1.

Risk and risk aversion

2. Capital allocation across risky and risk free
asset portfolios
3. The risk-free assets
4. Relationship between risk and return
5. Portfolios of one risky asset and a risk-free
asset
6. Risk tolerance and asset allocation
7. Passive strategies: The Capital Market Line 1
2. Capital allocation across risky and risk free
asset portfolios
Asset allocation is the proportion of funds
among different types of assets, such as stocks
and bonds, with different expected returns/ risk
Capital allocation is the apportionment of funds
between risk-free investments, such as T-bills,
and risky assets, such as stocks 2
2. Capital allocation across risky assets/ risk free
• Speculation is the undertaking of a risky
investment for its risk premium
• 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
– Risk-averse
– Risk lover
– Risk neutral 3
2. Capital allocation across Risky Assets
• Risk and return are trade-offs and follow a
linear relationship
• High-risk investments present a high
probability of an investor losing all
• Having a solid understanding of one’s u of
money can help investors make investment
decisions that are more suited to their risk
attitudes and investment strategies 4
2. Capital allocation: Utility theory
• Difficult to quantify u as individuals have
different u functions
• Marginal utility refers to how much
incremental u an individual derives from
obtaining 1 additional unit of a certain good/
service
• After having a certain amount of a particular
good or service, the u of acquiring one more
unit of the good/service falls 5
Utility curves

1. Risk Averse: As the investor takes on

more risk (hence possibility of greater
returns), they will start to have a
smaller desire to take on further risk
6
Utility curves
2. Risk neutral
such an investor would
continuously take on more risk
since this will result in more
utility. This type of investing
behavior is quite rare
7
Utility curves

3. Risk loving
This attitude towards risk would
be exponential, meaning that
this investor
experiences increasing
marginal utility
8
2. Capital allocation across Risky Assets
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
σ2 = standard deviation of returns
1⁄2 = a scaling factor

U= E (r) – 1 x A σ2
2 9
2. Capital allocation across risky and risk free asset
portfolios: the simplest case of capital allocation
 The risk-return profile of this 2-asset portfolio is
determined by the proportion of the risky asset
to the risk-free asset
 If this portfolio consists of a risky asset with a
proportion of y, then the proportion of the risk-
free asset must be 1 – y 10
3. The risk-free assets
Monetary policy environment influence risk free
assets - and overall portfolio construction
• The risk-free rate of return concept initially
contributed to the 1960 portfolio theory, now
known as the CAPM, refined independently by
W. Sharpe, J.Treynor, J. Lintner and J. Mossin
• However are Govt rates 100% risk-free ? 11
• Government bonds do hold risk - hence price
fluctuations in the secondary market
• However they are risk free if held to maturity
as governments will not default on their debt
Institutional Retail investors
investors
risk-free assets Risk-free assets are
ensure CF as - less risky than shares and
their liabilities - may dilute the effect on the portfolio
fall due of a stock market sell-off
12
 Holding a cash buffer as portfolio insurance
could be an alternative when bonds are dear
sensitive to rising interest rates
W.Sharpe:
‘’Investor with an average risk tolerance should
seek to maintain asset class positions in
proportion to the market values of the
underlying assets’’ 13
4. Portfolios of 1 risky asset and a risk-free asset
 Portfolio S has a 15% expected return and a
STDEV of 16%
 Treasury bills offer an interest rate (rf) of 5%,
hence their STDEV is zero
Suppose the portfolio S is 50% invested in T-bills
r = (1/2 x expected return on S) + (1/2 x int. rate)
= (0.5 x 0.16) + (0.5 x 0.05) = 10% 14
The STDEV is halfway between the STDEV of S
and the STDEV of Treasury bills:
STDEV (σ) = (1/2 x σ of S) + (1/2 x σ T-bills)
= (0.5 x 0.16) + (0.5 x
0) = 8%
Suppose you borrow at the T-bill rate an amount
equal to your initial wealth, and invest 100% in S
Hence twice the investment in S, but you have 15
r = (2 x 0.15) - (1 x
0.05) = 25%
STDEV (σ) = (2 x σ of S) - (1 x σ T-bills) =
32%
When you lend a portion of your money, you
end up partway between rf and S
 If you can borrow money at the risk-free rate,
you can extend your possibilities beyond S
 Regardless of the level of risk you choose, you 16
Graph of efficient portfolios

