Professional Documents
Culture Documents
Road Map
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Capital allocation
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Example: one risky asset
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Capital allocation line
• We can define the Capital allocation line (CAL) as
follows:
⎡E (rp ) − rf ⎤
E (rC ) = rf + y ⎡⎣E (rp ) − rf ⎤⎦ = rf + ⎣ ⎦σ
σ
C
p
E (rC ) = rf + SσC
Leverage
• Suppose that the initial investment budget is $300,000
but the investor borrows additional funds for $120,000 to
invest the total amount in the risky asset.
• This is called leveraged position in in the risky asset
420, 000
y= = 1.4 (or 140%)
300, 000
1 − y = 1 − 1.4 = −0.4
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Risk aversion and optimal portfolios
U = E (rC ) − 1 2 AσC2 =
= rf + y ⎡⎣E (rp ) − rf ⎤⎦ − 1 2 Ay 2σ2p
• Investor will choose their fraction to allocate to the risky
portfolio y by maximising their utility (given their attitude
towards risk, or risk aversion A):
maxU = rf + y ⎡⎣E (rp ) − rf ⎤⎦ − 1 2 Ay 2σ2p
y
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Risk aversion and optimal portfolios (cont’d)
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Risk aversion and optimal portfolios (cont’d)
0.15 − 0.07
y* = = 0.41
4 × 0.222
1 − y * = 0.59
• when 41% is invested in the risky asset the optimal
(complete) portfolio will exhibit
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Passive portfolio strategy
E (rM ) − rf
y *passive =
AσM 2
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Example: multiple risky assets
E ( rp ) = ∑ wi E ( ri )
i
σ = ∑∑ wi w j cov ( ri , rj )
2
p with cov ( ri , ri ) = σ i2
i j
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Portfolio diversification
• Assume that
– expected return E(ri) = μ
– variance of returns σ2i = v
– covariance of returns cov(ri,rj) = c
• Equally-weighted portfolio, that is wi = 1/n for
i=1,2, ..,n
• Expected return and variance on portfolio p:
⎛1⎞
E ( rp ) = ∑ wi E ( ri ) = n ⎜ ⎟ μ = μ
i ⎝n⎠
v ⎛ 1⎞
σ p2 = ∑∑ wi w j cov ( ri , rj ) = + ⎜1 − ⎟ c
i j n ⎝ n⎠
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Portfolio diversification (cont’d)
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Diversification and efficiency
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Efficient frontier with 2 risky assets
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… in diagrams
Example
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Example (cont’d)
Example (cont’d)
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Example (cont’d)
w1 =
[8 − 5] 400 − [13 − 5] 72 = 0.40
[ ] + [13 − 5]144 − [8 − 5 + 13 − 5] 72
8 − 5 400
w2 = 1 − 0.40 = 0.60
E ( rtan ) = ( 0.4 × 8 ) + ( 0.6 × 13) = 11%
σ tan = ( 0.4 2
× 144 ) + ( 0.62 × 400 ) + 2 × 0.4 × 0.6 × 72 = 14.2%
11 − 5
S tan = = 0.42
14.2
Example (cont’d)
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Example (cont’d)
• In order to find the solution to Step 3 we have to consider
individual preferences (i.e. risk aversion)
• This will tell us how much to invest in the risky (tangency)
portfolio and the risk-free asset
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HNWIs
HNWIs in 2005
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HNWIs in 2005 (cont’d)
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HNWIs in 2005 (cont’d)
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HNWIs in 2005 (cont’d)
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HNWIs vs Institutional Investors
• HNWIs:
– Use disciplined investment methodologies (no
sentiments or hearding)
– Frequently rebalance their portfolios (dynamic vs
static)
– Base investment selection upon fundamental
analysis
– Balance risk, reward and liquidity of overall
investments
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HNWIs Expectations
Readings
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