LECTURE 4: RISK AVERSION AND

CAPITAL ALLOCATION TO RISKY

ASSETS
Introduction
Lecture 2 and Lecture Lecture 4 and Lecture
3 5
Introduction
 Investment assets can be categorized into broad
asset classes, such as bonds, stocks, real estate,
commodities, and so on. Investors make two types
of decisions in constructing their portfolios:
1. The asset allocation decision is the choice among
these broad asset classes.
2. The security selection decision is the choice of which
particular securities to hold within each asset class.
Outline
 Risk and Risk Aversion (6.1)
 Scenario analysis
 Capital Allocation across Risky and Risk-free Portfolios
(6.2)
 The Risk-free Asset (6.3)
 Portfolios of One Risky Asset and a Risk-free Asset (6.4)
 Risk Tolerance and Asset Allocation (6.5)
Risk and Risk Aversion
 In general, to make a decision a decision-maker (DM) follows an objective
(criterion). He evaluates each possible options and chooses the one that gives
him the highest score.
 In the domain of asset allocation, possible criterions are:
1. Expected Value (EV) Criterion: a DM purely maximizes the expected value of his
final wealth. (=> in this case, his is risk-neutral.)
2. Mean-Variance (MV) Criterion: a DM takes both expected value and variance into
account in his evaluation.
Portfolio A dominates B if E(rA)≥E(rB) and σA≤σB And at least one inequality is strict.
In this module and the textbook, we assume a specific form of value function based
on MV criterion.
Risk and Risk Aversion
 When investors are choosing their optimal portfolio, we
assume that they only care about return (measured by
expected return), their utility function can be:
2
U =E(r) - 0.5 A s
“A” measures individual’s risk-aversion. If an individual is very
risk-averse, A is ______. If an individual is less risk-averse, A is
_____. Typically, we assume that investors are risk-averse.
 Risk and Risk Aversion
 The indifference curve
Expected Return

Mean-variance (M-V)
criterion
Portfolio A dominates B if
E(rA)≥E(rB) and σA≤σB
And at least one inequality is strict.
Standard Deviation
 Scenario Analysis
 Individuals would perform scenario analysis to determine the return
and risk for all of the assets available on the market.
 Assume initial price is $100.
State of the Probabilit Year-end Cash Holding- Deviation Squared
Market y Price Dividends period s from the Deviation
Return Mean s from
Mean
EXCELLE 25% 126.50 4.5 31% 21.24% 0.0451
NT
GOOD 45% 110.00 4.0 14% 4.24% 0.0018
POOR 25% 89.75 3.5 -6.75% -16.51% 0.0273
CRASH 5% 46.00 2.0 -52% -61.76% 0.3815
Scenario Analysis
 Please calculate:
Ending price - beginning price + cash dividend
Holding-period Return HPR =
Beginning price
n

Expected Return E(r) =å p(s)r(s) E(r) = ____

s=1
9.76%
n

Variance s =å p(s)[r(s) - E(r)]

2 2
s=2 ___0.038
s=1

Standard Deviation s = s s = ___

2
19.49%
The Asset-allocation Decision
 An individual maximizes his/her utility subject to
the budget constraint. The optimization problem:
Max U
s.t. Budget constraint
6.3: One risk-free asset

6.4: One risky asset and a risk-free asset

7.2: Two risky assets

7.3 Two risky assets and a risk-free asset

7.4 Many risky assets and a risk-free asset

One Risk-free Asset
 It is common practice to view T-bills as the risk-
free asset.
1. Very low default risk
2. Insensitive to interest rate fluctuations
Expected
Return

Standard
Deviation
Portfolios of One Risky Asset and a Risk-free Asset

 Suppose there are only two assets. One is risky and

the other is risk-free. You are deciding how much
money to invest in the risky asset and in the risk-
free asset.
Expected Standard
Return Deviation
Risky 15% 22%
Risk-free 7%
Portfolios of One Risky Asset and a Risk-free Asset

 Let’s first solve it graphically:

The optimal choice for an
Expected Return individual.

Risk-return combinations
available to investors.

Standard Deviation
Portfolios of One Risky Asset and a Risk-free Asset

 The budget line tells you the relationship between

portfolio’s expected return and standard deviation.

 Let y be the proportion of the investment budget

allocated to the risky asset. 1-y: the proportion of
the investment budget allocated to the risk-free
asset
Portfolios of One Risky Asset and a Risk-free Asset
 The complete portfolio (C) is composed of y in the
risky asset and 1-y in the risk-free asset.
y : proportion in the risky asset;
rc : RR of the complete portfolio; rp : RR of the risky asset; rf : RR of the risk-free asset
E(rc ): ER of the complete portfolio; E(rp): ER of the risky asset; E(rf): ER of the risk-free
asset
σc : Std of the complete portfolio; σp : Std of the risky asset; σf : Std of the risk-free asset
Portfolios of One Risky Asset and a Risk-free Asset
rc= y*rp+(1-y)*rf
1. E(rc)= y*E(rp)+(1-y)*rf=7%+y*8%
2. σc= y*σp = y*22%
3. Combining 1 and 2, we can derive the risk-return
relationship.
σc= y*22% => y= σc / (22%)
E(rc) = 7%+(σc / (22%)) * 8% = 7%+0.36σc
=> the slope of CAL is 0.36 (See next slide…)
Portfolios of One Risky Asset and a Risk-free Asset
 Capital Allocation Line (CAL): it depicts all the
risk-return combinations available to investors.
Expected Return
CAL: Reward-to-volatility
ratio
Sharpe ratio
r rowing
bo

Standard Deviation
Risk Tolerance and Asset Allocation
 Now, let’s solve for the optimal portfolio:

Max
2
U =E(rc ) - 0.5 A s c
{ y}

st. E(rc ) =rf + y ×[E(rp ) - rf ]

s =y ×s
2
c
2 2
p
Risk Tolerance and Asset Allocation

Max
2 2
U =rf + y ×[E(rp ) - rf ]- 0.5 A y ×s p
{ y}
2
f .o.c [E(rp ) - rf ]- A y ×s =0 p

E(rp ) - rf
*
=> y = The optimal portfolio
A ×s p2
Risk Tolerance and Asset Allocation
 Assume A=4,

* E(rp ) - rf 15% - 7%
y = 2
= 2
=0.41
A ×s p 4 ×(22%)

 The larger the value of A, the more you would

risk-free
invest in the _______ asset.