Utility, Indifference Curves

Portfolio Theory – Investing in One

Risky and One Risk-free Asset

Relevant sections from the textbook:

Chapter 6

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 Risk and Risk Aversion

Speculation Gamble
• Taking considerable risk • Bet on an uncertain
for a commensurate outcome for enjoyment
gain • Parties assign the
• Parties have same probabilities to
heterogeneous the possible outcomes
expectations
Some Background Assumptions
• As an investor you want to maximize the
returns for a given level of risk.
• Your portfolio includes all of your assets and
liabilities.
• The relationship between the returns for
assets in the portfolio is important.
• A good portfolio is not simply a collection of
individually good investments.
Some Background Assumptions
• Definition of Risk
– Uncertainty: Risk means the uncertainty of
future outcomes. For instance, the future value
of an investment in Google’s stock is uncertain;
so the investment is risky. On the other hand,
the purchase of a six-month CD has a certain
future value; the investment is not risky.
– Probability: Risk is measured by the probability
of an adverse outcome. For instance, there is
40% chance you will receive a return less than
8%.
 Portfolio Construction
Portfolio construction involves two steps:
1. Select the composition of the risky assets such as
bonds and stocks (optimal risky portfolio),
• This step is very straightforward one we know the
expected returns, expected variances (risk) and
correlation structure (co-movement).
2. Decide the percentage of the funds to be
allocated to the risky portfolio and to the risk-free
asset.
• This step will depend on the individual investor’s
attitude towards risk.
• Question: Can we measure / quantify the attitude
towards risk? 5
 Risk Aversion
• We have discussed in the previous lecture that
when choosing among possible investments,
the investors care about:
– Return (Expected excess return over the risk-free
rate)
– Risk (Variance of expected excess returns), and
– Co-movement among different financial assets
• Investment decisions also depend on the
degree of risk aversion that an investor has.
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 Risk Aversion
• Most investors would demand higher returns from
riskier investments.
• Exactly how much higher would depend on the
degree of risk-aversion of the investors (i.e. how
much she dislikes taking risk).
• The three main types of investors are:
• Risk-averse investors
• Risk-neutral investors
• Risk-loving investors

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 Risk Aversion (Exaqmple)
Expected Risk Risk
Return Premium (SD)
Risk-free Investment 5% 0%
Low Risk Investment 7% 2% 5%
Medium Risk Investment 9% 4% 10%
High Risk Investment 13% 8% 20%

If you are to pick one investment, which one would

you choose?

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 Utility Scores
• A formal way of ranking choices is to assign utility
scores to each one of the investments.
• A “Utility Score” measures the amount of satisfaction
(happiness) from an economic choice.
• Higher utility scores represent higher happiness.
• Utility from an investment depends on:
– Return
– Risk
– Degree of risk-aversion

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 Utility Scores
• We often use utility functions to calculate utility
scores.
• There are many types of utility functions, but the
work-horse of all is:

U  E  r  1 A 2
2
U Utility
E( r ) Expected Return
σ2 Risk (Variance)
A Index of the investor's risk aversion

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 Expected Return Risk Premium Risk (SD)
Risk-free Investment 5% 0%
Low Risk Investment 7% 2% 5%
Medium Risk Investment 9% 4% 10%
High Risk Investment 13% 8% 20%

Example: For an investor with A=2.0:

• Utility score from the low-risk investment:

– U = 0.07 – (1/2) * 2 * (0.05)2 = 0.0675
• Utility score from the medium-risk investment:
– U = 0.09 – (1/2) * 2 * (0.10)2 = 0.0800
• Utility score from the high-risk investment:
– U = 0.13 – (1/2) * 2 * (0.20)2 = 0.0900
• Utility score from the risk-free investment:
– U = 0.0500

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 Expected Return Risk Premium Risk (SD)
Risk-free Investment 5% 0%
Low Risk Investment 7% 2% 5%
Medium Risk Investment 9% 4% 10%
High Risk Investment 13% 8% 20%

