AGENDA

CAPITAL ALLOCATION
BETWEEN RISK AND RISK-
FREE ASSET

CAPITAL ALLOCATION
BETWEEN TWO RISKY
ASSETS

ASSET ALLOCATION
PROCESS OF CAPITAL ALLOCATION
RISK-FREE ASSET
PROPERTIES OF THE COMBINED PORTFOLIO
THE CAPITAL ALLOCATION LINE
OPTIMAL PORTFOLIO

CAPITAL ALLOCATION BETWEEN RISK
AND RISK-FREE ASSET
ASSET ALLOCATION
Capital allocation is the choice of the proportion
of portfolio.
Example: You have $10,000 to invest. Following
your brokers recommendation you have the
risky asset P as 60% stock and as 40% bonds
(recall that even government bonds are risky,
unless held to maturity). When you choose y
(risky assets proportion) = 0.6, the combined
portfolio C is:







With y = 0.8, the combined portfolio C would be?
You make yourself to figure it out.

ASSET ALLOCATION
Examine risk/return tradeoff
Demonstrate how different degrees of risk aversion
will affect allocations between risky and risk free
asset.
Consider the optimal risky portfolio as given and
analyze the allocation decision between the risky
asset and the risk-free asset (T-bills)
Rate of return:
PROCESS OF CAPITAL ALLOCATION
Technically, the risk-free asset is default-free and
without inflation risk (a price-indexed default-free
bond)
In practice, Treasury bills come closest, because:
- Short term means little interest-rate or inflation risk
- Default risk is practically zero, since the government
would no default
RISK-FREE ASSET









PROPERTIES OF THE COMBINED PORTFOLIO

Notation:
rf = rate of return on the risk-free asset
rp = rate of return on the risky asset
rc = rate of return on the complete portfolio
(including both the risk-free asset and the risky
asset)
y = proportion of the investment budget to be placed
in the risky asset
p = standard deviation of the return on the risky
asset
c = standard deviation of the return on the complete
portfolio
Expect rate of return:



Variance:



Standard Deviation:










PROPERTIES OF THE COMBINED PORTFOLIO

Solve for y:


Replace the equation for the expected rate of
return:



This defines a line in the mean-variance space
the capital allocation line (CAL)










PROPERTIES OF THE COMBINED PORTFOLIO

The CAL gives the trade-off between risk and
return or the CAL describes all risk-return
combinations available to investor.
It allows to see what expected return on the
combined portfolio (E[Rc]) is attainable for a given
level of risk (c).
is the Reward-to-Variability ratio of P

is the risk premium on P
CAPITAL ALLOCATION LINE
CAPITAL ALLOCATION LINE
Example:
Rf = 7%
E (Rp) = 15%
p = 22%
Risk premium = 15% - 7% = 8%
Rate of return of portfolio:



Standard Deviation for portfolio:


CAPITAL ALLOCATION LINE
CAPITAL ALLOCATION LINE
We have shown how to develop the CAL, the graph
of all feasible riskreturn combinations available
from different asset allocation choices. The investor
confronting the CAL now must choose one optimal
portfolio, C, from the set of feasible choices.

Preview formula of Utility:
U = R(rc) 1/2A

where A is the coefficient of risk aversion and 1/2 is a
scale factor.


OPTIMAL PORTFOLIO
The investor attempts to maximize utility, U, by
choosing the best allocation to the risky asset, y.
We derive the formula:

the solution is given by the first-order constraint

solving for y gives the optimal choice of investment in
the risky portfolio

OPTIMAL PORTFOLIO
Going back to our previous example the optimal
ssolution for an investor with a coefficient of risk
aversion A = 4, 4 is:


n other words, this particular investor will invest
41% of the investment budget in the risky asset and
59% in the risk-free asset which Utility is
maximized.
Notice that 3.28/9.02 = .36, which is the reward-to-
variability ratio assumed for this problem.
OPTIMAL PORTFOLIO
You manage a risky portfolio with an expected rate of return of 18% and a
standard deviation of 28%. The T-bill rate is 8%.
1. Your client chooses to invest 70% of a portfolio in your fund and 30% in a
T-bill money market fund. What is the expected value and standard
deviation of the rate of return on his portfolio?
2. Suppose that your risky portfolio includes the following investments in the
given proportions:
Stock A: 25%
Stock B: 32%
Stock C: 43%
What are the investment proportions of your clients overall portfolio,
including the position in T-bills?
3. Your clients degree of risk aversion is A = 3.5. What proportion, y, of the
total investment should be invested in your fund? What is the expected
value and standard deviation of the rate of return on your clients
optimized portfolio
PREVIEW EXERCISE
A PORTFOLIO WITH TWO RISKY ASSETS
OPTIMAL PORTFOLIO
CAPITAL ALLOCATION OF TWO RISKY
ASSETS
The Return of portfolio:


R1 is the return and w is the weight of asset 1
R2 is the return and (1-w) is the weight of asset 2
The weights of the portfolio sum to 1.
The variance of the portfolio:


A PORTFOLIO WITH TWO RISKY ASSETS
A PORTFOLIO WITH TWO RISKY ASSETS
Recalling that:



The variance of the return on a portfolio of two
risky assets can be expressed as a function of the
correlation coefficient:

There are 4 cases of correlation coefficient:
Perfect positive correlation
A PORTFOLIO WITH TWO RISKY ASSETS
Perfect negative correlation,



We make first order constraint, we conclude:
A PORTFOLIO WITH TWO RISKY ASSETS
No correlation,
A PORTFOLIO WITH TWO RISKY ASSETS

A PORTFOLIO WITH TWO RISKY ASSETS
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