# Fi8000 Risk, Return and Portfolio Theory

Milind Shrikhande

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Risk, Return and Portfolio Theory
Risk and risk aversion
Utility theory and the definition of risk aversion MeanMean-Variance (M-V or - ) criterion (MThe mathematics of portfolio theory

Capital allocation and the optimal portfolio
One risky asset and one risk-free asset riskTwo risky assets n risky assets n risky assets and one risk-free asset risk-

Equilibrium in capital markets
The Capital Asset Pricing Model (CAPM) Market Efficiency

Reward and Risk: Assumptions
Investors prefer more money (reward) to less: all else equal, investors prefer a higher reward to a lower one. Investors are risk averse: all else equal, investors dislike risk. There is a tradeoff between reward and risk: Investors will take risks only if they are compensated by a higher reward.

Reward and Risk

Reward

Quantifying Rewards and Risks
Reward
A welfare measure The expected (average) return

Risk
A welfare measure Measures of dispersion - variance Other measures

The mathematics of portfolio theory (1-3) (1-

Comparing Investments: an example
Which investment will you prefer and why? A or B? B or C? C or D? C or E? D or E? B or E, C or F? E or F?

Comparing Investments: the criteria
A vs. B ± If the return is certain look for the higher return (reward) B vs. C ± A certain dollar is always better than a lottery with an expected return of one dollar C vs. D ± If the expected return (reward) is the same look for the lower variance of the return (risk) C vs. E ± If the variance of the return (risk) is the same look for the higher expected return (reward) D vs. E ± Chose the investment with the lower variance of return (risk) and higher expected return (reward) B vs. E or C vs. F ± stochastic dominance E vs. F ± maximum expected utility

Comparing Investments
Maximum return If the return is risk-free (certain), all investors riskprefer the higher return Risk aversion Investors prefer a certain dollar to a lottery with an expected return of one dollar

Comparing Investments
Maximum expected return If two risky assets have the same variance of the returns, risk-averse investors prefer riskthe one with the higher expected return* Minimum variance of the return If two risky assets have the same expected return, risk-averse investors prefer the one riskwith the lower variance of return*

The Mean-Variance Criterion MeanLet A and B be two (risky) assets. All riskriskaverse investors prefer asset A to B if { {
A B

A>

B

and or if and

A

< 

B

} }

A

B

* Note that these rules apply only when we assume that the distribution of returns is normal.

The Utility of Certain Returns for Risk Averse Investors
Let us assume that the investor has an initial wealth of W0 dollars. Then U(W0) < U(W0 + \$1) The utility is an increasing function of the final dollar wealth. U(W0+\$1) - U(W0) > U(W0+\$101) - U(W0+\$100) The utility function is concave: the marginal utility is a decreasing function of the initial dollar wealth (an additional dollar has the same impact on the wealth of the ³rich´ investor, but it has a lower impact on the his welfare compared to the ³poor´ investor).

RiskRisk-Averse Investors: Increasing and Concave Utility Function

U(W)

The Expected Utility of Risky Returns
Let DA be the dollar return of asset A (a random variable), DA(i) be the dollar return of asset A in state i (i = 1, « n) and pi be the probability of state i. If you invest in A Your expected dollar wealth is E[W0+DA] = [W0+DA(1)]·p1 + « + [W0+DA(n)]·pn Your expected utility (welfare) is welfare) E[U(W0+DA)] = U[W0+DA(1)]·p1 + « + U[W0+DA(n)]·pn

Example (BKM page 193)
Consider a simple prospect where all your wealth of \$100,000 is invested in a fair gamble: you will get \$150,000 with probability 0.5 or \$50,000 with probability 0.5.

Note that this is called a fair gamble since the expected profit is zero: zero:
E(profit) = (150,000-100,000)·0.5 + (50,000-100,000) ·0.5 (150,000(50,000= 0.

Example - continued
a. b.

Calculate the expected final wealth. (\$100,000) wealth. Assuming that your utility function is logarithmic (i.e. U(W) = ln(W)), calculate your utility of the final wealth for each possible outcome. (11.9184, 10.8198) Show that for this function the marginal utility is decreasing in the final wealth (numeric example). Calculate the expected utility of the final wealth and compare it to the utility of the initial wealth. Will you wealth. enter the game? (f: 11.3691, i: 11.5129) How much will you pay me for the right to enter this game? Or should I pay you? (\$13,397.5)

c. d.

e.

The Certainty Equivalent
The certainty equivalent (CE) determines the maximum CE) dollar price an investor will pay for a risky asset with an uncertain dollar return D. The expected utility of the investment in the risky asset is equal to that of the certainty equivalent. In our example: E[U(W0+D)] = 0.5·U(\$50K) + 0.5·U(\$150K) = 11.3691 11.3691 = U[CE] CE = \$86,602.5 That means that you will not invest more than \$86,602.5 in that game, or that you will enter the game only if I will pay you a risk premium: \$100,000 - \$86,602.5 = \$13,397.5 premium:

Example - continued
Assume that you invest \$100,000 today (t = 0) and the outcome is expected a year from now (t = 1). What is the present value of the expected future CF if the risk-free rate is 5%? (\$82,478.6) riskWhat is your personal risk-premium in terms of the riskdollar difference between a certain CF at time t = 1 and the expected CF of this investment at t = 1?
(\$13,397.5)

What is your personal risk-premium in terms of the riskrequired rate of return? (k = 21.24%, k-rf = 16.24%) k-

Other Criteria
The basic intuition is that we care about ³bad´ surprises rather than all surprises. In fact surprises. dispersion (variance) may be desirable if it means that we may encounter a ³good´ surprise. When we assume that returns are normally distributed the expected-utility and the expectedstochasticstochastic-dominance criteria result in the same ranking of investments as the mean-variance meancriterion.

Practice problems

BKM Ch. 6: 1,13,14 BKM Ch. 6, Appendix B: 1 Mathematics of Portfolio Theory: Read and practice parts 1-10. 1-