve and the inverted yield curve
54
3. Risk free rates – HUMPED

Yield curve:A
When MT yields are greater
than both ST yields and LT
yields
A humped curve is rare and
typically indicates a slowing
of economic growth
55
3. Risk free rates: Inflation versus interest rates

Central banks tend to respond to a rise in expected
inflation with an increase in interest rates
Resulting in higher demand for UST/ Govt bonds
Eventually lead to a decrease in interest rate
A rise in inflation leads to a decrease in purchasing

power and, therefore, investors expect an increase
in the short-term interest rate 56
3. Risk free rates: Importance of yield curve

Normal upward sloping curve = LT UST higher yield,
Inverted curve shows ST UST have a higher yield
Ø The steeper the upward yield curve, the higher is
the profit between ST and LT borrowing rates
Ø Curve indicates trade-off between maturity/ yield
Ø and also whether a security is temporarily
overpriced (below curve) or overpriced (under) 57
3. Risk free rates

• Historically, risk-free UST have been higher than
interest rate swap (swap) of the same maturity
• The difference between the 2 rates is known as
the swap spread
• Swap spreads represent the incremental funding
cost for financial institutions and the credit
spread over the corresponding benchmark UST
for interbank lending 58
3. Risk free rates - European yield curves:
59
60
https://ycharts.com/indicators/2year_eurozone_central_government_bond_
par_yield_curve 61
62
63
UK yield curve – risk free rate:
3. Risk free rates – Yield curve
64
ØHolding a cash buffer as portfolio insurance

could be an alternative when bonds are dear
sensitive to rising interest rates
W.Sharpe:
‘’Investor with an average risk tolerance should
seek to maintain asset class positions in
proportion to the market values of the
underlying assets’’ 65
4. Relationship between risk and return - CAPM

• Least risky investment: T-bills with beta of 0
• Much riskier investment: a portfolio of stocks,
with an average market risk - its beta is 1.0
ØInvestors require a higher return from the
stocks portfolio than from T-bills measure by
the market risk premium (rm – rf)
Since 1900 the market risk premium has
averaged 7.3% a year 66
4. Relationship between risk and return - CAPM
67
But what is the expected risk premium when

beta is not 0 or 1?
W. Sharpe, J. Lintner and J. Treynor answered in
1960s with the Capital Asset Pricing Model:
In a competitive market, the expected risk
premium varies in direct proportion to beta
Meaning that in previous graph all investments
must plot along the sloping line, known as the
security market line 68
5. Portfolios of 1 risky asset and a risk-free asset

ØPortfolio S has a 15% expected return and a
STDEV of 16%
ØTreasury bills offer an interest rate (rf) of 5%,
hence their STDEV is zero
Suppose the portfolio S is 50% invested in T-bills
r = (1/2 x expected return on S) + (1/2 x int. rate)
= (0.5 x 0.16) + (0.5 x 0.05) = 10% 69
The STDEV is halfway between the STDEV of S

and the STDEV of Treasury bills:
STDEV (σ) = (1/2 x σ of S) + (1/2 x σ T-bills)
= (0.5 x 0.16) + (0.5 x 0) = 8%
Suppose you borrow at the T-bill rate an amount
equal to your initial wealth, and invest 100% in S
Hence twice the investment in S, but you have
to pay interest on the loan, expected return is: 70
r = (2 x 0.15) - (1 x 0.05) = 25%

STDEV (σ) = (2 x σ of S) - (1 x σ T-bills) = 32%
When you lend a portion of your money, you
end up partway between rf and S
ØIf you can borrow money at the risk-free rate,
you can extend your possibilities beyond S
ØRegardless of the level of risk you choose, you
can achieve the highest expected return from
a mixture of S and borrowing or lending 71
Graph of efficient portfolios
72
• Start on the vertical axis at rf and draw the

steepest line to the curved red line of efficient
portfolios
• That line will be tangent to the red line
• The efficient portfolio S at the tangency point
is better than all the others
S offers the highest ratio of risk premium to
standard deviation 73
This ratio of the risk premium to the standard

deviation is called the Sharpe ratio:
Sharpe ratio = Risk premium = r - rf

STDEV σ
Sharpe ratios measure the risk-adjusted

performance of investment managers
74
1) First, the best portfolio of common stocks

must be selected - S in our example
2) Second, this portfolio must be blended with
borrowing or lending to obtain a risk
exposure defined by the investor
3) Hence why the investor should invest into
just two benchmark investments:
- a risky portfolio S and
- a risk-free loan (borrowing or lending) 75
How to select stocks of portfolio S ?

