FINS5513 Lecture 3A

Capital Allocation to Risky Assets;

Optimal Risky Portfolios
 Optimal Risky Portfolios
Lecture Outline
❑ Combining risky and risk-free assets
❑ The Markowitz portfolio optimization model:
➢ Capital allocation between risky and risk-free assets - the
Capital Allocation Line (CAL)
➢ The Optimal Risky Portfolio P* and the CAL
➢ Investment decision along the CAL - indifference curves and
the optimal allocation to risky assets y*
➢ The Optimal Complete Portfolio C*

❑ Separation Theorem
➢ Commonality of the risky portfolio

❑ Borrowing constraints - the kinked CAL

Lecture 3A FINS5513 2
 Optimal Point on the
Efficient Frontier
❑ Last lecture we covered Step #1 of the Markowitz optimisation
model – derivation of the efficient frontier
❑ But where along the efficient frontier should we invest?
➢ We pick the point which provides the highest Sharpe ratio
➢ But how do we find this point?
➢ Steps #2 and #3 of the Markowitz optimisation approach tell
us how
❑ Note the 3 step Markowitz approach carefully as you have to
know how to follow it in your iLab project

BKM 7.4
Lecture 3A FINS5513 3
 Introducing the Risk-
free Asset
❑ In the last lecture we only considered risky assets
❑ Now let’s add the risk-free asset
➢ Short-term Government bills (T-bills) are the purest risk-free
asset as they are considered default free
➢ Some market practitioners also use the Government bond
rate as the risk-free asset for long-term investments
❑ The return on the risk-free asset is denoted rf
➢ Even if we don’t take risk we still want a positive return.
Hence rf is generally positive
❑ The risk premium R on a risky asset is: E(r) – rf
➢ Note that excess return/risk premium is denoted R, while
total return is denoted r
BKM 6.3
Lecture 3A FINS5513 4
 Combining Risky and
Risk-free Assets
❑ An important capital allocation decision is determining how much
of our portfolio to allocate to the risk-free asset vs risky assets
➢ Lets now combine a risky portfolio with a risk-free asset

❑ First let’s get the denotations right

➢ We have identified an efficient risky portfolio on the efficient
frontier, and denote it P. The Expected Return on P is
denoted E(rp) and its risk is denoted σp
➢ The risk-free asset (say T-bills) is denoted F. The return on
the risk-free asset is denoted rf and its risk is denoted σrf
➢ We can create a Complete Portfolio C where our capital is
fully allocated into a combination of P and F. The Expected
Return on C is denoted E(rC) and its risk is denoted σC

BKM 6.4
Lecture 3A FINS5513 5
 Combining Risky and
Risk-free Assets
❑ What we are trying to derive is the appropriate weighting
between P and F in our Complete Portfolio C. In the previous
lecture we denoted weights as w, but as this is a key asset
allocation decision, lets denote the weights as follows:
y = Portion allocated to the risky portfolio, P
(1 - y) = Portion to be invested in risk-free asset, F
❑ Now we can work out the expected return and risk on C. We
know from the previous lecture, the expected return is simply a
weighted average of the expected return on the risky and risk-
free assets, given by:
E(rC) = (1 - y)rf + y E(rp)
which can be restated as: E(rC) = rf + y (E(rp) - rf)
BKM 6.4
Lecture 3A FINS5513 6
 A Risky and A Risk-free
Asset
❑ What about risk? We know from the previous lecture, portfolio
risk for a 2-asset portfolio (between P and F) is given by:
𝜎2𝐶 = 𝑦2𝜎2𝑃 + (1 − 𝑦)2𝜎2𝑟𝑓 + 2𝑦(1 − 𝑦)𝐶𝑜𝑣(𝑟P, 𝑟𝑓)
❑ However, we know rf is a constant and has no variance (ie it is
certain). Therefore 𝜎2𝑟𝑓 = 0 and Cov(rP, rf) = 0
So the portfolio risk equation above simplifies to:
𝜎𝐶 = 𝑦 𝜎𝑃
And rearranging: y = σC / σp
Now replace y into our Expected Return derived on the last slide:
σ𝐶
E(rC) = rf + (E(rp) - rf)
σ𝑃
BKM 6.4
Lecture 3A FINS5513 7
 A Risky and A Risk-free
Asset
❑ What do you notice about this equation? The slope is the Sharpe Ratio
given by:
E ( rP ) E ( )
− rrf p − 8rf
Slope = S p = =
 P  p 22
❑ So graphically, if we drew a straight line connecting rf (y-intercept 𝜎 = 0)
to the risky asset P, the slope of the line will equal P’s Sharpe Ratio, and
y (the weight in risky assets) will tell us where along the line we sit
E(r) ❑ If y > 1, it means
borrowing at rf (instead
C(y=0.75)

