FINM3093: Investments

Lecture 3

Dr Sherry Zhou
BNU-HKBU United International College

1
Outline
• Capital Allocation to Risky Assets (Textbook Chapter 6)
• Two-step process of portfolio construction
1. Capital allocation decision: allocation of the overall portfolio to safe assets versus risky
assets
2. Determination of the composition of the risky portion of the complete portfolio
• Demonstration of how risk aversion can be characterized by a “utility function”
• Efficient Diversification (Textbook Chapter 7)
• Optimal risky portfolio construction
• Efficient diversification

2
Risk and Risk Aversion: Speculation and Gambling
(Textbook Chapter 6)

Speculation Gambling
• Assuming considerable investment • To bet or wager on an uncertain
risk to obtain commensurate gain outcome

• Occurs in spite of the risk involved

because one perceives a favorable • Risk is assumed for enjoyment of
risk-return trade-off the risk itself

3
Risk Aversion and Utility Values
• Risk-averse investors consider only risk-free or speculative prospects
with positive risk premiums

• Portfolio is more attractive when its expected return is higher and its
risk is lower
• What happens when risk increases along with return?

4
Available Risky Portfolios

5
Risk Aversion and Utility Values
• We assume each investor can assign a welfare, or utility, score to
competing portfolios
U = E (r ) − 1 A 2
2
• Utility function
• U = Utility value
• E(r) = Expected return
• A = Index of the investor’s risk aversion
• σ2 = Variance of returns
• ½ = Scaling factor

6
Example

Utility scores of alternative portfolios for investors with varying degrees of risk aversion

7
Investor Types
• Risk-averse investors consider risky portfolios only if they provide
compensation for risk via a risk premium
• A>0
• Risk-neutral investors find the level of risk irrelevant and consider
only the expected return of risk prospects
• A=0
• Risk lovers are willing to accept lower expected returns on prospects
with higher amounts of risk
• A<0

8
Trade-Off Between Risk and Return

9
Mean-Variance (M-V) Criterion
Mean-variance (M-V) criterion Requirements for Portfolio A to
dominate Portfolio B
• The selection of portfolios based • 𝐸 𝑟𝐴 ≥ 𝐸(𝑟𝐵 )
on the means and variances of • 𝜎𝐴 ≤ 𝜎𝐵
their returns
• At least one inequality is strict
• The choice of the highest (to rule out indifference
expected return portfolio for a between the two portfolios)
given level of variance or the
lowest variance portfolio for a
given expected return

10
Indifference Curves

Equally preferred
portfolios lie in the
mean–standard
deviation plane on an
indifference curve,
which connects all
portfolio points with the
same utility value

11
Self-Check Exercise
a. How will the indifference curve of a less risk-averse investor
compare to the indifference curve drawn in Figure 6.2?
b. Draw both indifference curves passing through point P.

12
Estimating Risk Aversion
• How can we estimate the levels of risk aversion of individual
investors?
• Questionnaires
• Varying degrees of complexity
• Observations of how portfolio composition changes over time
• Average degrees of risk aversion from groups of individuals

13
Capital Allocation Across Risky
and Risk-Free Portfolios
• Most basic asset allocation choice is risk-free money market securities
versus other risky asset classes

• Simplest way to control risk is to manipulate the ratio of risky assets

to risk-free assets

14
Basic Asset Allocation Example
(1 of 2)
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

15
Basic Asset Allocation Example
(2 of 2)

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

Suppose the investor wishes to decrease risk by reducing the allocation to the risk
portfolio from y= 0.7 to 0.56. How should he adjust the portfolio allocation?
16
The Risk-Free Asset
• Only the government can issue default-free bonds
• Broad range of money market instruments are considered effectively
risk-free assets

17
Portfolios:
Risky Asset and Risk-Free Asset
• It’s possible to create a complete portfolio by splitting investment
funds between safe and risky assets

Let
• y = Portion allocated to the risky portfolio, P
• (1 - y) = Portion to be invested in risk-free asset, F

18
One Risky Asset and a Risk-Free Asset:
Example (1 of 2)
E(rP) = 15%
p = 22%
rf = 7%

• Expected return on the complete portfolio

• Risk of the complete portfolio

𝜎𝐶 = 𝑦𝜎𝑃 = 22𝑦
19
One Risky Asset and a Risk-Free Asset:
Example (2 of 2)
• The slope of the line is:
E ( rP ) − rf 8
Slope = =
P 22

