Part Two

Portfolio Theory

Lecture 4. Risk Aversion

and Capital Allocation

This is based on Ch.5 of the textbook of this course: “Essentials of Invest-

ments,” written by Bodie/Kane/Marcus. Don't circulate it.
2 Contents

1. Risk Premium
2. Risk Aversion
3. Utility
4. Capital Allocation
3 Risk Premium
 Risk-free rate
 The rate of return on a risk-free investment. That is, the rate of return
that can be earned with certainty.
 The risk-free rate also varies over time. However, we know the risk-free
rate at the beginning of the holding period.
 There is no risk of default by the issuer of the investment.
 It is common to view Treasury bills as the risk-free asset.
 Risk premium
 A reward for bearing risk.
 The excess expected return on a risky investment over the risk-free
rate
Risk premium = Expected return – Risk-free rate
Expected return Risk-free rate Risk premium
4 Risk Aversion
 Risk aversion refers to reluctance to accept risk.
 It seems obvious that investors are risk averse in the sense that, with-
out a positive risk premium, they would not be willing to invest in risky
assets.
 In theory then, there must always be a positive risk premium on all risky
assets in order to induce risk-averse investors to hold the existing sup-
ply of these assets.
5 Risk Aversion
 Under the reasonable assumption that investors are risk averse,
portfolios are ranked as more attractive when their expected re-
turn is higher and less attractive when their risk is higher.
 But when risk increases along with return, the most attractive
portfolio is not obvious.
It depends on the investor’s degree of risk aversion.
 How can we quantify the risk-return trade-off based on an in-
vestor’s risk aversion?
6 Utility
 We will assume that each investor can assign a welfare, or utility,
score to competing investment portfolios based on the expected
return and risk of those portfolios.
Higher utility values are assigned to portfolios with more attractive
risk-return profiles.
Portfolios with higher expected return receive higher utility scores,
while those with higher risk receive lower scores.
7 Utility
 One reasonable function that has been employed by both financial
theorists and the CFA Institute assigns a portfolio with expected re-
turn and variance of return the following utility score:
(1)
where is the utility value and is an index of the investor’s risk
aversion.
 The factor of is just a scaling convention
 The inequality reflects the reasonable assumption that investors are risk
averse.
 The CFA Institute is a global association of investment professionals that offers the
Chartered Financial Analyst (CFA) designation to individuals who successfully com-
plete its education program and pass the CFA exams. The institute aims to promote
ethical and professional standards in the investment industry and provide continu-
ing education and career development opportunities for its members.
8 Utility
 We will use the utility function given by equation (1) unless oth-
erwise stated.
The equation is consistent with the notion that utility is enhanced by
high expected return and diminished by high risk.
Notice that investment only in the risk-free asset receive a utility
score equal to the risk-free rate.
The extent to which the variance of risky portfolios lowers utility de-
pends on , the investor’s degree of risk aversion.
More risk-averse investors (who have the larger values of A) penalize
risky investments more severely.
 Investors choosing among competing investment portfolios will
select the one providing the highest utility level.
9 Indifference Curves
 An indifference curve represents all combinations of the expected
value and standard deviation of portfolio returns that provide an
investor with the same level of utility.
 Portfolio analysis in terms of mean and standard deviation (or variance)
of returns is called mean-variance analysis.
10 Indifference Curves

 An indifference curve

𝐸 [𝑅 ]

𝜎
11 Indifference Curves
 An indifference map is a set of indifference curves
12 Indifference Curves

 An indifference map

𝐸 [𝑅 ]

𝜎
13 Sharpe Ratio
 The Sharpe ratio of a portfolio refers to ratio of the portfolio risk
premium to the standard deviation.

