Lecture 4

Risk Aversion and Capital Allocation to Risky Assets

INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Portfolio Choice Under Risk Aversion: How SHOULD People Choose Portfolios?
Capital Allocation Between a Risky and Risk-Free Asset (Chapter 6 BKM)
Capital Allocation Line Leveraged Investment

Capital Allocation Among Risky Assets (Chapter 7 BKM)

Diversification Efficient Frontier

Capital Allocation Among Risky Assets and a Risk-Free Asset (Chapter 7 BKM)
What if Everyone Chooses This Way? Market Equilibrium CAPM (Chapter 9 BKM)

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Allocation to Risky Assets

Risk Aversion:
Intuitively, risk aversion means that investors will avoid risk unless there is a reward.

The utility model gives the optimal allocation between a risky portfolio and a risk-free asset.

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Risk and Risk Aversion

Speculation
Taking considerable risk for a commensurate gain
Risk: material enough to affect the decision Commensurate gain: positive risk premium (expected profit is greater than the risk-free alternative)

Risk aversion and speculation are not inconsistent

Gamble
Bet or wager on an uncertain outcome for enjoyment Fair game: risky investment with a risk premium of zero. Will be rejected by a risk averse investor

When two parties enter into a transaction (e.g. a futures contract on the euro), can they both be speculating?

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Risk Aversion and Utility Values

Risk-averse investors are willing to consider:

risk-free assets
speculative positions with positive risk premiums Risk-neutral investors care only about expected returns. They would take on fair games. Portfolio attractiveness increases with expected return and decreases with risk.

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Mean-Variance (M-V) Criterion

E (rA ) E (rB )

Portfolio A dominates portfolio B if: And

A

What happens when return increases with risk?

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How to choose between these portfolios?

Each portfolio receives a utility score to assess the investors risk/return trade off

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Utility Function
U = utility E ( r ) = expected return on the asset or portfolio A = coefficient of risk aversion 2 = variance of returns = a scaling factor

1 2 U E (r ) A 2

6-9

Utility Scores of Alternative Portfolios for Investors with Varying Degree of Risk Aversion

The utility score of a risky portfolio can be interpreted as the certainty equivalent rate of return (rate which risk-free investments would need to offer to provide the same utility score as the risky portfolio.) A portfolio is desirable only if its certainty equivalent rate of return exceeds the risk-free rate.

6-10

Indifference Curves
If we plot all equally-preferred portfolios in the meanstandard deviation plane, we get the investors indifference curve.

More risk-averse investors have steeper indifference curves than less risk averse investors.

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Estimating Risk Aversion

Use questionnaires
Observe individuals decisions when confronted with risk Observe how much people are willing to pay to avoid risk

Capital Allocation Between a Risky and Risk-Free Asset

An Example: Risk-Free Asset Expected return 7% Standard Deviation 0% Portfolio share (1-y) Risk Premium: E{rp} - E{rf} = 8% Risky Asset (Portfolio) 15% 22% y

Extra return required to make people indifferent between risky and risk-free assets

Two Critical Rules for a portfolio with one risky and one risk-free asset:
Expected Return is weighted average of expected returns to each security: E{rc} = (1-y) E{rf} + y E{rp} For example, if y = 0.7, E{rc} = 12.6 = 0.3*7% + 0.7*15% Standard Deviation is weight on risky asset times standard deviation of risky asset: c = y p = (0.7) (22%) = 15.4% The rest of the portfolio-risk formula drops out (mathematically) 0 0 c2 = y2p2 + (1-y)2f2 + 2y(1-y)pfCorr(p,f)

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The Investment Opportunity Set

Possible combinations of risk and return form a straight line
At y = 0, invest all in zero-risk asset: E{rc} = 7%, c = 0
At y = 1, invest all in risky asset: E{rc} = 15%, c = 22% At y = 0.7, invest 30% in zerorisk asset, 70% in risky asset: E{rc} = 12.6%, c = 15.4%

Capital Allocation Between a Risky and Risk-Free Asset

U3 E{r} 15% U2 U1

More utility
Capital Allocation Line

7%

.y=0 0 22%

Capital Allocation Line Set of feasible combinations of E{rc} and c When considering investor portfolio choices, CAL serves as a budget line How to Choose the optimal allocation between the risk-free asset and the risky asset ? Maximize utility subject to CAL

Capital Allocation Between a Risky and Risk-Free Asset

U3 U2 E{r} 15% 11.4% 7%
.y=0.55

U1

Capital Allocation Line

12.1%

22%

How to Choose? Maximize utility subject to CAL Portfolio with 55% in risky asset provides highest possible utility, U2 for this investor (A=3) At y = 55%, what do we know about portfolio? E{r*c} = 0.45 E{rf} + 0.55 E{rp} = 11.4% *c = 0.55 p = 12.1%

Capital Allocation Between a Risky and Risk-Free Asset

Finding the best allocation, y*: Two approaches: 1. Numerical approximation: Calculate U(y) for all feasible values of y. Find y that gives highest value of U(y)
2.

Calculus, to get it exactly right

y*

E{rp}rf A 2 p

This makes sense:

Best share of risky asset y* grows with the risk premium on risky assets, E{rp} - rf Best share of risky asset falls with risk aversion, A Best share of risky asset falls with that asset's own risk, 2

6-17

Illustration of numerical optimization

6-18

Utility as a Function of Allocation to the Risky Asset, y

Risk Aversion and Portfolio Allocations

Lower risk aversion

E{r} 15% 13.8%

Higher risk aversion

Capital Allocation Line

.y=0.85 .y=0.55

7%

18.7% 22%

Lower risk aversion leads to higher share in risky asset (A=1.94) Higher expected return, higher risk E{U(y)}

.y=0.55

.y=0.85 1

Share in risky asset, y

Capital Allocation Between a Risky and Risk-Free Asset

E{r} 18.5% .y=1 15% .y=0 .y=1.5

7%

Why does the CAL continue up and to the right? Potential to borrow
If you borrow 50% of wealth "Investment" in zero-risk asset is negative: E{rc} = -0.5*7% + 1.5*15% = 18.5%, y = 1.5 (1-y) = - 0.5 c = 1.5*22% = 33%.

22%

33%

Capital Allocation Between a Risky and Risk-Free Asset

Even lower risk aversion

E{r}
17% 15%

Higher risk aversion

.y=1.25

Capital Allocation Line

.y=0.55

7%

22%

27.5%

Leveraged Investing: With even lower risk aversion, investor could choose to borrow (A=1.32) y* = 1.25, E{r*c} = - 0.25 E{rf} + 1.25 E{rp} = 17% *c = 1.25 p = 27.5%

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Capital Allocation Line with Leverage

Leveraged Investing: Borrowed funds typically cost more than the risk-free rate: Suppose borrowed funds cost 9% (rf = 7%). CAL now has a kink at P where y = 1 Slope for y > 1 is lower than slope for y 1 Lending range slope = 8/22 = 0.36

Borrowing range slope = 6/22 = 0.27

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The Opportunity Set with Differential Borrowing and Lending Rates

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Passive Strategies: The Capital Market Line

A natural candidate for a passively held risky asset would be a well-diversified portfolio of common stocks such as the S&P 500.
The capital market line (CML) is the capital allocation line formed from 1-month T-bills and a broad index of common stocks (e.g. the S&P 500).