• Expected return-standard deviation tradeoff for the complete

portfolio is:
8
E(rC) = 7% +
22
C

20
The Investment Opportunity Set

21
One Risky Asset and a Risk-Free Asset Portfolios
• Investment opportunity set offers feasible expected return and
standard deviation pairs of all portfolios resulting form different
values of y

• Graph showing all feasible risk-return combination of a risky and risk-

free asset is the capital allocation line (CAL)

• Reward-to-volatility ratio (aka Sharpe ratio)

• Ratio of expected excess return to portfolio standard deviation

22
The Opportunity Set with
Different Borrowing and Lending Rates

23
Risk Tolerance and Asset Allocation
• Investor must choose one optimal portfolio, C, from the set of feasible
choices
• Expected return of the complete portfolio:
𝐸 𝑟𝑐 = 𝑟𝑓 + 𝑦 𝐸 𝑟𝑝 − 𝑟𝑓
• Variance:
𝜎𝑐2 = 𝑦 2 𝜎𝑝2
• Investors choose the allocation to the risky asset, y, that maximizes their
utility function:
U = E ( r ) − 1 A 2
2
24
Utility Levels for
Various Positions in Risky Assets

25
Utility as a Function of Allocation to the Risky
Asset, y (1 of 2)

26
Utility as a Function of Allocation to the Risky
Asset, y (2 of 2)

E (rP ) − rf
y* =
A P2

27
Calculations of Indifference Curves

28
Indifference Curves for
U = .05 and U = .09 with A = 2 and A = 4

29
Finding the Optimal Complete Portfolio

30
Expected Returns on Four Indifference Curves
and the CAL

31
Passive Strategies: The Capital Market Line
• A passive strategy avoids any direct or indirect security analysis

• Supply/demand forces (in large capital markets) may make this

strategy the best choice for many investors

• A natural candidate for a passively held risky asset would be a well-

diversified portfolio of common stocks

• Capital market line (CML) results when using the market index as the
risky portfolio
32
Investment Decision (Textbook Chapter 7)
• The investment decision can be viewed as a top-down process:
1. Capital allocation between the risky portfolio and risk-free assets,
2. Asset allocation in the risky portfolio across broad asset classes
(e.g., U.S. stocks, international stocks, and long-term bonds),
3. Security selection of individual assets within each asset class.

33
Diversification and Portfolio Risk
• Market risk
• Attributable to marketwide risk sources
• Remains even after diversification
• Also called systematic or nondiversifiable risk

• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic risk

34
Portfolio Risk as a Function of
the Number of Stocks in the Portfolio

Panel A: All risk is firm specific Panel B: Some risk is systematic

35
Portfolio Diversification

36
Portfolios of Two Risky Assets: Expected Return
Consider a portfolio made up of equity (stocks) and debt (bonds)…

rp = wD rD + wE rE
where rP = rate of return on portfolio
wD = proportion invested in the bond fund
wE = proportion invested in the stock fund
rD = rate of return on the debt fund
rE = rate of return on the equity fund

• Expected return
E (rp ) = w D E (rD ) + wE E (rE )
37
Portfolios of Two Risky Assets: Risk
• Variance of rP
 p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )
• Bond variance
 D2
• Equity variance
 E2
• Covariance of returns for bond and equity
Cov ( rD , rE )
38
Portfolios of Two Risky Assets: Covariance
• Covariance of returns on bond and equity

𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸 = ρ𝐷𝐸σ𝐷σ𝐸

• DE = Correlation coefficient of returns

• D = Standard deviation of bond returns
• E = Standard deviation of equity returns

39
Portfolios of Two Risky Assets:
Correlation Coefficients
• Range of values for correlation coefficient
− 1.0 ≤ 𝜌 ≤ 1.0

• If  = 1.0 → perfectly positively correlated securities

• If  = 0 → the securities are uncorrelated
• If  = - 1.0 → perfectly negatively correlated securities

40
Portfolios of Two Risky Assets:
Correlation Coefficients
• When ρDE = 1, there is no diversification
 P = wE E + wD D
• When ρDE = -1, a perfect hedge is possible

D
wE = = 1 − wD
 D + E

41
Portfolios of Two Risky Assets:
Example — 50%/50% Split

Expected Return: E (rp ) = w D E (rD ) + wE E (rE )

