Risk Aversion

and Capital
Allocation to
Risky Assets
 Three Steps in Investment Decisions –
Top-down Approach
I. Capital Allocation Decision
 Allocate funds between risky and risk-free assets
 Made at higher organization levels

II. Asset Allocation Decision

 Distribute risk investments across asset classes – small-
cap stocks, large-cap stocks, bonds, & foreign assets

III. Security Selection Decision

 Select particular securities within each asset class
 Made at lower organization levels

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 Risk and Risk Aversion

• Speculation
– Considerable risk
• Sufficient to affect the decision
– Commensurate gain
• Gamble
– Bet or wager on an uncertain outcome

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 Risk Aversion and Utility Values

• Risk averse investors reject investment

portfolios that are fair games or worse
• These investors are willing to consider only
risk-free or speculative prospects with
positive risk premiums
• Intuitively one would rank those portfolios as
more attractive with higher expected returns

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It’s possible to split investment funds between safe
and risky assets.
Risk free asset: T-bills.
Risky asset: stock (or a portfolio).
Capital Allocation Decision: A choice among broad
investment classes rather than among the specific
securities within each asset class. It is considered as
the most important portfolio construction.
The Risk-Free Asset
Only the government can issue default-free
securities security is risk-free in real terms only
if its price is indexed and maturity is equal to
investor’s holding period-bills viewed as “the”
risk-free asset Money market funds also
considered risk-free in practice 6-5
The Risk-free Asset
We commonly view the T-Bills as the “risk-free asset”.
Their short-term nature makes their values insensitive
to interest rate fluctuations.There are other money
market instruments that may be used by the investors
as risk-free assets such as certificate of deposits and
commercial papers.

Portfolios of One Risky Asset and a Risk-Free

Asset
y: proportion of the investment allocated to the risky
portfolio, P,1-y: proportion of the investment allocated
to the risk-free asset, F.

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6-7
Table 6.1 Available Risky Portfolios
(Risk-free Rate = 5%)

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 Estimating Risk Aversion

• Observe individuals’ decisions when

confronted with risk
• Observe how much people are willing to pay
to avoid risk
– Insurance against large losses

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 Capital Allocation Across Risky and
Risk-Free Portfolios
• Control risk
– Asset allocation choice
• Fraction of the portfolio invested in
Treasury bills or other safe money
market securities

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 The Risk-Free Asset

• Only the government can issue default-free

bonds
– Guaranteed real rate only if the duration of
the bond is identical to the investor’s desire
holding period
• T-bills viewed as the risk-free asset
– Less sensitive to interest rate fluctuations

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 Portfolios of One Risky Asset and a
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)

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 Passive Strategies:
The Capital Market Line Continued
• A natural candidate for a passively held risky
asset would be a well-diversified portfolio of
common stocks
• Because a passive strategy requires devoting
no resources to acquiring information on any
individual stock or group we must follow a
“neutral” diversification strategy

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 Immunize a Bond Portfolio

Bond immunization is a strategy used to reduce interest rate

risk in a bond portfolio. As in medicine, the use of the word
immunization refers to reducing risks through preventative
action. Bonds are typically stable from day to day, but they
are exposed to interest rate risk. Without immunization,
rising interest rates send bond values down. Bond
immunization can reduce the price sensitivity of a bond
portfolio to rising interest rates. Institutional investors can
immunize portfolios using credit derivatives.

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 Interest Rate Risk

Bonds fluctuate in price as interest rates change. This

exposure is commonly referred to as interest rate risk, and
it is a consequence of unrealized losses suffered by the
bond owner.
If interest rates go up because of inflation, a bond’s
price drop would correspond to how its future payments
will be able to buy less. If interest rates rise with steady
or declining inflation, the drop in the bond price will
correspond to the opportunity cost of investing in a bond
while more attractive bond prices become available.

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A Bond is a debt instrument issued by governments, corporations
and other entities in order to finance projects or activities. In
essence, a bond is a loan that investors make to the bonds issuer

Immunization is a set of rules that is being used for the purpose

of minimizing the impact of a change in interest rate of a
financial wealth

Bond immunization is an investment strategy used to minimize

the interest rate of bond investments by adjusting the portfolio
duration to match the investors investment time horizon

A portfolio is Immunized when its duration equals the investors

time horizon. Maintaining an Immunized portfolio means
rebalancing the portfolios average duration every time interest
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