CHAPTER 6 Risk Aversion

and Capital
Allocation to
Risky Assets

Investments, 8th edition

Bodie, Kane and Marcus

Slides by Susan Hine

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Risk and Risk Aversion

• Speculation
– Considerable risk
• Sufficient to affect the decision
– Commensurate gain
• Gamble
– Bet or wager on an uncertain outcome

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 Risk Aversion and Utility Values

• Risk averse investors reject investment

portfolios that are fair games or worse
• These investors are willing to consider only
risk-free or speculative prospects with
positive risk premiums
• Intuitively one would rank those portfolios as
more attractive with higher expected returns

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Table 6.1 Available Risky Portfolios
(Risk-free Rate = 5%)

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 Utility Function
1 2
U  E (r )  A
2
Where
U = utility
E ( r ) = expected return on the asset or
portfolio
A = coefficient of risk aversion
 = variance of returns

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Table 6.2 Utility Scores of Alternative
Portfolios for Investors with Varying
Degree of Risk Aversion

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Figure 6.1 The Trade-off Between Risk
and Returns of a Potential Investment
Portfolio, P

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 Estimating Risk Aversion

• Observe individuals’ decisions when

confronted with risk
• Observe how much people are willing to pay
to avoid risk
– Insurance against large losses

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Figure 6.2 The Indifference Curve

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Table 6.3 Utility Values of Possible
Portfolios for an Investor with Risk
Aversion, A = 4

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Table 6.4 Investor’s Willingness to Pay
for Catastrophe Insurance

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 Capital Allocation Across Risky and
Risk-Free Portfolios
• Control risk
– Asset allocation choice
• Fraction of the portfolio invested in
Treasury bills or other safe money
market securities

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 The Risky Asset Example

Total portfolio value = $300,000

Risk-free value = 90,000
Risky (Vanguard & Fidelity) = 210,000
Vanguard (V) = 54%
Fidelity (F) = 46%

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The Risky Asset Example Continued

Vanguard 113,400/300,000 = 0.378

Fidelity 96,600/300,000 = 0.322
Portfolio P 210,000/300,000 = 0.700
Risk-Free Assets F 90,000/300,000 = 0.300
Portfolio C 300,000/300,000 = 1.000

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 The Risk-Free Asset

• Only the government can issue default-free

bonds
– Guaranteed real rate only if the duration of
the bond is identical to the investor’s desire
holding period
• T-bills viewed as the risk-free asset
– Less sensitive to interest rate fluctuations

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Figure 6.3 Spread Between 3-Month
CD and T-bill Rates

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 Portfolios of One Risky Asset and a
Risk-Free Asset
• It’s possible to split investment funds
between safe and risky assets.
• Risk free asset: proxy; T-bills
• Risky asset: stock (or a portfolio)

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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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Expected Returns for Combinations

E (rc )  yE (rp )  (1  y )rf

rc = complete or combined portfolio

For example, y = .75

E(rc) = .75(.15) + .25(.07)
= .13 or 13%

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Combinations Without Leverage

If y = .75, then
c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
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Capital Allocation Line with Leverage

Borrow at the Risk-Free Rate and invest in

stock.
Using 50% Leverage,
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

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Figure 6.4 The Investment Opportunity Set with
a Risky Asset and a Risk-free Asset in the
Expected Return-Standard Deviation Plane

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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 must choose one optimal
portfolio, C, from the set of feasible choices
– Trade-off between risk and return
– Expected return of the complete portfolio is
given by:
E (rc )  rf  y  E (rP )  rf 
– Variance is:
2 2 2
 y
C P

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Table 6.5 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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Table 6.6 Spreadsheet Calculations of
Indifference Curves

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 Figure 6.7 Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4

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Figure 6.8 Finding the Optimal Complete
Portfolio Using Indifference Curves

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Table 6.7 Expected Returns on Four
Indifference Curves and the CAL

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Passive Strategies: The Capital Market
Line
• Passive strategy involves a decision that avoids
any direct or indirect security analysis

• Supply and demand forces may make such a

strategy a reasonable choice for many investors

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 Passive Strategies:
The Capital Market Line Continued
• A natural candidate for a passively held risky
asset would be a well-diversified portfolio of
common stocks
• Because a passive strategy requires devoting
no resources to acquiring information on any
individual stock or group we must follow a
“neutral” diversification strategy

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Table 6.8 Average Annual Return on Stocks and
1-Month T-bills; Standard Deviation and Reward-
to-Variability Ratio of Stocks Over Time

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