Example: Assume A=5.0 (this person is MORE risk-averse)

• Utility score from the low-risk investment:

– U = 0.07 – (1/2) * 5 * (0.05)2 = 0.0638
• Utility score from the medium-risk investment:
– U = 0.09 – (1/2) * 5 * (0.10)2 = 0.0650
• Utility score from the high-risk investment:
– U = 0.13 – (1/2) * 5 * (0.20)2 = 0.0300
• Utility score from the risk-free investment:
– U = 0.0500

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 Estimating Risk Aversion

• Use questionnaires
• Observe individuals’ decisions when
confronted with risk
• Observe how much people are willing to pay
to avoid risk
 Estimating Risk Aversion

• Mean-Variance (M-V) Criterion

– Portfolio A dominates portfolio B if:
E  rA   E  rB 
and

A B
 Capital Allocation Across Risky
and Risk-Free Portfolios
• Asset Allocation
• The choice among broad asset classes that
represents a very important part of portfolio
construction
• The simplest way to control risk is to
manipulate the fraction of the portfolio
invested in risk-free assets versus the portion
invested in the risky assets
 Indifference Curves
Properties of Indifference Curves:

• Along a given indifference curve, the utility scores are constant :

The investor is equally happy with Portfolio P and Portfolio Q.

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Table 6.3 Utility Values of Possible Portfolios for an Investor with Risk
Aversion, A = 4
Figure 6.7 Indifference Curves for U = .05 and U = .09 with A = 2 and A = 4
Capital Allocation

INVESTING IN ONE RISKY AND ONE

RISK-FREE ASSET

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 Capital Allocation
• Let’s say we have a risky asset (a portfolio of stocks
and bonds), and a risk-free asset (a T-Bill).
• For now, we take the composition of the risky
portfolio as given.
• Capital Allocation: How much of the portfolio should
we allocate the into:
– The risky asset, represented by P, and
– The risk-free asset, represented by F

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 Capital Allocation: Calculating Weights
• You have $300,000 to invest
– $90,000 invested in the risk-free assets
– $210,000 invested in the risky asset
• The risk-free asset’s share in the portfolio is:

• The risky asset’s share in the portfolio is:

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 Risk-free Asset
• Example: Treasury Bills (T-Bills)
– The government raises money by selling bills to the
market
– Investors buys the bills at a discount from the stated
maturity value
– At the bill’s maturity, the holder receives from the
government a payment equal to the face value of the
bill.
– The difference between the purchase price and the
maturity value is the investor’s earnings.
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 Risk-free Asset
• Example: Treasury Bills (T-Bills)
– T-Bills are issued with initial
maturities of 28, 91, or 182
days.
– Minimum denomination of
$1,000.
– Highly liquid, low transaction
costs.
http://online.wsj.com/mdc/public/page/2_3020-treasury.html

Maturity Bid Ask Chg Asked

Yield
7/9/2015 0.015 0.005 0.013 0.05

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 Risk-free Assets with Different Maturities
• T-Bills
– Maturity up to 1 year
• Treasury Notes
– Maturity up to 10 years
• Treasury Bonds
– Maturity between 10 and 30 years
• Inflation Risk
– Inflation-Protected Treasury Bonds
– TIPS – Treasury Inflation-Protected Securities
– The principal amount is adjusted in proportion to the
increases in the Consumer Price Index (CPI).
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 Low-Risk Assets
• Certificates of Deposit (CD)
– Time deposit in a bank
– Cannot be withdrawn on demand
– The bank pays the interest + principal to the
depositor only at the end of the fixed term of CD.
– Insured up to $250,000 by the Federal Deposit
Insurance Corporation (FDIC).