y=1
CALP
C(y=0.25)

of investing at rf ) and
P
investing the proceeds
C(y=1.25)

rf into risky assets ie

C(y=0.5)

taking a geared
position in the risky
rf is on the
y-intercept σ asset
as 𝜎 = 0
BKM 6.4
Lecture 3A FINS5513 8
 A Risky and A Risk-free
Asset Example
❑ Q3.1

BKM 6.4
Lecture 3A FINS5513 9
 Capital Allocation Line
(CAL)
The Capital Allocation Line
14.0% The CAL depicts
At C: E(rC) = 7.11% efficient risk-return
12.0%
and σ = 12%. combinations
Portfolio Expected Return E(r)

10.0% P available to
investors
8.0% At P: E(rP) = 9.21%
6.0% C and σ = 16.92%.

4.0%
Slope of CAL =
2.0% Sharpe Ratio
❑ See file ”L3
0.0% Deriving the EF, CAL
& Optimal Complete
0 0.05 0.1 0.15 0.2 0.25 0.3

rf = 2.0% Portfolio Standard Deviation σ

Portfolio”
σ
E(rC) = rf + σ𝐶 (E(rp) - rf) = 2 + .426 σC
𝑃

❑ This equation describes the Capital Allocation line. The y-intercept is

rf = 2% and the slope is the Sharpe Ratio (Risk Premium / Risk):
(9.21 – 2)/16.92 = 7.21/16.92 =.426
BKM 6.4
Lecture 3A FINS5513 10
 Which Risky Portfolio P?
❑ But what portfolio P should we choose?
❑ Remember, the slope of the CAL is the Sharpe Ratio and as we
want to maximise the Sharpe Ratio, we want to maximize the
slope of the CAL for any possible portfolio, P
❑ The optimally (steepest) sloping CAL maximises reward E(rP) at
each level of risk P (or minimises risk at each level of reward).
It therefore maximises the Sharpe ratio

BKM 7.4
Lecture 3A FINS5513 11
 Which Risky Portfolio P?
CALPE
PE
E(r)
CPE CALPI
PI
CPI
Efficient frontier
rf

σ
❑ Clearly it is not optimal to combine the risk-free asset with an
interior (inefficient) risky portfolio, PI
❑ But CALPE and portfolios CPE and PE are also not optimal. Why?
❑ What CAL would be optimal?
BKM 7.4
Lecture 3A FINS5513 12
 The Optimal Risky
Portfolio P*
CALP* has the CALP* = CAL
highest possible
E(r) Sharpe Ratio
P*

rf
Efficient frontier

σ
❑ CALP* is the optimal CAL - often simply denoted CAL and called
the Capital Allocation Line
❑ The CAL which is tangent to the efficient frontier is CALP*
❑ The point of tangency P* is the Optimal Risky Portfolio P*
BKM 7.4
Lecture 3A FINS5513 13
 The Optimal Risky
Portfolio P*
❑ Key rules to remember:
➢ Only risky portfolios on the efficient frontier should be considered
➢ CAL links the risk-free asset to a portfolio on the efficient frontier (EF)
➢ The steeper the CAL the better eg CAL2 clearly dominates CAL1
➢ The optimal risky portfolio P* is on the steepest possible CAL and the
EF and is therefore the tangent line from rf to the EF
➢ This tangent portfolio (P*) is the Optimal Risky Portfolio, and the
tangent line is the Capital Allocation Line (CAL)
CALP* = CAL

