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Risky Aversion and Capital Allocation to Risky Assets
power point chapter 6 buku Manajemen Portofolio dan Investasi (bodie, Kane , and Marcus)

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Allocation to Risky Assets

McGraw-Hill/Irwin

MARCUS

6-2

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.

MARCUS

6-3

Speculation

Taking considerable risk for a

commensurate gain

Parties have heterogeneous

expectations

MARCUS

6-4

Gamble

Bet or wager on an uncertain outcome

for enjoyment

Parties assign the same probabilities to

the possible outcomes

MARCUS

6-5

Investors are willing to consider:

risk-free assets

speculative positions with positive risk

premiums

expected return and decreases with risk.

What happens when return increases

with risk?

INVESTMENTS | BODIE, KANE,

MARCUS

6-6

(Risk-free Rate = 5%)

assess the investors risk/return trade off

INVESTMENTS | BODIE, KANE,

MARCUS

1

2

U

E

(r)2A

6-7

Utility Function

U = utility

E ( r ) = expected

return on the asset

or portfolio

A = coefficient of risk

aversion

= variance of

returns

= a scaling factor

MARCUS

6-8

Portfolios for Investors with Varying Degree

of Risk Aversion

MARCUS

6-9

Portfolio A dominates portfolio B if:

E rA E rB

And

A B

INVESTMENTS | BODIE, KANE,

MARCUS

6-10

Use questionnaires

Observe individuals decisions when

confronted with risk

Observe how much people are willing to

pay to avoid risk

INVESTMENTS | BODIE, KANE,

MARCUS

6-11

Risk-Free Portfolios

Asset Allocation:

Is a very important

part of portfolio

construction.

Refers to the choice

among broad asset

classes.

Controlling Risk:

Simplest way:

Manipulate the

fraction of the

portfolio invested in

risk-free assets

versus the portion

invested in the risky

assets

INVESTMENTS | BODIE, KANE,

MARCUS

6-12

Total Market Value

$300,000

fund

$90,000

Equities

Bonds (long-term)

Total risk assets

$113,400

$96,600

$210,000

$113,400

WE

0.54

$210,000

$96,600

WB

0.46

$210,00

MARCUS

6-13

Let y = weight of the risky portfolio, P, in

the complete portfolio; (1-y) = weight of

risk-free assets:

$210,000

y

0.7

$300,000

$113,400

E:

.378

$300,000

$90,000

1 y

0.3

$300,000

$96,600

B:

.322

$300,000

MARCUS

6-14

Only the government can issue

default-free bonds.

Risk-free in real terms only if price

indexed and maturity equal to investors

holding period.

Money market funds also considered

risk-free in practice

INVESTMENTS | BODIE, KANE,

MARCUS

6-15

CD and T-bill Rates

MARCUS

6-16

Risk-Free Asset

Its possible to create a complete portfolio

by splitting investment funds between safe

and risky assets.

Let y=portion allocated to the risky portfolio, P

(1-y)=portion to be invested in risk-free asset,

F.

MARCUS

6-17

Numbers

rf = 7%

rf = 0%

E(rp) = 15%

p = 22%

y = % in p

(1-y) = % in rf

MARCUS

E

(rc)fPy E

(r)f

6-18

Example (Ctd.)

The expected

return on the

complete

portfolio is the

risk-free rate

plus the weight

of P times the

risk premium of

P

E rc 7 y 15 7

MARCUS

6-19

Example (Ctd.)

The risk of the complete portfolio is

the weight of P times the risk of P:

C y P 22 y

MARCUS

6-20

Example (Ctd.)

Rearrange and substitute y=C/P:

C

8

E rC rf

E rP rf 7 C

P

22

Slope

E rP rf

22

MARCUS

Opportunity Set

MARCUS

6-21

6-22

Leverage

Lend at rf=7% and borrow at rf=9%

Lending range slope = 8/22 = 0.36

Borrowing range slope = 6/22 = 0.27

CAL kinks at P

MARCUS

6-23

Differential Borrowing and Lending

Rates

MARCUS

E

(rc)

y

(2

E

rP)f

fP

C2

6-24

Allocation

portfolio, C, from the set of feasible

choices

Expected return of the complete

portfolio:

Variance:

MARCUS

Risky Assets (y) for an Investor with Risk

Aversion A = 4

MARCUS

6-25

6-26

Allocation to the Risky Asset, y

MARCUS

6-27

of Indifference Curves

MARCUS

6-28

U = .05 and U = .09 with A = 2 and

A=4

MARCUS

6-29

Complete Portfolio Using Indifference

Curves

MARCUS

6-30

Indifference Curves and the CAL

MARCUS

6-31

Passive Strategies:

The Capital Market Line

The passive strategy avoids any direct or

indirect security analysis

Supply and demand forces may make such

a strategy a reasonable choice for many

investors

MARCUS

6-32

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 S&P 500.

The capital market line (CML) is the capital

allocation line formed from 1-month T-bills

and a broad index of common stocks (e.g.

the S&P 500).

MARCUS

6-33

Passive Strategies:

The Capital Market Line

The CML is given by a strategy that

involves investment in two passive

portfolios:

1. virtually risk-free short-term T-bills (or

a money market fund)

2. a fund of common stocks that mimics

a broad market index.

INVESTMENTS | BODIE, KANE,

MARCUS

6-34

Passive Strategies:

The Capital Market Line

From 1926 to 2009, the passive risky

portfolio offered an average risk

premium of 7.9% with a standard

deviation of 20.8%, resulting in a rewardto-volatility ratio of .38.

MARCUS

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