CHAPTER 6

Risk Aversion and Capital Allocation to

Risky Assets

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 6-2

Allocation to Risky Assets

• The process of constructing an investor portfolio can be
viewed as a sequence of two steps:
i. Selecting the composition of the portfolio of risky assets such as
stocks and long-term bonds.
ii. Deciding how much to invest in that risky portfolio versus a safe
assets such as short term t-bills.
• 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.

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Risk and Risk Aversion

• Speculation
– The assumption of considerable risk for a commensurate
gain. Here, term ‘considerable risk ’ implies sufficient degree
of risk that can affect the investment decision. Whereas
‘commensurate gain’ implies positive expected profit beyond
the risk free alternative i.e. risk premium.
– Parties have heterogeneous expectations

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Risk and Risk Aversion

• Gamble
– It implies bet or wager on an uncertain outcome for nothing
or enjoyment

– Parties assign the same probabilities (homogenous

expectations) to the possible outcomes.

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An Example
Assume that dollar-denominated T-bills un the united
states and pound denominated bills in the united
kingdom offer equal yields to maturity. Both are short
term assets, and both are free of default risk. Neither
offer investor a risk premium. However, a U.S. investor
who holds U.K. bills is subjected to exchange rate risk.

Is the U.S. investor engaging in speculation or

gambling?
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Risk Aversion and Utility Values

• Investors are willing to consider:
– risk-free assets
– speculative positions with positive risk premiums
• Portfolio attractiveness increases with expected return
and decreases with risk.
• What happens when return increases with risk?

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Table 6.1 Available Risky Portfolios (Risk-

free Rate = 5%)

Each portfolio receives a utility score to

assess the investor’s risk/return trade off

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Utility Function

U = utility
E ( r ) = expected
return on the asset 1
or portfolio U  E ( r )  A 2

A = coefficient of risk 2
aversion
 = variance of
returns
½ = a scaling factor

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Table 6.2 Utility Scores of Alternative Portfolios for

Investors with Varying Degree of Risk Aversion

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An Example

A portfolio has an expected rate of return of 20% and

standard deviation of 20%. Bills offer a sure rate of
return of 7%. Which investment alternative will be
chosen by an investor whose degree of risk aversion
is 4? What if it is 8?

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Some Comments on Utility Value

 Utility value can be used to compare the rate of return
offered on risk-free investment and portfolio of risky
investment.
 An investor can interpret a portfolio’s utility value as
certainty equivalent rate of the portfolio.
 A portfolio is desirable only when its certainty equivalent
return ( i.e. utility value) exceeds that of the risk-free
alternative.

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Some Comments on Utility Value

 A risk averse investor (i.e. A>0) prefer to invest in portfolio
of risky investment when the certainty equivalent return is
more than the return from risk-free investment.
 A risk neutral investor (i.e. A=0) judge risky investment
solely by their expected rate of return. The level of risk is
irrelevant to the risk-neutral investor. For this investor a
portfolio’s certainty equivalent rate is simply its expected
rate of return.
 A risk lover investor (i.e. A<0) is willing to engage in fair
games or gambles. This investor adjusts the expected
return upward to take into account the ‘fun’ of confronting
the investment risk.
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Mean-Variance (M-V) Criterion

• Portfolio A dominates portfolio B if:

E  rA   E  rB 

• And
A B

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Estimating Risk Aversion

• Use questionnaires

• Observe individuals’ decisions when

confronted with risk

• Observe how much people are willing to

pay to avoid risk

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Capital Allocation Across Risky and Risk-

Free Portfolios

Asset Allocation: Controlling Risk:

• Is a very important • Simplest way:
part of portfolio Manipulate the
construction. fraction of the
portfolio invested in
• Refers to the choice risk-free assets
among broad asset versus the portion
classes. invested in the risky
assets

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Basic Asset Allocation

Total Market Value $300,000
Risk-free money market fund $90,000

Equities $113,400
Bonds (long-term) $96,600
Total risk assets $210,000

$113,400 $96,600
WE   0.54 WB   0.46
$210,000 $210,00

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Basic Asset Allocation

• Let y = weight of the risky portfolio, P, is the complete

portfolio; (1-y) = weight of risk-free assets:
$210,000 $90,000
y  0.7 1 y   0.3
$300,000 $300,000
$113,400 $96,600
E:  .378 B:  .322
$300,000 $300,000

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The Risk-Free Asset

• Only the government can issue default-free bonds.
– Risk-free in real terms only if price indexed and maturity
equal to investor’s holding period.
• T-bills viewed as “the” risk-free asset
• Money market funds also considered risk-free in
practice

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Portfolios of One Risky Asset and a Risk-Free

Asset

• It’s 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.

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Example Using Chapter 6.4 Numbers

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf

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Example (Ctd.)
The expected return
on the complete
portfolio is the risk-
free rate plus the By rearrangement, we get:
weight of P times the
risk premium of P E ( rc )  r f  y  E ( r P )  r f 

E  rc   7  y 15  7 
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Example (Ctd.)

• The risk of the complete portfolio is

the weight of P times the risk of P:

 C  y P  22 y

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Example (Ctd.)
• Again, risk of complete portfolio is
 C  y P
• Rearrange and substitute y=C/P:
C
E  rC   rf 
P
 E  rP   rf   7   C
8
22
E  rP   rf 8
Slope  
P 22

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Figure 6.4 The Investment Opportunity Set

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An Example
Consider the following data
Return Risk
T-bill 7% 0%
Risky portfolio 15% 22%
Requirements:
Calculate the expected rate of return and risk of the portfolio and reward to
variability ratio (slope of the CAL Sharp Ratio) based on the following
cases:
Case 1: 90 percent investment made on T-bill.
Case 2: 70 percent investment made on T-bill.
Case 3: 50 percent investment made on T-bill.
Case 4: 20 percent investment made on T-bill.
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Capital Allocation Line with Leverage

• What about points on the line to the right of the
portfolio P in the investment opportunity set?
• Suppose the investor borrows an additional
$120,000, investing the total available funds in the
risky asset. This is a leveraged position in the
risky asset, it is financed in part by borrowing.

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Capital Allocation Line with Leverage

If, lend at rf=7% and borrow at rf=7%
y=(420,000/300,000)=1.4
And (1-y)=(1-1.4)=-0.4, reflects a short position in the risk-free
asset, which is borrowing position. Then:
E ( rc )  r f  y  E ( r P )  r f  = 7%+(1.4*8)= 18.2%
 C  y P  1.4 * 22  30.8%
Lending range slope = 8/22 = 0.36
Borrowing range slope = 7/22 = 0.36
CAL extends to the right of point P

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Capital Allocation Line with 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

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Figure 6.5 The Opportunity Set with

Differential Borrowing and Lending Rates

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Risk Tolerance and Asset Allocation

• The investor confronting the CAL must choose one optimal
portfolio, C, from the set of feasible choices.
• Individual investor differences in risk aversion imply that, given
an identical opportunity set, different investor will choose
different positions in the risky asset. In particular, the more risk
averse investors will choose to hold less of risky asset and more
of the risk free asset.
– Expected return of the complete portfolio:
E ( rc )  r f  y  E ( r P )  r f 
– Variance:
 2
C  y  2 2
P
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Table 6.4 Utility Levels for Various Positions in Risky

Assets (y) for an Investor with Risk Aversion A = 4

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Figure 6.6 Utility as a Function of

Allocation to the Risky Asset, y

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Figure 6.8 Finding the Optimal Complete

Portfolio Using Indifference Curves

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Table 6.6 Expected Returns on Four

Indifference Curves and the CAL

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