RISK AVERSION AND CAPITAL
ALLOCATION TO RISKY ASSETS
1) Construction of Investor’s Portfolio.
Risky asset composition (-stocks, long-term bonds etc)
Decision making about i) how much to invest in risky assets ii)and in risk
free assets.
2) Above decision requires to know the expected returns of the
constructed portfolio and risks involved.
3) Personal preferences towards expected returns and risk.
4) Framework for investor’s preferences.
Risk Aversion. Avoid risk unless there are higher rewards.
Utility Functions. Quantification of preferences for alternative
investments plans.
RISK AVERSION AND UTILITY VALUES
1. Risk Aversion Defined Again:
First principle of this framework is that investor avoid risk
till the time there is some payoff associated with it.
2. Utility Function Defined Again:
Second thing is to quantify this risk within utility
functions. Thus the portfolio with higher utility for the
given expected return and standard deviation are the
preferred ones.
BASIC ASSUMPTION FOR OPTIMAL
CAPITAL ALLOCATION
ØThe risky portfolio has already been constructed
and investor has this information about expected
return and risk of overall portfolio.
ØGiven these parameters of expected returns and
risk, find the optimal allocation of capital
between risky portfolio and risk-free asset, using
the given utility function.
RISK AND RISK AVERSION
ØSpeculation
Considerable risk to obtain commensurate gain.
It means that risk is sufficient to affect the decision, such
that a risk taking investment will bring a premium.
In Chapter 5, we have seen that there is a premium
attached with investment in risky investments over risk-
free investments.
ØGambling
It is about a disconnect between risk and reward, a person
finds an excitement in taking risk.
To describe the difference mathematically. Gambling is to
go for a fair game, that is, an investment may be taken even
if premium is zero.
RISK AVERSION AND UTILITY VALUES
ØThe risk averse investor penalizes the expected
returns of the risky investment by “certain percentage”
e.g., returns of S&P-500 and KSE-100.
ØLets say, a risk averse investor is confronted with a
choice of investment among different portfolios, with
varying expected returns and risk.
ØIntuitively the decision must involve some weighting
scheme for the expected returns (attractive aspect) and
for risk (annoying aspect). Lets see the example.
TABLE 6.1 AVAILABLE RISKY
PORTFOLIOS (RISK-FREE RATE = 5%)
Decision criteria, that is in which portfolio to
invest ???
UTILITY FUNCTION
Where
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
s2 = variance of returns
Now use risk aversion A=2, 3.5 and 5 and
give these portfolios their utility scores.
TABLE 6.2 UTILITY SCORES OF ALTERNATIVE PORTFOLIOS FOR
INVESTORS WITH VARYING DEGREE OF RISK AVERSION
Utility score is also known as certainty equivalent.
Risk neutral and risk lover.
CONCEPT CHECK 2
TRADE-OFF BETWEEN RISK AND RETURNS .
Mean variance efficient criteria in Quadrat I and IV.
TRADE-OFF BETWEEN RISK AND RETURNS .
in Quadrat II and III, we can select different portfolios with
different expected returns and standard deviations but still all do
have the same utility score. A mean variance curve which gives
same utility for different combinations of portfolios is called
indifference curve.
TABLE 6.3 UTILITY VALUES OF POSSIBLE PORTFOLIOS FOR
AN INVESTOR WITH RISK AVERSION, A = 4
ASSIGNMENT AND CONCEPT CHECK.
The less risk averse
investor will have
shallower curve because
it requires less return
against increase in risk to
restore utility to original
level.
ESTIMATING RISK AVERSION
§Many financial advisors' asses the level of one’s risk through
questioners
§ The benefit of the questionnaires is that they are an
objective resource people can use to get at least a rough
idea of their risk tolerance
§ Questionnaires should be used simply as a first step to
assessing risk tolerance
§ The second step, many experts agree, is to ask yourself
some difficult questions, such as: How much you can stand to
lose over the long term?
ESTIMATING RISK AVERSION
ESTIMATING RISK AVERSION
CAPITAL ALLOCATION ACROSS RISKY AND RISK-FREE
PORTFOLIOS
CAPITAL ALLOCATION ACROSS RISKY AND RISK-FREE
PORTFOLIOS
Asset Classes are different in terms of risk, Further within
each Asset Class there are different securities.
The Capital Allocation is the allocation of capital among
different asset classes.
To control for the risk some fraction of the portfolio is
invested in Treasury bills or other safe money market
securities.
This is indicated with F, the partition of investment in the
risk free assets.
Whereas, for the risky P is the portion of the risky
investment in different asset classes such as equity(E) and
Bond(B).
THE RISKY ASSET EXAMPLE
Total portfolio value = $300,000
Risk-free value = 90,000
Risky (E& B) = $113,400 +$96,600 = $
210,000
(E) = 113,400/210,000 =54%
(B) = 96,600/210,000=46%
KEEPING THE WEIGHTS FIXED FOR BOND AND EQUITY
INVESTMENT
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
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)
PORTFOLIOS OF ONE RISKY ASSET AND A RISK-FREE ASSET
PORTFOLIOS OF ONE RISKY ASSET AND A RISK-FREE ASSET
EXAMPLE USING CHAPTER 6.4 NUMBERS
rf = 7% srf = 0%
E(rp) = 15% sp = 22%
y = % in p (1-y) = % in rf
rc = yrp+(1-y)rf
COMBINATIONS WITHOUT LEVERAGE
If y = .50, then
sc = .5(.22) = .11 or 11%
If y = 1
s c = 1(.22) = .22 or 22%
If y = 0
s c = (.22) = .00 or 0%
COMBINATIONS WITHOUT LEVERAGE
COMBINATIONS WITHOUT LEVERAGE
CAPITAL ALLOCATION LINE WITH LEVERAGE
FIGURE 6.5 THE OPPORTUNITY SET WITH DIFFERENTIAL
BORROWING AND LENDING RATES
TABLE 6.5 UTILITY LEVELS FOR VARIOUS POSITIONS IN RISKY
ASSETS (Y) FOR AN INVESTOR WITH RISK AVERSION A = 4
FIGURE 6.6 UTILITY AS A FUNCTION OF ALLOCATION TO
THE RISKY ASSET, Y
TABLE 6.6 SPREADSHEET CALCULATIONS OF INDIFFERENCE
CURVES
FIGURE 6.7 INDIFFERENCE CURVES FOR
U = .05 AND U = .09 WITH A = 2 AND A = 4
TABLE 6.7 EXPECTED RETURNS ON FOUR INDIFFERENCE
CURVES AND THE CAL
FIGURE 6.8 FINDING THE OPTIMAL COMPLETE PORTFOLIO
USING INDIFFERENCE CURVES
ASSIGNMENT
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
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
