BE331 - Lecture 5 Slides

BE331 The Pricing of Securities in
Financial Markets
Dr Nick Rowe
nick.rowe@essex.ac.uk
Lecture 5
Cash flows can’t be perfectly predicted
• Last class: we started treating financial assets as
random variables
– Random variable: a variable that can take a number
of different possible values
– “different possible values” here  return/payoff on
financial asset
• This class:
– How uncertainty can show up in investor preferences
– Mean-Variance (Markowitz) Problem
BE331 Asset Pricing 2

Preferences & Uncertainty

Personal Preferences in Uncertain Markets
 When developing investment decisions, investors must account for:
• Future predictions (assessing outcomes and their probabilities)
 In random events (i.e. “gambles” denoted by G), in addition to the
outcome, we have to consider the probability of achieving that outcome
• Personal preferences (individual utility function)
 Outcomes of each event and the events’ probabilities add a certain

degree of uncertainty
 Personal preferences are individually-defined and can be expressed

mathematically by defining a utility function

Characteristics of Rational Preferences
 Completeness
• Preferences are complete if any two choices can
be ranked (a ≻ b, b ≻ a, or a ∼ b)
 Transitivity
• Preferences are transitive if given any a, b, and c:
(a ≻ b) and (b ≻ c) imply (a ≻ c)
 Transitivity

Accounting for Uncertainty
To define rational preferences in a uncertain
world, we will need the following definition
 Gamble
• A gamble G is a list G = ((p1,x1),…,(pN,xN) with pn ≥0
for all events xn and p1+…+pN = 1, where pn is
interpreted as the probability of outcome xn
occurring

 Transposition
• Preferences are transposable if for any gamble G, there
exists a certainty equivalent xG such that one is
indifferent between taking the gamble G and the
certainty equivalent xG
 Ranking
• Preferences have the ranking characteristic if the
preference relation between any two gambles G and H
is identical to the preference relation between their
certainty equivalents xG and xH
Rational Preferences under Uncertainty
 Transposition
• Denote by the gamble for event to occur, where are certain outcomes for event ,
respectively
• This assumption states that for any gamble we can find one certainty equivalent
that yields the same utility as the gamble, that is:

Assumptions under Uncertainty
 Ranking
• This assumption states that it is possible to rank the utility derived from
two different gambles according to their prospective certainty equivalents
• We have two gambles and four certain outcomes such that and , then:

Assumptions under Uncertainty
By adding the transposition and ranking assumptions,
we are now able to handle uncertainty
An individual whose utility function meets

requirements of completeness, consistency
transposition and ranking can unequivocally state his
preference between two random future events

What has all this formality bought us?
 Gambles
• “Gambles” are our stand-in for financial assets
 Certainty equivalent
• Since “gambles” can be ranked in terms of their
certainty equivalents, we have created a mapping
from a more complex, uncertain world to
something we already know how to do, i.e.,
characterize preferences under certain
What does it all mean?
 Gambles
• “Gambles” are our stand-in for financial assets
 Certainty equivalent
• Since “gambles” can be ranked in terms of their
certainty equivalents, we have created a mapping
from a more complex, uncertain world to
something we already know how to do, i.e.,
characterize preferences under certain
Risk Aversion

Risk Aversion
Investors’ risk seeking reflect their choice between:
 Being assured of the mean value of the gamble

• i.e. the probability-weighted average of the gamble
 Taking part in the gamble

Risk Aversion
In uncertain markets, we distinguish three personality types:
 Risk seeking
• An investor who enjoys the uncertainty of participating in the gamble
 Risk averse
• An investor who prefers the certainty of receiving the mean value of
the gamble rather than participating in the gamble
 Risk neutral
• An investor who is indifferent between receiving the mean value of
the gamble or participating in the gamble

Risk Aversion
More formally:
 Risk averse
• An individual whose utility from the mean value of the gamble is greater
than the mean utility of the gamble
 Risk seeking
• An individual whose utility from the mean value of the gamble is smaller
than the mean utility of the gamble
 Risk neutral
• An individual whose utility from the mean value of the gamble is equal to
the mean utility of the gamble
Risk Averse Individual

Risk Seeking Individual

Risk Neutral Individual

Numerical Example
An investor whose utility function is is faced with a gamble offering an
80% chance of winning $5 and a 20% chance of winning $30
 The mean value of the gamble is:
 The utility from being guaranteed $10 (utility from the mean value) is:
 The mean of the utilities for both possible events is:
Comparing the calculated utility values, we find that
The utility function describes a risk-averse individual

Arrow-Pratt Measures of Risk Aversion
 Absolute Risk Aversion
A measure of the absolute amount of wealth an individual is willing to expose to
risk as a function of changes in wealth
– A’(W) < 0 → Decreasing Absolute Risk Aversion