17
• Start on the vertical axis at rf and draw the
steepest line to the curved red line of efficient
portfolios
• That line will be tangent to the red line
• The efficient portfolio S at the tangency point
is better than all the others
S offers the highest ratio of risk premium to
standard deviation 18
This ratio of the risk premium to the standard
deviation is called the Sharpe ratio:

Sharpe ratio = Risk premium = r - rf

STDEV
σ

Sharpe ratios measure the risk-adjusted

19
1) First, the best portfolio of common stocks
must be selected - S in our example
2) Second, this portfolio must be blended with
borrowing or lending to obtain a risk
exposure defined by the investor
3) Hence why the investor should invest into
just two benchmark investments:
- a risky portfolio S and
- a risk-free loan (borrowing or lending) 20
How to select stocks of portfolio S ?
 If the investor is better informed than others,
portfolio should include large investments in
undervalued stocks
 But in a competitive market, there is no
reason to hold a different portfolio from
others - the market portfolio
Reason why there are market-index portfolios
and well-diversified portfolios 21
4. Relationship between risk and return - CAPM
• Least risky investment: T-bills with beta of
0
• Much riskier investment: a portfolio of stocks,
with an average market risk - its beta is 1.0
 Investors require a higher return from the
stocks portfolio than from T-bills measure by
the market risk premium (rm – rf)
Since 1900 the market risk premium has 22
4. Relationship between risk and return - CAPM

23
But what is the expected risk premium when
beta is not 0 or 1?
W. Sharpe, J. Lintner and J. Treynor answered in
1960s with the Capital Asset Pricing Model:
In a competitive market, the expected risk
premium varies in direct proportion to beta
Meaning that in previous graph all investments
must plot along the sloping line, known as the
security market line 24
Capital Market line:
Theoretical concept representing all the
portfolios that optimally combine the risk-free
rate of return and the portfolios of risky assets
Security market line
Measures the risk through beta, which helps to
find the security´s risk contribution to the
portfolio 25
Beta of Expected risk premium on the market
0.05 Half or 50% on the market
2 Twice or 200% on the market

Expected risk premium on stock =

beta x expected risk premium on market
R – rf = Beta x ( rm – rf)

26
Estimates of the betas of 10 stocks:

Investors are looking for a return of 8.9% from

businesses with the risk of Exxon 27
 Risk free rf bills is about 2%.
Assume market risk premium is 7%
Dow Chemical present the highest return: 14.5%
Heinz present the lowest return: 4.78%
Difference between short- and long-term
interest rates: a cost of capital based on short-
term rates may be inappropriate for long-term
capital investments
https://www.blackrock.com/institutions/en-us/insights/charts/capital-market-assumptions 28
Emerging and frontier markets facing tighter
financial conditions and higher probability of
portfolio outflows: 30% in Q1, up from 20% in
Oct 21 (Global Financial Stability Report)

29
1. Define efficient portfolios
2. Why would one efficient portfolio is better
than all the others ?
3. What is the difference in the portfolio
structure between risk-averse and risk-
tolerant investor ?
4. What does the composition of the best
efficient portfolio depends on ? 30
1. Efficient portfolios offers the highest
expected return for a given STDEV
2. A risk-averse investor will invest partly in the
efficient portfolio and in the risk-free asset,
whilst a risk-tolerant investor may invest all in
the efficient portfolio, or/and may borrow
3. The composition of the best efficient
portfolio depends on expected returns,
standard deviations, and correlations 31
 If all investors have the same info, then all
investment portfolios would be similar
 Focus on the contribution of a stock to the
portfolio risk: hence beta
 Therefore the risk premium demanded by
investors is proportional to beta: what CAPM
states
32
 Future state of alternative investments

