CHAPTER 6
Risk Aversion and Capital
Allocation to Risky Assets
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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
6-2
Allocation to Risky Assets
• Investors will avoid risk unless there
is a reward.
• The utility model allows 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 (a positive risk
premium)
– Parties have heterogeneous
expectations and assign different
probabilities
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Risk and Risk Aversion
• Gamble
– Bet or wager on an uncertain
outcome for enjoyment
– Parties assign the same probabilities
to the possible outcomes
– A fair game (zero risk premium) is
similar to gambling. A risk averse
investor will reject it.
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Risk Aversion and Utility Values
• Investors are willing to consider:
– risk-free assets
– speculative positions with positive risk premia
• Investors will reject fair games or worse
• Portfolio attractiveness increases with
expected return and decreases with risk.
• What happens when return increases with
risk?
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6-6
Table 6.1 Available Risky Portfolios
(Risk-free Rate = 5%)
How to compare?
Each portfolio receives a utility score to
assess the investor’s risk/return trade off
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A Utility Function
U E r As
1 2
2
U = utility or welfare (measure of happiness)
E[ r ] = expected return on the asset or portfolio
A = coefficient of risk aversion
s2 = variance of returns
½ = a scaling factor
There are other utility functions out there: must
increase with E[r] and decrease with s2
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A Utility Function – Meaning of A
U E r As
1 2
2
A = coefficient of risk aversion. Interpretation:
• A>0: Risk Averse. Penalizes risk. Will want a
larger risk premium for riskier investments.
• A=0: Risk Neutral. A pure trader, only concerned
about expectation. Will accept a fair game.
• A<0: Risk Lover. Adjusts utility up for risk
because enjoys the risk. A gambler, bored with
risk-free, will prefer for riskier investments.
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Table 6.2 Utility Scores of Alternative Portfolios for
Investors with Varying Degree of Risk Aversion
U Er As 2
1
2
Three investors with A= 2.0, 3.5 and 5.0
Q. What portfolio will each choose?
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Let’s play a game
• I will toss a coin and pay you some money
X if heads and nothing if tails
• How much are you willing to pay to play
this game?
– For X=$0
– For X=$1
– For X=$10
– For larger X?
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Let’s flip the game
• I will toss a coin and you pay me some
money X if heads and nothing if tails
• How much are you asking me to play this
game?
– For X=$0
– For X=$1
– For X=$10
– For larger X?
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Risk-Return Trade-off
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6-13
Mean-Variance (M-V) Criterion
• Portfolio A dominates portfolio B if:
E rA E rB
• And
sA sB
Q. How do you find a family of portfolios
you are indifferent to?
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Utility Indifference Curve
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6-15
How Do You Estimate Risk Aversion?
• Use questionnaires
• Observe individuals’ decisions when
confronted with risk
• Observe how much people are willing
to pay to avoid risk
• Use common sense
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Capital Allocation Across Risky and Risk-
Free Portfolios
Asset Allocation: Controlling Risk:
• Is a very important
• Simplest way:
part of portfolio
Manipulate the
construction.
fraction of the
• Refers to the choice portfolio invested in
among broad asset risk-free assets
classes. versus the portion
invested in the risky
assets
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Basic Asset Allocation
Portfolio Total Market Value $300,000
Risk-free money market fund $90,000
Equities $113,400
Bonds (long-term) $96,600
Total risk assets $210,000
$113,400 $96,600
WE 0.54 WB 0.46
$210,000 $210,00
These weights are within the risky portfolio
Q. What is the risk-free vs risky composition?
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Basic Asset Allocation
• Let y = weight of the risky portfolio, P,
in the complete portfolio; (1-y) = weight
of risk-free assets:
$210,000 $90,000
y 0.7 1 y 0.3
$300,000 $300,000
$113,400 $96,600
E: .378 B: .322
$300,000 $300,000
These weights are within the entire portfolio
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The Risk-Free Asset
• Only the government can issue
default-free bonds (caveats).
– Risk-free in real terms only if price
indexed and maturity equal to investor’s
holding period.
• T-bills viewed as “the” risk-free asset
• Money market funds also considered
risk-free in practice
(caveat, remember fall 2008?)