ØIf the investor is better informed than others,
portfolio should include large investments in
undervalued stocks
ØBut in a competitive market, there is no
reason to hold a different portfolio from
others - the market portfolio
Reason why there are market-index portfolios
and well-diversified portfolios 76
Capital Market line:

Theoretical concept representing all the
portfolios that optimally combine the risk-free
rate of return and the portfolios of risky assets
Security market line
Measures the risk through beta, which helps to
find the security´s risk contribution to the
portfolio 77
Beta of Expected risk premium on the market

0.05 Half or 50% on the market
2 Twice or 200% on the market
Expected risk premium on stock =

beta x expected risk premium on market
R – rf = Beta x ( rm – rf)
78
Estimates of the betas of 10 stocks:
Investors are looking for a return of 8.9% from

businesses with the risk of Exxon 79
Risk free rf bills is about 2%.

Assume market risk premium is 7%
Dow Chemical present the highest return: 14.5%
Heinz present the lowest return: 4.78%
Difference between short- and long-term
interest rates: a cost of capital based on short-
term rates may be inappropriate for long-term
capital investments
https://www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions 80
Emerging and frontier markets facing tighter
financial conditions and higher probability of
portfolio outflows: 30% in Q1, up from 20% in
Oct 21 (Global Financial Stability Report)
81
1. Define efficient portfolios

2. Why would one efficient portfolio is better
than all the others ?
3. What is the difference in the portfolio
structure between risk-averse and risk-
tolerant investor ?
4. What does the composition of the best
efficient portfolio depends on ? 82
1. Efficient portfolios offers the highest

expected return for a given STDEV
2. A risk-averse investor will invest partly in the
efficient portfolio and in the risk-free asset,
whilst a risk-tolerant investor may invest all in
the efficient portfolio, or/and may borrow
3. The composition of the best efficient
portfolio depends on expected returns,
standard deviations, and correlations 83
üIf all investors have the same info, then all

investment portfolios would be similar
üFocus on the contribution of a stock to the
portfolio risk: hence beta
üTherefore the risk premium demanded by
investors is proportional to beta: what CAPM
states
84
Future state of alternative investments
85
Source: CAIA Association
86
ØIdiosyncratic risks facing companies can be

diversified away by holding a combination of
shares - Modern Portfolio Theory (Markowitz)
ØIn a perfectly diversified equity portfolio, the
risk of owning shares equates to the rises and
falls of the market - known as beta risk
The returns of an ETF outperforming a market
index are market moves + dividends - small fee. 87
ØCurrently energy security, supply chains and

inflation expectations are being re-thought
ØHence more disperse returns on common
stocks in future
According to E. Fama and K. French, share prices
driven by 3 factors:
1. Beta
2. Companies size -outperformance of smallcap
3. Value - outperformance of sotck P/B value <188
P/B value = Share price = Market cap

BV per share Book Value
Book Value = Total Assets + Total Liabilities
ØThe 3 factors model was true in 1960s but not
recently as
1.) eco growth powered by businesses deriving
productivity gains from intangible assets such
as R&D, technology patents and brands 89

https://www.mckinsey.com/business-functions/marketing-and-sales/our-
insights/getting-tangible-about-intangibles-the-future-of-growth-and-productivity
2). Historically low interest rates and monetary

policy measures to control the money supply
- like quantitative easing (QE), have favored
investing in more expensive stocks that
promise sustained earnings growth
90
In 2015, Fama and French (and M. Crarhart)

added 2 factors to their model:
4). The proportionate effect that companies’
profitability had on their stock returns
5). Momentum, the fact that stocks continuing
to outperform after the market catches on to
a positive news story
91
Importance of interest rates environment:

- Higher interest rates environment enhance a
reset to valuation assumptions
- Implied stocks' forward rate of returns are
lower if shares trade at high levels
- A low rates environment support eco growth
and companies’ profits - making it more
probable to beat earnings targets 92
Importance of interest rates environment:

- Stocks usually more attractive relative to
supposedly riskless assets – calculated by the
equity risk premium (ERP), compensation for
the risks of investing in shares
93
https://www.investorschronicle.co.uk/news/2022/03/31/keeping-risk-at-bay/
95
https://www.schwab.com/resource-center/insights/content/2022-outlook-stocks-bonds-and-more
96
Would you invest in a stock that do not lie on the

Security Market Line (SML)?
97
Would you invest in a stock that do not lie on the

Security Market Line (SML)?
98
Would you buy stock A?

