FIN 435 (Faculty- SfR)

CHAPTER 6

RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETS

Suggested Problems: 4, 5, 6, 10, 11, 13,14,15,16, 19
(4)

a. The expected cash flow is: (0.5 x $70,000) + (0.5 x 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is 14%.
Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421
b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of $135,000,
then the expected rate of return [E(r)] is derived as follows:
$118,421 x [1 + E(r)] = $135,000
Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return with
the required rate of return.
c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407
d. For a given expected cash flow, portfolios that command greater risk premium must sell at
lower prices. The extra discount from expected value is a penalty for risk.

(5)

When we specify utility by U = E(r) .005A2, the utility from bills is 7%, while that from the
risky portfolio is U = 12 .005A x 182 = 12 1.62A. For the portfolio to be preferred to bills,
the following inequality must hold: 12 1.62A > 7, or,
A < 5/1.62 = 3.09. A must be less than 3.09 for the risky portfolio to be preferred to bills.

(6)

Points on the curve are derived as follows:

U = 5 = E(r) .005A2 = E(r) .0152
The necessary value of E(r), given the value of 2, is therefore:

0%
5
10
15
20
25

2
0
25
100
225
400
625

E(r)
5.0%
5.375
6.5
8.375
11.0
14.375

FIN 435 (Faculty- SfR)

The indifference curve is depicted by the bold line in the following graph (labeled Q3).

E(r)

U(Q4,A=4)
U(Q3,A=3)

U(Q5,A=0)

U(Q6,A<0)

(10)

The portfolio expected return can be computed as follows:

Wbills x

Return
on bills +

Exp. return
Wmarket x on market

Portfolio
expected
return

Portfolio
standard deviation

_______________________________________________________________(=wmarketx16.2%)___

0.0
.2
.4
.6
.8
1.0

5%
5
5
5
5
5

1.0
.8
.6
.4
.2
0.0

8.66%
8.66
8.66
8.66
8.66
8.66

8.66%
7.93
7.20
6.46
5.73
5.00

16.5%
13.2
9.9
6.6
3.3
0

FIN 435 (Faculty- SfR)

(11)

Computing the utility from U = E(r) .005 x A2 = E(r) .0152 (because A = 3), we arrive at
the following table.
Wbills
Wmarket
E(r)

2
U(A=3)
U(A=5)
___________________________________________________________________
0.
.2
.4
.6
.8
1.0

1.0
.8
.6
.4
.2
0

8.66%
7.93
7.20
6.46
5.73
5.0

16.5
13.2
9.9
6.6
3.3
0

271.92
174.03
97.89
43.51
10.88
0

4.58
5.32
5.73
5.81
5.57
5.0

1.86
3.58
4.75
5.38
5.46
5.0

The utility column implies that investors with A = 3 will prefer a position of 40% in the
market and 60% in bills over any of the other positions in the table.
(13)

Expected return = .3 8% + .7 18% = 15% per year.

Standard deviation = .7 28% = 19.6%

(14)

Investment proportions:
.7 27% =
.7 33% =
.7 40% =

(15)

30.0%
18.9%
23.1%
28.0%

in T-bills
in stock A
in stock B
in stock C

18 8
28 = .3571
15 8
Client's reward-to-variability ratio = 19.6 = .3571
Your reward-to-variability ratio

30
25

CA L (Slope = .3571)

20
E( r)
15
%

Client

10
5
0
0

10

20

30

40

Problem 16

FIN 435 (Faculty- SfR)

(19) a.
y* =

E(rP) - rf

18 - 8
10
=
=
2
27.44 = .3644
.01 3.5 282
.01 AsP

So the client's optimal proportions are 36.44% in the risky portfolio and 63.56% in T-bills.
b.

E(rC) = 8 + 10y* = 8 + .3644 10 = 11.644%

C= .3644 28 = 10.20%

EXTRA PROBLEM
1. XYZ wish to combine two stocks: Brac and Delta, into a portfolio with an expected return of 16%.
The expected return of Brac is 2% and the standard deviation of 1%. The expected return of Delta is 25%
with a standard deviation of 10%. The correlation between the two stocks is 0.40.
A. What is the composition (weights) of the portfolio?
B. What is the portfolio standard deviation?
Solution:
A. What is the composition (weights) of the portfolio?
Set w = weight in Brac
16% w * 2% (1 w) * 25%
16% 25%
w
2% 25%
39.1304%
B. What is the portfolio standard deviation?

P2 .391304 .01 .608696 .10 2 *.4 * .391304 .608696 .01.10

2

0.00391097

P 0.062538
6.2538%

2. An investor can design a risky portfolio with two stocks, A and B. Stock A has an expected
return of 18% and a standard deviation of 22.5%. Stock B has an expected return of 15% and a standard
deviation of 15%. The correlation coefficient between the two stocks is 0.75 and the risk-free T-bill rate is
9%.
(a) what are the weights of stocks A and B in the optimal risky portfolio (P)?

FIN 435 (Faculty- SfR)

wA

[E(rA ) rf ] B2 [ E(rB ) rf ] A B AB
[ E(rA ) rf ] B2 [ E(rB ) rf ] A2 [ E(rA ) rf E(rB ) rf ] A B AB

[0.18 0.09] * (0.15)2 [0.15 0.09] * 0.225* 0.15* 0.75

wA
[0.18 0.09] * (0.15)2 [0.15 0.09] * (0.225)2 [0.18 0.09 0.15 0.09] * 0.225* 0.15* 0.75
0.00051
wA
0.4 40%
0.00127
wB 1 0.4 0.60 60%
(b) what is the expected return on the portfolio P?

E (rP ) 0.4 * 0.18 0.6 * 0.15 16.20%

(c) what is the standard deviation of the return on portfolio P?

p (0.4) 2 * (0.225) 2 (0.6) 2 * (0.15) 2 2 * (0.4) * (0.6) * (0.15) * (0.225) * 0.75

p 0.02835 0.168375 16.8375%

3. Assume the T-Bill rate is 10% and the expected return on the market portfolio is 18%. An
investment is twice as risky as the market portfolio, in terms of its systematic risk. What is the
opportunity cost of capital (OCC) for this investment?

Based on CAPM:
r= rf + [E (Rm) rf]

where r = Required rate of return, rf = risk-free rate, =

Beta, E(Rm) = Market Index Return

OCC = 10% + 2(18% 10%) = 26.0%