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6-20
Figure 6.3 Spread Between 3-Month
CD and T-bill Rates
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Portfolios of One Risky Asset and a Risk-Free
Asset
You can create a complete portfolio by splitting
funds between safe and risky assets. Let:
• y = portion allocated to the risky portfolio, P
• (1-y) = portion to invest in risk-free asset, F.
Build a complete portfolio C: rC yrp 1 y rf
Take expectations: E rC yE rp 1 y rf
Rearrange terms: E rC rf yE rp rf
risk premium
Q. What’s the porfolio’s sc?
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6-22
Example Using Chapter 6.4 Numbers
Risky Risk-free
E(rp) = 15% rf = 7%
sp = 22% srf = 0%
y = % in p (1-y) = % in rf
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Example (Ctd.)
The expected
return on the E rC rf yE rp rf
complete
risk premium
portfolio is the
risk-free rate plus
the weight of P E rc 7 y15 7
times the risk
premium of P
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Example (Ctd.)
• The risk of the complete portfolio is
the weight of P times the risk of P
because the risk free asset has
zero standard deviation:
s C ys P 22 y
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Example (Ctd.)
Place the two portfolios P and F on the {r,s}
plane. Varying y from 0 to 1 describes a line
between F and P, what is the slope?
Rearrange and substitute y=sC / sP:
sC
E rC rf
sP
E rP rf 7 s C
8
22
E rP rf 8
Slope Intercept rf 7
sP 22
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Figure 6.4 The Investment
Opportunity Set
y =1
Q. What’s the
value of y
here?
What does it
mean?
y =0
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6-27
Capital Allocation Line with Leverage
• y>1 means borrow money to lever up
your investment (e.g. buy on margin)
• There is asymmetry: lend (or invest) at
rf=7% and borrow at rf=9%
– Lending range slope = 8/22 = 0.36
– Borrowing range slope = 6/22 = 0.27
• CAL kinks at P
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Figure 6.5 The Opportunity Set with
Differential Borrowing and Lending Rates
You
borrow
You lend
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Risk Tolerance and Asset Allocation
• The investor must choose one optimal
portfolio, C, from the set of feasible
choices (by changing y)
– Expected return of the complete
portfolio:
E rC rf y E rp rf
– Variance:
s ys
2
C
2 2
P
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Utility Function depending on y
• Express U as a function of y
E rC
1
U As C
2
2
U rf y E rp rf A y s P
1
2
2 2
• U is a quadratic function of y
U ay yb c
2
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Table 6.4 Utility Levels for Various Positions in Risky
Assets (y) for an Investor with Risk Aversion A = 4
Example:
rf = 7%
E(rp) = 15%
sp = 22%
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6-32
Figure 6.6 Chart Utility as a Function of
the Allocation to the Risky Asset (y)
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Maximize Utility Function w.r.t. y
• Express U as a function of y
E rC
1
U As C
2
2
U rf y E rp rf A y s P
1
2
2 2
E rp rf
• The maximize w.r.t. y
ymaxU
As 2
P
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Utility Indifference curves
Utility Indifference Levels
U E r
1 2
As const
2
For example :
U 0.05, 0.09
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Table 6.5 Spreadsheet Calculations of
Indifference Curves
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Table 6.6 Expected Returns on Four
Indifference Curves and the CAL
Risk aversion coefficient A=4
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Put it together and find your optimal allocation 6-37
2. Map your
Utility
3. Find optimal y indifference
to maximize your curves
U along Capital
Alllocation Line
1. Draw the Capital
Alllocation Line
by varying y
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Passive Strategies:
The Capital Market Line
• The passive strategy avoids any direct or
indirect security analysis
• Supply and demand forces may make such
a strategy a reasonable choice for many
investors
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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).
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Passive Strategies:
The Capital Market Line
• The CML is given by a strategy that
involves investment in two passive
portfolios:
1. a virtually risk-free portfolio of short-
term T-bills (or a money market fund)
2. a fund of common stocks that mimics
a broad market index.
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Passive Strategies:
The Capital Market Line
• From 1926 to 2009, the passive risky
portfolio offered an average risk premium
of 7.9% with a standard deviation of
20.8%, resulting in a reward-to-volatility
ratio of .38.
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