You should not as investing 50% in T-bills and
50% in A would provide a higher expected
return
If all investors have the same expectation for A,
then the price of A will fall until the expected
return matches what one could get elsewhere
99
What about stock B ?

ØOne could get a higher expected return for the
same beta by borrowing 50% of total
investment and investing in the market prtflio
ØIf all investors do the same, the price of B will
fall until the expected return on B is equal to
expected return on the combination of
borrowing + investment in the market portflio 100
• An investor can always obtain an expected risk

premium of beta ( rm - rf ) by holding a mixture
of the market portfolio and a risk-free loan
• But are there stocks offering a higher expected
risk premium - that lie above the security
market line ?
• Stocks on average lie on the line, none lies
below the line, they can’t be any above 101
Therefore each and every stock must lie on the

security market line (SML) and offer an expected
risk premium of:
r – rf = Beta x (rm – rf)
102
6. Risk tolerance: first phase

Desired asset allocation?
Ø how much of portfolio should be invested in each
asset class (e.g., U.S. stocks, international stocks,
and bonds)
The primary factors determining risk tolerance are:
1. The investor’s economic/financial ability
2. The investors’ emotional/psychological ability
3. The investors’ economic ability to handle risk 103

Comfort with Volatility “How far could one’s portfolio
fall before wanting to sell and move to cash?”
At age 25 you experienc a 40% loss and can handle it
At 45, and your portfolio is 10-times the size that it
was at age 25, hence a 40% loss is different
A conservative approach can only result in missing
out on a relatively small incremental return.
104

A too aggressive portfolio will suffer during periods
of high volatility
Selling after a sharp decline in the market can
eliminate the extra return from having a stock-
heavy allocation, for instance
https://www.tiaa.org/public/pdf/Asset_Allocation_Guide_A38473.pdf
Second phase: asset allocation decision:

stock/bond allocation 105

6. Risk tolerance levels: 3 options for 2022
Lower risk tolerance: Pursue a higher return than
cash in ST bond strategies
Investors are anxious given recent market volatility
> An actively managed ST bond strategy help
- enhancing returns
- reserving capital, and
- maintaining daily liquidity
106

Medium risk tolerance: Seek out the opportunities
in public bond markets
Opportunities from domestic bond investments
while taking on manageable risk, favouring AAA
assets and senior tranches of residential mortgage-
backed securities (RMBS), backed by robust cash
flows
107

Higher risk tolerance: Focus on illiquidity premium
Some areas of credit market, private credit, special
situations, and distressed credit market
Ø Additional compensation to investors for limiting
their ability to take advantage of future market
dislocations, as their capital is locked up for a
specified period
108

6. Risk tolerance: second phase
• Limit stock allocation to the maximum tolerable
loss determined above, times two
• Assume that the investor’s stocks can lose 50% of
their value at any time
• A loss greater than 50% certainly could occur,
even though such declines are historically
uncommon / BUT possible if holdings are not well
diversified or high-risk 109

• Primary goal of investing a portion of a portfolio
internationally should NOT be to increase returns,
(as no guarantee that international markets will
outperform) BUT to increase portfolio’s
diversification, thereby reducing your risk
• Most professionals recommend allocating more
than 50% of the stock portion of your portfolio to
domestic equities 110

Ø International funds generally have higher
expense ratios than domestic funds
Ø Investing internationally introduces an additional
type of risk into your portfolio: currency risk
When the stock allocation experience a downturn,

it is critical to REBALANCE the portfolio
111

6. Risk tolerance: rebalance: third phase
Ø Adjusting portfolio’s holdings to bring them back
in line with your ideal asset allocation
Ø A periodic rebalancing program helps keep the
risk level of the portfolio in line with goals
Ø How often ? Once your portfolio is off balance by
a certain amount (such as your stock allocation
being either 10% higher or 10% lower than
intended) or at regular intervals
112

6. Rebalance: third phase
• Primary determinant: risk tolerance
• of stock/bond allocation
• Professionals recommend investing between 20%
and 40% of international stock, for the sake of
additional diversification
• Rebalancing align the portfolio back to its
targeted asset allocation / targeted risk level
113
114
7. Passive strategies: CAPM

CAPM: Capital Asset Pricing Model
> cost of equity
Cost of capital: necessary return on a project to

make it worthwhile
Discount rate: rate used to discount future cash
flows of an investment / project
115

