19/03/2023

Econ 122 Financial Economics I

Lecture 5: Capital Allocation

Jianxin Wang

Today’s Topics
Characterizing investors
Utility function
Risk preference
Capital allocation
Capital allocation line
Optimal allocation

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Utility Function
A numerical representation of well being.
Two basic assumptions
Utility increases with wealth (W)
Marginal utility decreases with wealth
• Risk aversion: losing hurts more than winning pleases
Examples:
U(W) = ln(W)
U[E(r),] = E(r) - 0.5A2
where E(r) and 2 are expected return and risk, and A is
the parameter for risk aversion

An Example: U(W) = ln(W)

U(W) More W is preferred to less
Marginal utility decreases
U(150)=5.0
U(100)=4.6

U(50)=3.9

Losing Winning

Wealth
50 100 150
Losing $50 hurts more than
winning $50 pleases.

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Indifference Curves
Expected Return
Feasible choice set
Optimal
choice


Indifference curves


Increasing Utility

Risk

Risk Aversion and Indifference Curve

E(r)
Highly risk averse: A >> 0

Less risk averse: A > 0

Risk neutral: A = 0

Risk loving: A < 0



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Mean-Variance Criterion

For risk-averse investors, assets in I is preferred to P,

which is preferred to assets in IV. Why?
Some assets in II and III have the same utility as P.

Comparing Risky Assets

Utility function: U[E(r),σ E(r)-(1/2)Aσ2
An investor’s preference for return and risk
Example: A = 4
Asset Exp Ret St Dev U=E(r) - 0.5A2
A 10% 20% 0.02
B 15% 25.5% 0.02
C 20% 30% 0.02
D 25% 33.9% 0.02
The investor is indifferent across the 4 assets

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Comparing Risky Assets

Example: A = 4
Asset Exp Ret St Dev U=E(r)-0.5A2
A 10% 20% 0.02
B 17% 25.5% 0.04
C 24% 30% 0.06
D 31% 33.9% 0.08
The investor prefers asset D

Risk and Risk Aversion

rf = 5%.
U(Risk-Free) = 0.05-0.5 A (0)2 = 0.05
Risky asset: E(r) = 0.22, σ2 = 0.1176
U(Risky) = E(r)-0.5Aσ2 = 0.22-0.5A 0.1176
Risk Aversion A U(RI) U(Rf) Invest?
High 5 -0.074<0.05 No
Medium 3 0.044<0.05 No
Low 1 0.161>0.05 Yes

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How Do I Know My Risk Tolerance?

Questionnaires on risk attitude and capacity to
absorb losses. BKM p164

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Demand for Risky Assets

What determines demand for risky assets?
Risk-free return (set by central bank)
Expected return and risk of risky assets (asset characteristics)
Risk tolerance (investor characteristics)
Mean-variance analysis
Normally distributed asset returns: mean and variance
determine its shape.
• Other distributions have parameters harder to interpret
Utility function: U[E(r),]=E(r)-0.5A2

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Capital Allocation
Risk-free return
In reality, there are many assets with no default risk, but
with (small) price risk: T-bills, CP, money market funds, etc.
For a given investment horizon, there may not be a truly
risk-free asset.
We assume that there is always a risk-free asset with a
return rf known before investing.
A portfolio of risky assets
How to mix risky assets is discussed later.
How much of your fund should be allocated to the
risk-free asset and the risky portfolio?
The best combination of the risk-free and risky assets.

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The Capital Allocation Line (CAL)

Portfolio P: E(rP)=15%, P=22%. E(r)
A risk-free asset: rf = 7%. CAL
Portfolio C: wP = 70% in P and 15% 
wf = 30% in rf. P
E(rC) (stocks)
E(rC) = 70%15%+30%7% 
C
= 12.6%
C = 70%22% =15.4%
rf=7% 
By changing wP and wf = 1-wP, (Bank)
the combined portfolio C forms
the investment opportunity set: 
a linear combination of P and rf
0 C 22%

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Capital Allocation – Margin Trading

Borrow at rf to invest in P E(r)
Have $100, borrow $50 CAL
E(rC)
$150 on P, -$50 on rf 
C
Portfolio value $100
15% P
wP = 150%, wf = -50%
E(rC)=1.515%-0.57%=19%
C = 150%22% =33% 
rf=7%


22% C

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Capital Allocation – Margin Trading

Borrow at rB=9%>rf to invest in P
Have $100, borrow $50 E(r)
$150 on P, -$50 on rf
Portfolio value $100
E(rC)  CAL
wP = 150%, wf = -50% C
15% P
E(rC)=1.515%-0.59%=18%
C = 150%22% =33% rB=9%

rf=7%


22% C

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The Capital Allocation Line

CAL: P and C have same slope (rB = rf)
→E r r σ

Sharpe ratio = : Reward per unit risk

expected reward per
= rf + total risk
retrun unit risk
The capital market line (CML) when P is the market
portfolio.
What is the best allocation on CAL?

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Optimal Capital Allocation

CAL
E(r)
Indifference curves
CL
Less risk-averse investors borrow
money to invest in risky assets
CH P

High risk-averse investors hold
rf both risk-free and risky assets


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Optimal Capital Allocation

Let y be the weight on the risky asset. The return
of the combined portfolio is rC = yrP + (1-y)rf
E(rC) = yE(rP) + (1-y)rf = rf + y[E(rP)-rf]
Var(rC) = σ = (yP)2

U = E(rC)–0.5Aσ = rf + y[E(rp)-rf] - 0.5A(yP)2

First-order condition: E(rP)-rf-0.5A(2y)σ = 0
E r r
y∗
Aσ

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Optimal Capital Allocation

E(rP) = 15%, and σP = 22%; rf = 7%; A = 4
Optimal weight in risky assets:
0.15 0.07
y∗ 0.41
4 0.22
An investor will invest 41% of her capital in portfolio P.
E(rC) = 0.07 + 0.41x[0.15 – 0.07] = 10.28%
C = 0.41x0.22 = 9.02%
Do not use percentage values to compute y*.
15 7
y∗ 0.0041
4 22

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Estimating Risk Aversion A

The China index average annual return 3.8% with
standard deviation 21%. The risk-free return is 2%.
If the average Chinese investors has 20% in the
China index and 80% in bank deposit,
0.038 0.02
0.2
A 0.21
The risk aversion of Chinese investors is A = 2.
Studies show that the range of A for US investors is
between 2 and 4.

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Optimal Capital Allocation

The optimal weight y* is high when A is low
Which investors will borrow fund to invest?
. .
If y ∗ 1, A < 1.64
.
Investors with A < 1.64 will engage in margin trading.
. .
If A = 1.2, y ∗ 1.37
. .
Investors should invest 137% of his/her capital in P.
Investors will borrow additional 37% at 7% interest rate.
. .
If the borrowing rate is 9%, y ∗ 1.033
. .
Higher borrowing cost reduces investment in P.

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Optimal Capital Allocation

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Passive Investment
Invest in a broad market index: P = M (market)
Exposed to market risk only. No firm-specific risk.
Much higher long-term returns than bank deposits.
Low cost in terms of money, time, and emotion:
free-ride on research by others.

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Readings and Exercises

Readings
Ch 6 all sections
Recommended exercises
Ch 6: 1, 2, 4, 5, 13 – 19, CFA: 4 – 7

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