= .50  8% + .50 13% = 10.5%
Variance:  p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )
= .502 122 + .502  202 + 2  .5  .5  72 = 172
 P = 172 = 13.23%

42
Portfolio Expected Return

43
Portfolio Standard Deviation

44
The Minimum-Variance Portfolio
• Weights of the minimum-variance portfolio
𝜎𝐸2 − 𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
𝑤𝑀𝑖𝑛 𝐷 = 2 ,
𝜎𝐷 + 𝜎𝐸2 − 2𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
2
𝜎𝐷 −𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
𝑤𝑀𝑖𝑛 𝐸 = 1 − 𝑤𝑀𝑖𝑛 𝐷 = 2 +𝜎 2 −2𝜌
𝜎𝐷 𝐸 𝐷𝐸 𝜎𝐷 𝜎𝐸

• For a pair of assets,

• When 𝜌𝐷𝐸 < 𝜎𝐷 /𝜎𝐸 , volatility will initially fall when we start with all bonds and begin
to move into stocks.
• When 𝜌𝐷𝐸 > 𝜎𝐷 /𝜎𝐸 , volatility will increase monotonically from the low-risk asset
(bonds) to the high-risk asset (stocks). Even in this case, however, there is a positive
(if small) benefit from diversification.

45
The Minimum-Variance Portfolio
• The minimum-variance portfolio has a standard deviation smaller
than that of either of the individual component assets

• Risk reduction depends on the correlation:

• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of either
component asset
• If  = -1.0, a riskless hedge is possible

46
Portfolio Expected Return as a Function of
Standard Deviation

47
The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs

Portfolio A
E (rA ) = 8.9%
 A = 11.45%

Portfolio B
E (rB ) = 9.5%
 B = 11.70%

48
The Sharpe Ratio
• Objective is to find the weights wD and wE that result in the highest
slope of the CAL

• Thus, our objective function is the Sharpe ratio:

E (rp ) − rf
Sp =
p

49
The Sharpe Ratio: Example
Portfolio A
E (rA ) = 8.9%
 A = 11.45%
E ( rA ) − rf 8.9% − 5%
SA = = = .34
A 11.45%

Portfolio B
E (rB ) = 9.5%
 B = 11.70%
E ( rB ) − rf 9.5% − 5%
SB = = = .38
B 11.70% 50
Debt and Equity Funds with the Optimal Risky
Portfolio
Optimal Risky Portfolio
E (rP ) = 11%
 P = 14.2%
E ( rP ) − rf
SP =
P
11% − 5%
=
14.2%
= .42

51
Optimal Risky Portfolio
• Optimization problem
𝐸 𝑟𝑝 − 𝑟𝑓
max
𝑤𝑖 𝜎𝑝

s.t. 𝑤𝐷 + 𝑤𝐸 = 1

• Optimal risky portfolio

𝐸 𝑅𝐷 𝜎𝐸2 − 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐷 = , 𝑤𝐸 = 1 − 𝑤𝐷
𝐸 𝑅𝐷 𝜎𝐸2 + 𝐸 𝑅𝐸 𝜎𝐷2 − [𝐸 𝑅𝐷 + 𝐸 𝑅𝐸 ]𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )

where R denotes the excess return.

52
Optimal Risky Portfolio
• Using the data in Table 7.1

8 − 5 400 − 13 − 5 72
𝑤𝐷 = = .40, 𝑤𝐸 = 1 − .40 = .60
8 − 5 400 + 13 − 5 144 − 8 − 5 + 13 − 5 72

𝐸 𝑟𝑃 = .4 × 8 + .6 × 13 = 11%

𝜎𝑃 = [ .42 × 144 + .62 × 400 + 2 × .4 × .6 × 72 ]1/2 = 14.2%

53
Determination of the Optimal Complete Portfolio
Using Equation on Slide 27,
Optimal Allocation to P
A=4
E ( rP ) − rf
y=
A P2
11% − 5%
= = .7439
4  (14.2%) 2

54
Proportions of the Optimal Complete Portfolio
Overall Portfolio
E (rP ) = 11% y = .7439
 P = 14.2% rf = 5%

E (rOverall ) = y  E (rp ) + (1 − y )  rf
= .7439 11% + .2561 5%
= 9.46%
 Overall = .7439 14.2% = 10.56%
9.46% − 5%
SOverall = = .42
10.56%
55
Steps to Arrive at the Complete Portfolio
1. Specify the return characteristics of all securities (expected returns,
variances, covariances)
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, P (Equation on Slide 52).
b. Calculate the properties (i.e., E(rp) and σP) of portfolio P using the weights
determined in step (a)
3. Allocate funds between the risky portfolio and the risk-free asset
(capital allocation):
a. Calculate the fraction of the complete portfolio allocated to portfolio P (the
risky portfolio) and the risk-free asset (Slide 54).
b. Calculate the share of the complete portfolio invested in each asset.