CAL2
E(r)
P*
Any CAL above CALP*
is not attainable (highest CAL1
possible Sharpe Ratio)

rf Efficient frontier

Lecture 3A FINS5513 14
σ
 Optimal Risky Portfolio
P* Weights
❑ Note the optimal risky portfolio P* is different from the GMVP. The
optimal weights for P* for a 2 asset portfolio (asset E and D - see
equation 7.13, note 6) can be derived mathematically as:
E(RD )s 2E - E(RE )s DE
wD =
E(RD )s 2E + E(RE )s 2D - [E(RD ) + E(RE )]s DE
It can also be solved using Excel solver (constraint w=1)
❑ Q3.2

BKM 7.2
Lecture 3A FINS5513 15
 The Optimal Complete
Portfolio
❑ So the last question is, where along the Capital Allocation Line should we
invest?
➢ More risk averse investors would invest less in P
• ie invest in risk-free bonds and (y*<100%) in risky assets P*
➢ Less risk averse investors would invest more in P
• ie borrow at rf and invest (y*>100%) in risky assets P*
➢ How is this decision shown graphically?
➢ So this depends on each investor’s individual level of risk aversion ie
their risk aversion coefficient A
❑ This final Complete Portfolio C’s exact location will be where the highest
possible indifference curve is tangent to the CAL (at allocation point y*)

❑ So, how do we determine the optimal risky allocation y*?

BKM 7.4
Lecture 3A FINS5513 16
 Finding the Optimal
Complete Portfolio C*
❑ We choose y* based on our individual risk preferences
➢ The risk aversion coefficient A is different for different investors
➢ Different investors have different utility scores for the same investment
➢ So, different investors have different indifference curves:

Unattainable
E(r)
C* is the Optimal
Complete Portfolio
P*
– the tangent
between the CAL C* is specific to
and the highest C* this investor
attainable based on their
indifference curve indifference
rf * Note: These are
curves different indifference
curves for one
individual
C* is determined
at the optimal
σ
risky share y*
BKM 7.3
Lecture 3A FINS5513 17
 Finding the Optimal
Complete Portfolio C*
❑ Note the figure on the
previous slide is
essentially Figure 7.8
from BKM
Efficient
Frontier ❑ CAL(P) is universal for
all investors (doesn’t
depend on individual
risk preferences)
❑ But each individual’s
indifference curve
determines where
they sit along Cal(P)

BKM 7.3
Lecture 3A FINS5513 18
 Optimal Allocation to
the Risky Asset (y*)
❑ We can derive the optimal allocation to the risky asset y* mathematically:
❑ We have already derived:
Expected Return: E(rC) = rf + y (E(rp) - rf)
And Risk: σC = y*σp or re-stated as variance: σC2 = y2σp2
❑ Replace these into the utility function and optimise: State returns
and SD in
Max (U) = E(rC) – 1/2 A σC 2 decimals
= rf + y (E(rp) - rf) – 1/2 A (yσp)2
❑ Take the 1st derivative to maximise U and solve for y:
E(rp)– rf – A yσp2 = 0 y is positively correlated
to the risk premium and
E (rp ) − rf negatively correlated to
y=
* risk aversion and
A p2 portfolio risk

