Chapter 5

Capital Allocation to Risky Assets

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 Chapter Summary

• Objectives:
• To present the basics of individual decision-making
under risk
• The utility function
• Indifference curves
• To examine the asset allocation decision between
risky and riskless asset
• T-bills and a stock portfolio
• The capital allocation line

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 The Utility Function

• Choice between expected return and risk, the latter

measured by the variance or standard deviation
• Quadratic utility
• U = E(r) - (½)Aσ2

U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
s2 = variance of returns

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 Table 5.1 Available Risky Portfolios
(Risk-free Rate = 5%)

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 Table 5.2 Utility Scores of Alternative Portfolios for
Investors with Varying Degrees of Risk Aversion

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 Figure 5.1 The Trade-off Between Risk and
Return of a Potential Investment Portfolio

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 Figure 5.2 The Indifference Curve

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 Table 5.3 Utility Values of Possible
Portfolios for an Investor with A = 4

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 Allocating Capital Between
Risky and Risk Free Assets

• 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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 Allocating Capital Between
Risky and Risk Free Assets

• Examine risk/return tradeoff

• Demonstrate how different degrees of risk
aversion will affect allocations between risky
and risk free assets

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 The Risk-Free Asset

• Perfectly price-indexed bond – the only risk

free asset in real terms;
• T-bills are commonly viewed as “the” risk-
free asset;
• Money market funds - the most accessible
risk-free asset for most investors.

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 Figure 5.3 Yield Spread Between 3-
Month Corporate Paper and T-bills

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 Portfolios of One Risky Asset
and One Risk-Free Asset

• Assume a risky portfolio P defined by:

• E(rp) = 15% and p = 22%

• The available risk-free asset has:

• rf = 7% and rf = 0%

• And the proportions invested:

• y% in P and (1-y)% in rf
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 Expected Returns for Combinations

E(rc) = yE(rp) + (1 - y)rf

rc = complete or combined portfolio

If, for example, y = .75

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

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 Variance on the Possible
Combined Portfolios

Since r = 0, then
f

*
 c
= y
p

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 Possible Combinations

E(r)

E(rp) = 15%
E(rc) = 13% P
C

rf = 7%
F

0 c 22% 
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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 =0(.22) = .00 or 0%
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 Figure 5.4 The Investment Opportunity Set
with a Risky Asset and a Risk-Free Asset

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 Using Leverage with
Capital Allocation Line

• Borrow at the Risk-Free Rate and invest in stock

• Using 40% Leverage
• rc = rf + y[E(rP) - rf
• rc = 07 + (1.4) (.15-.07) = .182

c = (1.4) (.22) = .308

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 Figure 5.5 The Opportunity Set with
Differential Borrowing and Lending Rates

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 Table 5.4 Utility Levels for Various Positions in Risky
Assets (y) for Investor with Risk Aversion A = 4

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 Figure 5.6 Utility as a Function of
Allocation to the Risky Asset, y

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 Risk Aversion and Allocation

• Greater levels of risk aversion lead to larger

proportions of the risk free rate
• Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets
• Willingness to accept high levels of risk for
high levels of returns would result in
leveraged combinations

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 Figure 5.7 Indifference Curves for U =
.05 and U = .09 with A = 2 and A = 4

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 Figure 5.8 Finding the Optimal Complete
Portfolio Using Indifference Curves

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 Table 5.6 Expected Returns on Four
Indifference Curves and the CAL

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 Table 5.7 Annual rates of return for common stock and
3-month T-bills, Standard Deviations and
Sharpe Ratios of Stock Risk Premiums over Time

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