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 Low-Risk Assets
• Commercial Paper
– Issued by large companies
– Often, CP is backed by a bank line of credit.
– Maturities up to 270 days.
• Can be issued for longer maturity, with SEC (security
Exchange Commission) registration
• Most common maturity – 1 to 2 months.
– Issued in multiples of $100,000
• Money Market Mutual Funds
– https://flagship.vanguard.com/VGApp/hnw/FundsStocksOverview
– https://investor.vanguard.com/mutual-funds/select-funds
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 Risky Assets
• Common Stock
• Preferred Stock
• Stock Market Indices
• International Stock Market Indices
– MSCI – Morgan Stanley Capital International

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 Portfolios of One Risky and One Risk-Free
Asset
• Objective:
– To determine the proportion of the investment
budget to be allocated to the risky portfolio
(wrisky) and to the risk-free portfolio (wrisk-free).
• Notation
P Risky Portfolio
F Risk-free Asset
E(rp) Rate of Return on the Risky Portfolio
rf Risk-free rate
σP Standard deviation (risk) of the risky portfolio
E(rc) Expected return on the complete portfolio
wP Share (weight) of the risky asset in the complete portfolio
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 Portfolios of One Risky and One Risk-Free
Asset (cont’d)
• The expected return of the complete portfolio is
calculated as:
E(rc) = wp E(rp) + (1-wp) rf

• This formula is identical to:

E(rc) =rf + wp E(rp - rf)

• The standard deviation, and variance (risk) of the

complete portfolio is:
σC=wP σP

σC2=wP2 σP2
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 Portfolios of One Risky and One Risk-Free
Asset (cont’d)
• Example: The expected return on a risky portfolio is 15 %,
its standard deviation is 22%, and the risk-free rate is 7%.
What would the expected return and risk of the complete
portfolio be if you invest 60% of your capital in the risky
portfolio?
• Expected return is:
E(rc) =rf + wp E(rp - rf)
E(rc)=7%+0.60 (15%-7%) = 11.8%

• The standard deviation (risk) of the complete portfolio is:

σC=wP σP
σC = 0.60 * 22%= 13.2%
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Figure 6.4 The Investment Opportunity Set with a Risky Asset and a Risk-
free Asset in the Expected Return-Standard Deviation Plane
 Capital Allocation Line

• Capital allocation line gives all risk-return combinations

available to the investors.

• The slope of the capital allocation line is equal to the

increase in the expected return per unit of additional
standard deviation.

• The slope is also called the “reward-to-variability” ratio, or

“Sharpe Ratio.”

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Picking the Optimal Portfolio from the Capital
Allocation Line
• Intuition: Different investors will choose different
portfolios from the capital allocation line
depending on the degree of their risk-aversion.
• The more risk-averse investors will hold a higher
portion of the risk-free asset, and a lower portion
of the risky portfolio in their portfolios.
• Investors maximize utility by choosing the weights
of the risky assets in their portfolio.

U  E  r   1 A 2
2
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Picking the Optimal Portfolio from the Capital
Allocation Line

• Investors maximize utility by choosing the weights

of the risky assets in their portfolio.

U  E  r   1 A 2
2

• Substitute in the equation:

E(rc) =rf + wp E(rp - rf)

σC2=wP2 σP2

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 Picking the Optimal Portfolio from the Capital
Allocation Line

• The optimization problem is:

• To solve the optimization problem:

– take the derivative of this equation with respect to
w,
– Set the derivative to zero,
– Solve for w.

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Picking the Optimal Portfolio from the Capital
Allocation Line

• Intuitive explanation for the solution to the

optimization problem is:
• Optimal position in the risky asset:
(a) depends on the level of risk aversion, the risk and the
risk premium offered by the risky asset.
(b) is inversely proportional to the level of risk aversion
(c) is inversely proportional to the level of risk, and
(d) is directly proportional to the risk premium offered by
the risky asset.
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Picking the Optimal Portfolio from the Capital
Allocation Line – Graphical Solution
• Indifference curve analysis.
• Aim: Reach the highest indifference curve.
• Constraint: Capital Allocation Line

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Figure 6.8 Finding the Optimal Complete Portfolio Using Indifference Curves