BKM 6.5
Lecture 3A FINS5513 19
 Optimal Risky Allocation
(y*) Example
❑ Q3.3

BKM 6.5
Lecture 3A FINS5513 20
 Markowitz Portfolio
Optimisation Model
❑ As described in BKM 7.4, in the last part of the previous lecture and this
lecture, we have described the Markowitz Portfolio Optimisation model
in 3 important steps:
① Identify the optimal risk-return combinations from all risky assets
to form the minimum variance frontier. Discard the bottom part
below the GMVP, thereby identifying the Efficient Frontier
② Identify the Optimal Risky Portfolio P* by drawing the CAL with
the highest Sharpe ratio (ie tangent to the Efficient Frontier)
③ All investors invest in P*, regardless of their degree of risk
aversion. Individual investors decide where they sit along the CAL
by determining their optimal risky allocation (y*) to P*
➢ More risk averse investors put more in the risk-free asset
➢ Less risk averse investors put more in P*
This last step identifies the Optimal Complete Portfolio C*
❑ See file ”L3 Deriving the EF, CAL & Optimal Complete Portfolio”
BKM 7.4
Lecture 3A FINS5513 21
 Separation Theorem
❑ The 3-step process for asset allocation/security selection described
has an important conclusion – all investors will invest in the same
optimal risky portfolio P*, regardless of their level of risk aversion
❑ Therefore the portfolio choice problem may be separated into two
independent tasks (BKM p.212)
➢ Determine the CAL and optimal risky portfolio (P*)
• A general result which applies to all investors (ie all
investors invest along the same CAL)
➢ Determine your optimal complete portfolio (C*) – (ie your
individual optimal allocation (y*) to the risky portfolio P* and
optimal allocation (1-y*) to the risk-free asset
• An individual result which depends on your personal
preference for risk (risk-aversion index A)
BKM 7.4
Lecture 3A FINS5513 22
 Separation Theorem
❑ Lets verify the separation theorem:
➢ Investors with different risk aversion (A) have different complete
portfolios
➢ But they invest in the same risky portfolio P*
➢ They only differ in terms of the fraction (y*) of their investments in
the risky portfolio P*
CA* is the Optimal
Complete Portfolio
❑ Q3.4 for investor A CB *

E(r)
P* CB* is the Optimal
Complete Portfolio
for investor A
CA*
rf

σ
BKM 7.4
Lecture 3A FINS5513 23
 iLab
❑ The Markowitz optimisation process described in this and the last
lecture, are critical to understand in order to complete the first
iLab activity (and elements of the second activity as well)
➢ Understand in detail Lectures 2B (particularly slides 17-22)
and 3A (this lecture)
➢ Practice the questions 2.12 and 3.1-3.4
➢ Practice the process of optimisation by familiarising yourself
with files “L2 Deriving the MVF and Efficient Frontier” and
”L3 Deriving the EF, CAL & Optimal Complete Portfolio”
➢ See also Appendix 7A pg 232 for excel-based application with
more than 2 assets
➢ Watch the iLab assistance videos on Moodle a few times
➢ Read all supporting instructional materials
➢ Be curious!
Lecture 3A FINS5513 24
 Borrowing Above the
Risk-Free Rate
❑ What if the risk-free rate is available for investing but not for
borrowing?
❑ This is realistic as it is unlikely all parties in the market (other than
Government) will be able to borrow at the rf . They will borrow at a
higher rate to account for their risk profile
❑ As we know, points on the CAL to the left of P represent lending
(investing) at the rf and points to the right represent borrowing
❑ Simple Example: CAL with margin on borrowing
➢ E(rP) = 15%, σP = 22%
➢ Lend (invest) at rf = 7% and borrow at rf = 9%
➢ CAL lending slope (Sharpe Ratio) = (15-7)/22 = 8/22 = 0.36
➢ CAL borrowing slope (Sharpe Ratio) = (15-9)/22 = 6/22 = 0.27
➢ CAL kinks at P

BKM 6.4
Lecture 3A FINS5513 25
 Kinked CAL
Lending at rf Borrowing at rf
B

❑ Graphically the CAL has a kink where y = 1 (at P) – the slope

(and Sharpe Ratio) change at P
❑ Unless explicitly asked, we assume no borrowing constraints
BKM 6.4
Lecture 3A FINS5513 26
 Next Lecture
❑ BKM 7.4 and Chapter 9, including end-of-chapter questions

❑ Complete Case Study III Questions

❑ Focus on understanding the implications of the separation

theorem that lead to the CAPM, the basic derivation of the CAPM,
and the important concept of beta

Lecture 3A FINS5513 27