• Amount invested in risky assets increases as W increases
– A’(W) = 0 → Constant Absolute Risk Aversion
• Amount invested in risky assets is unchanged as W increases
– A’(W) > 0 → Increasing Absolute Risk Aversion
• Amount invested in risky assets decreases as W increases
This measure increases with the curvature of the utility function

Absolute Risk Aversion

Arrow-Pratt Measures of Risk Aversion
 Relative Risk Aversion
A measure of the percentage of wealth an individual is willing to expose to
risk as a function of changes in wealth
– R’(W) < 0 → Decreasing Relative Risk Aversion

• Percentage invested in risky assets increases as W increases
– R’(W) = 0 → Constant Relative Risk Aversion
• Percentage invested in risky assets is unchanged as W increases
– R’(W) > 0 → Increasing Relative Risk Aversion
• Percentage invested in risky assets decreases as W increases

Relative Risk Aversion

Types of Utility Functions
 Linear utility function
• Represents a risk-neutral agent

• The coefficients of absolute and relative risk aversion are zero
 Quadratic utility function
• If , it represents a risk-averse agent

• Exhibits increasing absolute risk aversion and increasing relative risk aversion
 Logarithmic utility function
• Represents a risk-averse agent

• Exhibits decreasing absolute risk aversion & constant relative risk aversion
• Is consistent with the behaviour of a risk-averse investor
– Who prefers more to less
– Whose percentage invested in risky assets remains constant as wealth increases

The Mean-Variance Model

The Mean-Variance Model
 First pioneered by Harry Markowitz in his 1952 article,
it is referred to as the most well-known theory of
portfolio selection
 Markowitz derived the functional relation between the

average returns required by investors on portfolios and
their inherent risk as measured by their variance
 Individual investors should choose from this portfolio’s

opportunity line their own optimal portfolio, according
to their individual utility function
Portfolio Return
Consider two risky assets
 Let and be the % invested in these assets, where is

known as the budget constraint
 Portfolio return depends on the return realized on the
two assets, and and is given by:
• is the contribution to the portfolio return of asset 1

• is the contribution to the portfolio return of asset 2
Portfolio Return
If and are not known, we compute the expected
portfolio return
are the expected returns on the two risky assets

is a weighted average of the expected returns of
the two assets in the portfolio

Portfolio Risk
Portfolio risk is measured by the variance of the portfolio return :
In finance, variance is denoted as , the above formula can be rewritten:
Where:
is the correlation between the returns of assets 1 and 2

Portfolio Risk
Portfolio return variance is the risk measure in

the mean-variance framework
Note: often, the square root of the variance , is

used to denote the risk of a portfolio, but this is
the risk in terms of standard deviation

Portfolio Risk with Many Risky Assets
Consider investing in risky assets with:
• Random returns
• Portfolio weights (% allocations)
 The budget constraint
 The portfolio return
 The expected portfolio return

 The expected portfolio variance
Where
• The 1st term is the sum of the N variances
• The 2nd term is the sum of all N(N-1) covariances
between the different assets

The riskiness of the N assets is summarized by the covariance matrix:
In matrix notation, the portfolio risk can also be rewritten as:
Where
is an N-vector formed by the portfolio weights

Diversification
The diversification effect allows to reduce portfolio risk by combining
assets with certain statistical attributes
 Let’s investigate the impact of the assets’ correlation on portfolio variance
Suppose we hold two assets characterized by:

• The same expected return
• The same variance,
• The same weights
Suppose returns are statistically independent,
The portfolio return variance is therefore:
Therefore by holding the two assets, the is one half of the variance of a
portfolio composed of just one of the two assets
Diversification Effect
Suppose returns are perfectly correlated,
In this case the portfolio return variance becomes:
1
and
Therefore in case of perfect positive correlation, the

risk is the weighted sum of the individual risks
Suppose returns are perfectly negatively correlated,
In this case the portfolio return variance becomes:

-1
and
Therefore in case of perfect negative correlation, the risk is the

weighted difference of the individual risks
Note: for some values of , and can be set to zero

Suppose returns are imperfectly correlated
 is not a linear function of the returns anymore

 Is the case most likely to be encountered in practice
 However, the diversification effect is quite limited
with only two risky assets
Diversification possibilities are increased when there

are assets

Diversification with Many Risky Assets
 Consider a portfolio of N risky assets with:
• Same expected return,
• Same variance,
• Uncorrelated return, covariances are zero
 Then the portfolio risk is given by
 As more assets are added, the portfolio risk diminishes to zero
Therefore in this case diversification can potentially eliminate all

risks
Diversification with Many Risky Assets
Previous example was unrealistic as, in the real
world, asset returns are correlated
 Now assume that all assets have the same
correlation , where
 Then the portfolio risk is given by
 As N approaches infinity, the portfolio variance

approaches , a positive number that cannot be
lowered
Optimal Portfolio Choice
Given the desired level of expected return , what
is the minimum risk an investor has to take?
 The answer lies in finding portfolio weights that

yield this minimum
Mathematically, how can we minimize portfolio

risk?
We need to find to minimize , that is:
Where the weights have to satisfy two constraints:
Constraint n. 1: budget constraint