For example, the Sharpe ratio of a portfolio with an annual risk pre-
mium of 8% and standard deviation of 20% is 8/20 = 0.4.
A higher Sharpe ratio indicates a better reward per unit of SD, in
other words, a more efficient portfolio.
The Sharpe ratio is sometimes called the reward-to-volatility ratio.
14 Capital Allocation
 A simple strategy to control portfolio risk is to specify the fraction
of the portfolio invested in broad assets classes such as stocks,
bonds, and safe assets. This aspect of portfolio management, as
mentioned previously, is called asset allocation and plays an im-
portant role in the determination of portfolio performance.
 The most basic form of asset allocation classifies all assets as ei-
ther risky or risk free.
 The capital allocation to risky assets, which refers to the fraction
of the portfolio invested in such assets, directly reflects the in-
vestor’s risk aversion.
15 Capital Allocation
 To focus on the capital allocation decision, we think about an in-
vestor who allocates funds between the risk-free asset and a
portfolio, , of risky assets.
Thus, when we shift wealth into and out of the risky portfolio , we do
not change the relative proportion (weight) of the various securities
within the risky portfolio.
We will address the optimal construction of the risky portfolio at a
later time.
 We call the overall portfolio, , composed of the risk-free asset and
the risky portfolio the complete portfolio that includes the entire
wealth.
16 Capital Allocation
 Because the composition of the risky portfolio, , already has been
determined, the only concern here is with the proportion, , of the
investment budget to be allocated to it.
 The remaining proportion, , is to be invested in the risk-free as-
set, which has a rate of return denoted
 We assume
 When , we have , which is the case where borrowing at the risk-free
rate occurs, which we assume to be possible.
 We denote the rate of return of the complete portfolio by , the
expected rate of return on by , and its standard deviation by .
 We denote the rate of return of the risky portfolio by , the ex-
pected rate of return on by , and its standard deviation by .
17 Capital Allocation
 Remark
Since the composition of the risky portfolio, , already has been de-
termined regardless of , so have and .
The risk-free rate is also a known constant regardless of .
However, and are determined depending on .
18 Capital Allocation
 Then, we have, for ,
, that is,

 Therefore, we have, for ,

 Thus, we have, for ,

, that is,
, where , the Sharpe ratio of the risky portfolio .
19 Capital Allocation
 Both the risk premium and the standard deviation of the com-
plete portfolio increase in proportion to the investment in the
risky portfolio.
 The points of (, ) that describe the combination of the risk and re-
turn of the complete portfolio for various capital allocations, , are
all plotted on the straight line with the intercept of and slope
equal to the Sharpe ratio of .
 The straight line depicts the risk-return combinations available by
varying capital allocation, that is, by choosing different values of .
 For this reason, it is called the capital allocation line (CAL).
20 Capital Allocation
 If you invest all of your funds in the risky portfolio, that is, , then,
you have the following combination of risk and return.


 If you put all of your funds into the risk-free asset, that is, , then,
you have the following combination of risk and return.

21 Capital Allocation
 If you allocate equal amounts of your complete portfolio to the
risky portfolio and the risk-free asset, that is, you choose , then,
you have the following combination of risk and return.


 If you choose , then, you have the following combination of risk

and return.
22 Capital Allocation

 Capital Allocation Line

𝐸 [𝑅 𝐶 ]

1 .5 𝐸 [ 𝑅 𝑃 ] −0.5 𝑟 𝑓
𝐸 [𝑅 𝑃 ]
0.5 𝐸 [ 𝑅 𝑃 ] +0.5 𝑟 𝑓
𝑟𝑓
𝜎𝐶
0.5 𝜎 𝑃 𝜎 𝑃 1.5 𝜎 𝑃
23 Capital Allocation
 The slope, S, of the CAL equals the increase in the expected re-
turn that an investor can obtain per unit of additional standard
deviation, or equivalently, extra return per extra risk.
 Notice that the Sharpe ratio is the same for risky portfolio and
the complete portfolio that mixes and the risk-free asset.
That is, the Sharpe ratio is the same for all complete portfolios that
are plotted on the capital allocation line.
While the risk-return combinations differ according to the investor’s
choice of y, the ratio of reward to risk is constant.
24 Capital Allocation

 Ex 1) , , and

𝐸 [𝑅 𝐶 ]

19%
15 %
11 %
7%
𝜎𝐶
11 % 22 33
% %
25 Capital Allocation
 We have developed the CAL, the graph of all feasible risk-return
combinations available from allocating the complete portfolio be-
tween a risky portfolio and a risk-free asset.
 The investor confronting the CAL now must choose an optimal
combination from the set of all feasible choices.
 This choice entails a trade-off between risk and return.
 Individual investors with different levels of risk aversion, given an
identical capital allocation line, will choose different positions in
the risky asset.
Specifically, the more risk-averse investors will choose to hold less of
the risky asset and more of the risk-free asset.
26 Capital Allocation
 The investor’s problem is to choose a risk-return combination to
maximize his utility subject to for .
 The solution to the optimization problem.
The optimal combination:
The optimal capital allocation:
The maximum utility:
27 Capital Allocation
 We can illustrate the solution by the following figure.
𝑆2
𝑈= +𝑟 𝑓
2𝐴
𝐸 [𝑅 𝐶 ]
CAL

2
𝑆
+𝑟 𝑓
2𝐴
𝑟𝑓 ( 𝑆 𝑆2
,
𝐴 𝐴
+𝑟 𝑓 )
𝜎𝐶
28

Thank you!!!