33
Source: CAIA Association
Future state of alternative investments

34
 Idiosyncratic risks facing companies can be
diversified away by holding a combination of
shares - Modern Portfolio Theory (Markowitz)
 In a perfectly diversified equity portfolio, the
risk of owning shares equates to the rises and
falls of the market - known as beta risk
The returns of an ETF outperforming a market
index are market moves + dividends - small fee. 35
 Currently energy security, supply chains and
inflation expectations are being re-thought
 Hence more disperse returns on common
stocks in future
According to E. Fama and K. French, share prices
driven by 3 factors:
1. Beta
2. Companies size -outperformance of smallcap
3. Value - outperformance of sotck P/B value <136
P/B value = Share price = Market cap
BV per share
Book Value
Book Value = Total Assets + Total Liabilities
 The 3 factors model was true in 1960s but not
recently as
1.) eco growth powered by businesses deriving
productivity gains from intangible assets 37
https://www.mckinsey.com/business-functions/marketing-and-sales/our-insights/getti
ng-tangible-about-intangibles-the-future-of-growth-and-productivity

2). Historically low interest rates and monetary

policy measures to control the money
supply - like quantitative easing (QE), have
favored investing in more expensive stocks
that promise sustained earnings growth
38
In 2015, Fama and French (and M. Crarhart)
added 2 factors to their model:
4). The proportionate effect that companies’
profitability had on their stock returns
5). Momentum, the fact that stocks continuing
to outperform after the market catches on
to a positive news story
39
Importance of interest rates environment:
- Higher interest rates environment enhance a
reset to valuation assumptions
- Implied stocks' forward rate of returns are
lower if shares trade at high levels
- A low rates environment support eco growth
and companies’ profits - making it more
probable to beat earnings targets 40
Importance of interest rates environment:
- Stocks usually more attractive relative to
supposedly riskless assets – calculated by the
equity risk premium (ERP), compensation for
the risks of investing in shares

41
 Future state of alternative investments

https://www.investorschronicle.co.uk/news/2022/03/31/keeping-risk-at-bay/
5. Portfolios of one risky asset and a risk-free
asset
1. Risk tolerance and asset allocation

43
Would you invest in a stock that do not lie on the
Security Market Line (SML)?

44
Would you invest in a stock that do not lie on the
Security Market Line (SML)?

45
Would you buy stock A?
You should not as investing 50% in T-bills and
50% in A would provide a higher expected
return
If all investors have the same expectation for A,
then the price of A will fall until the expected
return matches what one could get elsewhere
46
What about stock B ?
 One could get a higher expected return for the
same beta by borrowing 50% of total
investment and investing in the market prtflio
 If all investors do the same, the price of B will
fall until the expected return on B is equal to
expected return on the combination of
borrowing + investment in the market portflio 47
• An investor can always obtain an expected risk
premium of beta ( rm - rf ) by holding a mixture
of the market portfolio and a risk-free loan
• But are there stocks offering a higher expected
risk premium - that lie above the security
market line ?
• Stocks on average lie on the line, none lies
below the line, they can’t be any above 48
Therefore each and every stock must lie on the
security market line (SML) and offer an expected
risk premium of:

r – rf = Beta x (rm – rf)

49
Testing the Capital Asset Pricing Model CAPM
In 1931, ten investors gathered together in a
Wall Street bar and agreed to establish
investment trust funds for their children. Each
investor decided to follow a different strategy.
Investor 1 opted to buy the 10% of the New York
Stock Exchange stocks with the lowest
estimated betas; investor 2 chose the 10% with 50
2. Capital Allocation Line and Optimal Portfolio
CAL is a line that graphically depicts the risk-and-
reward profile of assets, and can be used to find
the optimal portfolio
Portfolio expected return and variance
The portfolio’s expected return is a weighted
average of its individual assets’ expected
returns, and is calculated as:
51
2. Capital Allocation Line and Optimal Portfolio
E(Rp) = w1E(R1) + w2E(R2)
w1, w2 : the respective weights for the 2 assets
E(R1), E(R2), the respective expected returns
Higher variance means higher levels of risk and
vice versa
The variance of a portfolio also depends on the
covariance and correlation of the two assets 52
2. Capital Allocation Line and Optimal Portfolio:
Var(Rp) = w21Var(R1) + w22Var(R2) + 2w1w2Cov(R1,
R2)
Cov(R1, R2): covariance of the 2 asset returns
Alternatively, the formula can be written as:
σ2p = w21σ21 + w22σ22 + 2ρ(R1, R2) w1w2σ1σ2
ρ(R1, R2): the correlation of R1 and R2
ρ(R1, R2) = Cov(R1, R2)/ σ1σ2: conversion between 53
2. Capital Allocation Line and Optimal Portfolio:
Diversification is a technique that minimizes
portfolio risk by investing in assets with negative
covariance
In practice, we do not know the returns and
standard deviations of individual assets, but we
can estimate these values based on these assets’
historical values
54
2. Capital Allocation Line (CAL) and Optimal
Portfolio
CAL is a line that graphically depicts the risk-and-
reward profile of assets, and can be used to find
the optimal portfolio
Portfolio expected return and variance
The portfolio’s expected return is a weighted
average of its individual assets’ expected
returns, and is calculated as: 55
2. The efficient/ portfolio frontier
Graph that maps out all possible portfolios with
different asset weight combinations and with
x-axis: levels of portfolio standard deviation
y-axis: portfolio expected return
To construct a portfolio frontier, first assign
values for E(R1), E(R2), stdev(R1), stdev(R2), and
ρ(R1, R2 56
2. The efficient frontier
Calculation of the
portfolio expected return
and variance for each
possible asset weight
combinations