Constraint n. 2: constraint necessary to meet a given desired
expected portfolio return
To optimize our objective function we have to set the
first-order conditions (FOCs) to zero and then solve
them
The solution to the FOCs is the solution to the

optimization problem
Note: as the variance is a quadratic function,

unbounded above, our solution is minimize the function
We have a N-asset portfolio
 Minimizing is the same as minimizing (which
simplifies our FOCs)
 We have to add our 2 constraints into the
Lagrangian function
Where and are the Lagrangian multipliers that

reflect the two constraints
Taking the 1st derivatives w.r.t. and :
Which, after solving, yields the optimal portfolio

weights:

Where:
And

 To achieve the desired level of expected portfolio return , investors
should choose weights according to equation
 These weights are defined as optimal as they allow to achieve the

minimum portfolio risk among all possible portfolios with the same
expected portfolio return
 If we apply the equation to the optimal portfolio, for a given level of

expected portfolio return , we obtain the mean variance frontier, a
hyperbola obtained by plotting ( together for all possible

Mean-Variance Frontier

Mean-Variance Frontier
 Those portfolios whose risk and return trade-offs fall on
the curve are referred to as frontier portfolios
 The portfolio that yields the minimum possible portfolio
risk, point G on the frontier, is known as the global mean-
variance portfolio
 Frontier GB is inefficient (not of interest to investors)
GA is known as the efficient frontier/mean-variance

frontier (with efficient portfolios on it), representing the risk
and return trade-offs available to investors from which they
choose
Two Fund Theorem
When there are N risky assets available for
investment
 It is not necessary to consider all possible portfolios
 Two portfolios are sufficient
Consider the optimal portfolio weights (OPW)

equation
• If = 0 then , i.e. portfolios with

• If = 1 then , i.e. portfolios with
Two Fund Theorem
Thus, rewriting the OPW equation as:
 We can produce an arbitrary frontier portfolio with
 All frontier portfolios are portfolios of the g and (g+h), the 0 and the 1
expected return portfolios
• Since investors only hold efficient portfolios, they will be satisfied by holding a
suitable mix of the 0 and the 1 expected return portfolios
 That is, investors need to hold

• units of g
• units of (g + h)
Hope you enjoyed the course!
Thank you for your attention!

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BE331 The Pricing of Securities in

BE331 Asset Pricing 2

BE331 Asset Pricing 3

 Outcomes of each event and the events’ probabilities add a certain

 Personal preferences are individually-defined and can be expressed

BE331 Asset Pricing 4

BE331 Asset Pricing 5

BE331 Asset Pricing 6

BE331 Asset Pricing 8

BE331 Asset Pricing 9

An individual whose utility function meets

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 Being assured of the mean value of the gamble

 Taking part in the gamble

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BE331 Asset Pricing 18

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 The mean of the utilities for both possible events is:

Comparing the calculated utility values, we find that

The utility function describes a risk-averse individual

BE331 Asset Pricing 20

– A’(W) < 0 → Decreasing Absolute Risk Aversion

This measure increases with the curvature of the utility function

BE331 Asset Pricing 22

– R’(W) < 0 → Decreasing Relative Risk Aversion

BE331 Asset Pricing 23

BE331 Asset Pricing 24

• Represents a risk-neutral agent

 Quadratic utility function

• If , it represents a risk-averse agent

 Logarithmic utility function

• Represents a risk-averse agent

BE331 Asset Pricing 25

BE331 Asset Pricing 26

 Markowitz derived the functional relation between the

 Individual investors should choose from this portfolio’s

 Let and be the % invested in these assets, where is

• is the contribution to the portfolio return of asset 1

are the expected returns on the two risky assets

BE331 Asset Pricing 29

In finance, variance is denoted as , the above formula can be rewritten:

is the correlation between the returns of assets 1 and 2

BE331 Asset Pricing 30

Portfolio return variance is the risk measure in

Note: often, the square root of the variance , is

BE331 Asset Pricing 31

 The budget constraint

 The portfolio return

 The expected portfolio return

BE331 Asset Pricing 33

In matrix notation, the portfolio risk can also be rewritten as:

is an N-vector formed by the portfolio weights

Suppose we hold two assets characterized by:

Suppose returns are statistically independent,

The portfolio return variance is therefore:

Therefore in case of perfect positive correlation, the

In this case the portfolio return variance becomes:

Therefore in case of perfect negative correlation, the risk is the

Note: for some values of , and can be set to zero

 is not a linear function of the returns anymore

Diversification possibilities are increased when there