CAPM = Rf + beta * (Erm – Rf)
Rf: Risk free rate or the most conservative
investment like Government bond, T-Bill (US),
Gilt (UK), Bund (Germany)
Risk premium = ERm – Rf
Calculate the CAPM if the T-Bill rate is 1%, the
beta 1.2 and the risk premium 4% 116

Calculate the CAPM if the T-Bill rate is 1%, the
beta 1.2 and the risk premium 4%
Risk Premium = ERm – Rf
4% = ERm – 0.01%
ERm = 5%
CAPM = 0.01 + 1.2 * 0.04
CAPM = 0.058 or 5.8% 117
Imagine that in 1931 ten investors agreed to

establish an investment trust fund
ØEach investor followed a different strategy:
Investor 1 opted to buy the 10% of the NYSE
stocks with the lowest estimated betas
ØInvestor 2 chose the 10% with the next-lowest
betas; and so on ..
Øup to investor 10, who proposed to buy the
stocks with the highest betas 118
• The beta of investor 10’s portfolio was 1.54 and

highest return, averaging 16.1%
• The market portfolio over the same 80-year
period provided an average return of 12.3% (beta
of 1.0)
• Then investor 1’s portfolio, with a beta of 0.50,
should have provided a risk premium of 6.1%
• But the difference was not as great as the CAPM
predicts: 119
Returns are in line with the CAPM with the exception
of the 2 highest-risk portfolios
Investor 10, high-beta portfolio, earned a return that
was only marginally above that of the market - of
course, before 1966 the line was correspondingly
steeper
120
Relationship
between beta
and actual av.
return is weaker
since the 1960s
Stocks with
highest betas
have provided
poor
returns
121
122
Value stocks: defined as those with

high ratios of book value to market value
Growth stocks: those with low ratios of book to
Market
Notice that value stocks have provided a higher
long-run return than growth stocks.
123

0522 Financial Investment UNIT 5

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FINANCIAL INVESTMENTS MBF301

UNIT 5 – Capital Allocation to risky assets

1. Risk and risk aversion

UNIT 5 – Capital Allocation to risky assets

1. Risk and risk aversion

UNIT 5 – Capital Allocation to risky assets

UNIT 5 – Capital Allocation to risky assets

• 2. Risk and risk aversion

UNIT 5 – Capital Allocation to risky assets

2. Risk and risk aversion

UNIT 5 – Capital Allocation to risky assets

2. Risk and risk aversion

UNIT 5 – Capital Allocation to risky assets

The ranking reveals a significant fall in overall

UNIT 5 – Capital Allocation to risky assets

2. Capital Allocation Line CAL

UNIT 5 – Capital Allocation to risky assets

E(Rp) = w1E(R1) + w2E(R2)

UNIT 5 – Capital Allocation to risky assets

UNIT 5 – Capital Allocation to risky assets

2. Capital Allocation Line and Optimal Portfolio:

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

UNIT 5 – Capital Allocation to risky assets

2. The efficient frontier

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

UNIT 5 – Capital Allocation to risky assets

• Investors often combine risky assets with risk-

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

UNIT 5 – Capital Allocation to risky assets

Or E(Rc) = Rf + Spσ(Rc), where Sp =

UNIT 5 – Capital Allocation to risky assets

• The optimal portfolio consists of a risk-free

FINANCIAL INVESTMENTS MBF301

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

FINANCIAL INVESTMENTS MBF301

UNIT 5 – Capital Allocation to risky assets

2. The efficient/ portfolio frontier

This asset weight combination gives the best

UNIT 1 and 2 – Rate of return, don´t get confused

Required rate of return: CAPM

Cost of capital: necessary return on a project to

Discount rate: rate used to discount future cash

UNIT 1 and 2 – Rate of return, don´t get confused

Used in Dividend growth model =

UNIT 5 – Capital Allocation to risky assets

2. Capital allocation across risky and risk free

UNIT 5 – Capital Allocation to risky assets

2. Capital allocation across risky assets/ risk free

UNIT 5 – Capital Allocation to risky assets

2. Capital allocation across Risky Assets

UNIT 5 – Capital Allocation to risky assets

2. Capital allocation: Utility theory

UNIT 5 – Capital Allocation to risky assets

2. Capital allocation across Risky Assets

UNIT 5 – Capital Allocation to risky assets

1. Risk Averse: As the investor takes on

UNIT 5 – Capital Allocation to risky assets