56
Markowitz Portfolio Optimization Model
• Security selection – generalize the portfolio construction problem to
the case of many risky securities and a risk-free asset
• Determine the risk-return opportunities available
• Minimum-variance frontier of risky assets
• All portfolios that lie on the minimum-variance frontier from the global
minimum-variance portfolio and upward provide the best risk-return
combinations
• Efficient frontier of risky assets is the portion of the frontier that lies above the global
minimum-variance portfolio

57
The Minimum-Variance Frontier of Risky
Assets

58
Markowitz Portfolio Optimization Model
• Security selection (continued)
• Search for the CAL with the highest Shape ratio (i.e., the steepest slope)
• Individual investor chooses the appropriate mix between the optimal risky
portfolio P and T-bills
• Everyone invests in P, regardless of their degree of risk aversion
• More risk averse investors put less in P
• Less risk averse investors put more in P

59
The Efficient Frontier of
Risky Assets with the Optimal CAL

60
Markowitz Portfolio Optimization Model
• Capital allocation and the separation property
• Portfolio choice problem may be separated into two independent tasks
• Determination of the optimal risky portfolio is purely technical
• Allocation of the complete portfolio to risk-free versus the risky portfolio depends on
personal preference

61
Capital Allocation Lines with Various
Portfolios from the Efficient Set

62
Markowitz Portfolio Optimization Model
• The power of diversification
 p2 =  wi w j Cov ( ri , rj )
n n
• Recall:
i =1 j =1

• For equally weighted portfolio, i.e., wi = 1/n

𝑛 𝑛 𝑛
1 1 1
𝜎𝑝2 = ෍ 𝜎𝑖2 + ෍ ෍ 2 Cov 𝑟𝑖 , 𝑟𝑗
𝑛 𝑛 𝑛
𝑖=1 𝑗=1 𝑖=1
𝑗≠𝑖
• Assume we define the average variance and average covariance of the
securities as:
1 1
𝜎ത 2 = σ𝑛𝑖=1 𝜎𝑖2 , Cov = σ𝑛𝑗=1 σ𝑛𝑖=1 Cov 𝑟𝑖 , 𝑟𝑗
𝑛 𝑛 𝑛−1
𝑗≠𝑖

63
Markowitz Portfolio Optimization Model
• The power of diversification (continued)
• We can then express portfolio variance as
1 2 𝑛−1
𝜎𝑝2 = 𝜎ത + Cov
𝑛 𝑛
• Portfolio variance can be driven to zero if the average covariance is zero
• The risk of a highly diversified portfolio depends on the covariance of the
returns of the component securities

64
Risk Reduction of
Equally Weighted Portfolios

65
Summary
• Risk aversion and utility values

U = E (r ) − 1 A 2
2
• Risk-averse investors: A > 0; Risk-neutral investors: A = 0; Risk lovers: A < 0
• Mean-variance (M-V) criterion
• Requirements for Portfolio A to dominate Portfolio B:
• 𝐸 𝑟𝐴 ≥ 𝐸 𝑟𝐵 ; 𝜎𝐴 ≤ 𝜎𝐵 ; At least one inequality is strict

66
Summary
• Indifference curves
• A portfolio has an expected rate of return of
0.15 and a standard deviation of 0.15. The
risk-free rate is 6%. To make this investor
indifferent between the risky portfolio and
the risk-free asset, the value of A is
_________.

