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Optimal Utility Risk Riskfree

The document discusses the optimal allocation of an investor's wealth between a risky portfolio and a risk-free asset, detailing the Capital Allocation Line and its implications for expected returns and risk. It introduces the concept of mean-variance utility to derive the optimal proportion of wealth to invest in the risky portfolio, which is influenced by the investor's risk aversion coefficient. The optimal allocation formula is derived, emphasizing the relationship between expected returns, risk, and the investor's utility maximization.

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yaswanthghodkaramarnathlal.mba25
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1 views2 pages

Optimal Utility Risk Riskfree

The document discusses the optimal allocation of an investor's wealth between a risky portfolio and a risk-free asset, detailing the Capital Allocation Line and its implications for expected returns and risk. It introduces the concept of mean-variance utility to derive the optimal proportion of wealth to invest in the risky portfolio, which is influenced by the investor's risk aversion coefficient. The optimal allocation formula is derived, emphasizing the relationship between expected returns, risk, and the investor's utility maximization.

Uploaded by

yaswanthghodkaramarnathlal.mba25
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Optimal Allocation Between a Risky Portfolio and a

Risk-Free Asset

Let an investor allocate a proportion y of total wealth to a risky portfolio P and the
remaining proportion (1−y) to a risk-free asset. Denote the expected return and standard
deviation of the risky portfolio by E(rP ) and σP , respectively, and let the risk-free return
be rf .

1 The Capital Allocation Line


The return on the complete portfolio is

rC = yrP + (1 − y)rf .

Its expected return is

E(rC ) = yE(rP ) + (1 − y)rf = rf + y [E(rP ) − rf ] .

The variance of the complete portfolio is

Var(rC ) = y 2 Var(rP ) + (1 − y)2 Var(rf )


+ 2y(1 − y) Cov(rP , rf ).

Since the risk-free return is constant,

Var(rf ) = 0 and Cov(rP , rf ) = 0.

Thus,
Var(rC ) = y 2 σP2 ,
and, for y ≥ 0,
σC = yσP .
Therefore,
σC
y= .
σP
Substituting this expression into the expected-return equation gives

E(rP ) − rf
E(rC ) = rf + σC .
σP

This is the equation of the capital allocation line. It is a straight line in mean–
standard-deviation space, with
intercept = rf ,

1
and
E(rP ) − rf
slope = .
σP
The slope is the Sharpe ratio of the risky portfolio. It measures the expected excess
return earned per unit of risk.

2 Optimal Portfolio Allocation


Assume that the investor has mean–variance utility:
1
U = E(rC ) − AσC2 ,
2
where A > 0 is the investor’s coefficient of risk aversion, and C denotes the complete
portfolio.
The expected return of the complete portfolio is

E(rC ) = yE(rP ) + (1 − y)rf .

Because the risk-free asset has zero variance and zero covariance with the risky port-
folio,
σC2 = y 2 σP2 .
Therefore, utility can be written as
1
U (y) = yE(rP ) + (1 − y)rf − Ay 2 σP2 .
2
Differentiating with respect to y gives
dU
= E(rP ) − rf − AyσP2 .
dy
The first-order condition for an optimum is

E(rP ) − rf − AyσP2 = 0.

Hence, the optimal proportion invested in the risky portfolio is

E(rP ) − rf
y∗ = .
AσP2

The second-order condition is


d2 U
= −AσP2 < 0,
dy 2
so y ∗ maximizes the investor’s utility.

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