Capital Allocation Between The

Risky And The Risk-Free Asset

 It’s possible to split investment funds between
safe and risky assets.
 Risk free asset: proxy; T-bills
 Risky asset: stock (or a portfolio)
Issues
 Examine risk/return tradeoff.
 Demonstrate how different degrees
of risk aversion will affect
allocations between risky and risk
free assets.
rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf
E(rc) = yE(rp) + (1 - y)rf

rc = complete or combined portfolio

For example, y = .75

E(rc) = .75(.15) + .25(.07)
= .13 or 13%
 E(r)

E(rp) = 15%
P
E(rc) = 13%
C

rf = 7%
F

0 
c 22%
Since  r = 0, then
f

 c = y p
If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
Borrow at the Risk-Free Rate and invest in stock.
Using 50% Leverage,
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

 E(r)

P
E(rp) = 15%

E(rp) - rf = 8%
) S = 8/22
rf = 7%
F

0

p = 22%
E(r)

) S = .27

9%
) S = .36
7%


p = 22%
 Greater levels of risk aversion lead to larger
proportions of the risk free rate.

 Lower levels of risk aversion lead to larger

proportions of the portfolio of risky assets.

 Willingness to accept high levels of risk for

high levels of returns would result in
leveraged combinations.
U = E ( r ) - .005 A 2
Where
U = utility
E ( r ) = expected return on the asset or
portfolio
A = coefficient of risk aversion
 = variance of returns
 E(r) The lender has a larger A when
compared to the borrower

Borrower

7%
Lender


p = 22%
Optimal Risky Portfolios
St. Deviation

Unique Risk

Market Risk

Number of
Securities
Range of values for 1,2
+ 1.0 >  > -1.0
If = 1.0, the securities would be
perfectly positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated
rp = W1r1 + W2r2 + W3r3

2p = W1212 + W2212 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
 E(rp) = W1r1 + W2r2

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

p = [w1212 + w2222 + 2W1W2 Cov(r1r2)]1/2

 E(r)

13%
 = -1

 = .3

 = -1 =1
%8

12% 20% St. Dev

 The relationship depends on correlation
coefficient.
 -1.0 <  < +1.0
 The smaller the correlation, the greater the
risk reduction potential.
 If = +1.0, no risk reduction is possible.
Sec 1 E(r1) = .10  1 = .15
12 = .2
Sec 2 E(r2) = .14  2 = .20
22 - Cov(r1r2)
W1 =
21 + 22 - 2Cov(r1r2)
W2 = (1 - W1)
 (.2)2 - (.2)(.15)(.2)
W1 =
(.15)2 + (.2)2 - 2(.2)(.15)(.2)

W1 = .6733
W2 = (1 - .6733) = .3267
rp = .6733(.10) + .3267(.14) = .1131

 p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
1/2
2(.6733)(.3267)(.2)(.15)(.2)]

 p = [.0171]
1/2
= .1308
 (.2)2 - (.2)(.15)(.2)
W1 =
(.15)2 + (.2)2 - 2(.2)(.15)(-.3)

W1 = .6087
W2 = (1 - .6087) = .3913
rp = .6087(.10) + .3913(.14) = .1157

 p = [(.6087)2(.15)2 + (.3913)2(.2)2 +
1/2
2(.6087)(.3913)(.2)(.15)(-.3)]

 p= [.0102]
1/2
= .1009
 The optimal combinations result in lowest
level of risk for a given return.

 The optimal trade-off is described as the

efficient frontier.

 These portfolios are dominant.

E(r)

Efficient
frontier

Individual
Global
assets
minimum
variance
portfolio
Minimum
variance
frontier

St. Dev.
 The optimal combination becomes linear.

 A single combination of risky and riskless

assets will dominate.
 E(r) CAL (P) CAL (A)

M
M
P
P CAL (Global
minimum variance)
A A

P P&F M A&F 
E(r) U’’’ U’’ U’

Efficient
S frontier of
P risky assets

Q
Less
risk-averse
More investor
risk-averse
investor
St. Dev
 CAL
E(r)
B
Q
P

A
rf F

St. Dev