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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 and a Risk-Free Asset (Chapter 7 BKM)
What if Everyone Chooses This Way? Market Equilibrium CAPM (Chapter 9 BKM)
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The utility model gives the optimal allocation between a risky portfolio and a risk-free asset.
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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-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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E (rA ) E (rB )
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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
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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.
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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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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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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
U1
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%
y*
E{rp}rf A 2 p
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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
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%
E{r}
17% 15%
.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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