57
2. The efficient/ portfolio frontier
Use the scatter chart with smooth lines to plot
the portfolio’s expected return and standard
deviation

58
2. The efficient/ portfolio frontier
To know which portfolios are attractive to
investors we introduce the concept of mean-
variance criterion:
Portfolio A dominates Portfolio B if E(RA) ≥ E(RB)
and σA ≤ σB , hence investors would prefer A
Any investor would optimally select a portfolio
on the upward-sloping portion of the portfolio
frontier, called the efficient frontier,
or minimum variance frontier 59
2. The efficient/ portfolio frontier
Investors often combine risky assets with risk-
free assets (such as govies) to reduce risks
The expected return of a complete portfolio is
given as: E(Rc) = wpE(Rp) + (1 − wp)Rf
And the variance and standard deviation of the
complete portfolio return is given as:
Var(Rc) = w2pVar(Rp), σ(Rc) = wpσ(Rp),
where wp is the fraction invested in the risky
60
2. The efficient/ portfolio frontier
While the expected excess return of a complete
portfolio is calculated as
E(Rc) – Rf, if we substitute E(Rc) with the previous
formula, we get wp(E(Rp) − Rf
The standard deviation of the complete portfolio
is σ(Rc) = wpσ(Rp), which gives us:
wp = σ(Rc)/σ(Rp)
Therefore, for each complete portfolio: 61
2. The efficient/ portfolio frontier

Or E(Rc) = Rf + Spσ(Rc), where Sp =

The line E(Rc) = Rf + Spσ(Rc) is the capital
allocation line (CAL)
The slope of the line, Sp, is the Sharpe ratio, or
reward-to-risk ratio. The Sharpe ratio measures
the increase in expected return per unit of 62
2. The efficient/ portfolio frontier
The optimal portfolio consists of a risk-free asset
and an optimal risky asset portfolio.
The optimal risky asset portfolio is at the point
where the CAL is tangent to the efficient frontier.
The slope of CAL is the highest meanng we
achieve the highest returns per additional unit
of risk
63
 s:

2. The efficient/ portfolio frontier

64
 s:

2. The efficient/ portfolio frontier

The tangent portfolio weights are calculated as
follows:

This asset weight combination gives the best

risk-to-reward ratio, as it has the highest slope
for CAL
65
Required rate of return: CAPM

Cost of capital: necessary return on a project to

make it worthwhile

Discount rate: rate used to discount future cash

flows of an investment / project

66
Net proceeds / transaction or flotation costs:
Cost of issuance of new share for a company

Used in Dividend growth model =

Share price = D1
k-g
k = required rate of return
g = growth rate
67
CAPM (Capital Asset Pricing Model) or Required Rate of Return:
CAPM = Rf + beta * (Erm – Rf)

Rf: Risk free rate or the most conservative investment like

Government bond, T-Bill (US), Gilt (UK), Bund (Germany)

Risk premium = ERm – Rf

Calculate the CAPM if the T-Bill rate is 1%, the beta 1.2 and the
risk premium 4%
68
CAPM or Required Rate of Return:
CAPM = Rf + beta * (Erm – Rf)

Calculate the CAPM if the T-Bill rate is 1%, the beta 1.2 and the risk
premium 4%

Risk Premium = ERm – Rf

4% = ERm – 0.01%
ERm = 5%

CAPM = 0.01 + 1.2 * 0.04

69
CAPM = 0.058 or 5.8%