67
 Summary
• Capital allocation across risky and risk-free portfolios
• 𝐸 𝑟𝐶 = 𝑟𝑓 + 𝑦 𝐸 𝑟𝑃 − 𝑟𝑓 , 𝜎𝐶 = 𝑦𝜎𝑃

• Capital allocation line (CAL)

𝐸 𝑟𝑃 − 𝑟𝑓
𝐸 𝑟𝐶 = 𝑟𝑓 + 𝜎𝐶
𝜎𝑃

• Slope is the reward-to-volatility ratio (Sharpe ratio)

68
Summary
Investment opportunity set with Investment opportunity set with
borrowing at risk-free rate different borrowing and lending rates

69
Summary
• Consider a T-bill with a rate of return of 5% and the following risky securities:
Security A: E(r) = 0.15; Variance = 0.04
Security B: E(r) = 0.10; Variance = 0.0225
Security C: E(r) = 0.12; Variance = 0.01
Security D: E(r) = 0.13; Variance = 0.0625

From which set of portfolios, formed with the T-bill and any one of the four risky
securities, would a risk-averse investor always choose his portfolio?

A) The set of portfolios formed with the T-bill and security A.

B) The set of portfolios formed with the T-bill and security B.
C) The set of portfolios formed with the T-bill and security C.
D) The set of portfolios formed with the T-bill and security D.
E) Cannot be determined. 70
Summary
• Risk tolerance and asset allocation
• Algebraic solution
E (rP ) − rf
y* =
A 2
P
• Graphical approach
• The portfolio represents the point at which the indifference curve is tangent to the CAL.

71
Summary
• Capital market line (CML)
• Results when using the market index as the risky portfolio
• The capital market line
I) is a special case of the capital allocation line.
II) represents the opportunity set of a passive investment strategy.
III) has the one-month T-Bill rate as its intercept.
IV) uses a broad index of common stocks as its risky portfolio.

A) I, III, and IV
B) II, III, and IV
C) III and IV
D) I, II, and III
E) I, II, III, and IV

72
Summary
• Market risk and firm-specific risk
• Market risk: nondiversifiable, systematic
• Firm-specific risk: diversifiable, nonsystematic
• Which of the following factors reflect pure market risk for a given corporation?
a. Increased short-term interest rates.
b. Fire in the corporate warehouse.
c. Increased insurance costs.
d. Death of the CEO
e. Increased labor costs.

73
Summary
• Portfolios of two risky assets
• Minimum-variance portfolio
𝜎𝐸2 − 𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
𝑤𝑀𝑖𝑛 𝐷 = 2 ,
𝜎𝐷 + 𝜎𝐸2 − 2𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸

2
𝜎𝐷 −𝜌𝐷𝐸 𝜎𝐷 𝜎𝐸
𝑤𝑀𝑖𝑛 𝐸 = 1 − 𝑤𝑀𝑖𝑛 𝐷 = 2 +𝜎 2 −2𝜌
𝜎𝐷 𝐸 𝐷𝐸 𝜎𝐷 𝜎𝐸

74
Summary
• Asset allocation with two risky assets and
one risk-free asset
• Find weights of risky assets that result in the
highest Sharpe ratio

𝐸 𝑅𝐷 𝜎𝐸2 − 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐷 = ,
𝐸 𝑅𝐷 𝜎𝐸2 + 𝐸 𝑅𝐸 𝜎𝐷2 − [𝐸 𝑅𝐷 + 𝐸 𝑅𝐸 ]𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )

𝑤𝐸 = 1 − 𝑤𝐷

75
Summary
• Determination of the optimal complete portfolio for an individual
investor

𝐸(𝑟𝑃 ) − 𝑟𝑓
𝑦=
𝐴𝜎𝑃2

76
Summary
• Steps to arrive at the complete portfolio
1. Specify the return characteristics of all securities (expected returns,
variances, covariances)
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, P (Equation on Slide 52).
b. Calculate the properties (i.e., E(rp) and σP) of portfolio P using the weights
determined in step (a)
3. Allocate funds between the risky portfolio and the risk-free asset
(capital allocation):
a. Calculate the fraction of the complete portfolio allocated to portfolio P (the
risky portfolio) and the risk-free asset (Slide 54).
b. Calculate the share of the complete portfolio invested in each asset.

77
Summary
• Markowitz portfolio optimization model
• Minimum-variance frontier and efficient frontier

78
Summary
• Which one of the following portfolios cannot lie on the efficient frontier as
described by Markowitz?
Portfolio Expected Standard
Return Deviation
A 10% 12%
B 5% 7%
C 15% 20%
D 12% 25%
A. A.
B. B.
C. C.
D. D.
E. Cannot be determined.
79