Lecture 4

Portfolio Mathematics and Capital Allocation

 Recap from Last Lecture
• Expected vs. Realized Return & Risk
• Expected: µ, σ2, Realized: R(r), s2

• Value at Risk (VaR)

• Another measure of risk, works well for any distribution

• Riskfree Prospects & the Risk Premium

• Risk Preferences & Returns Utility

2
 Risk: Averse, Neutral, Loving
• Utility function: U = E(r) – 1/2 Aσ2
• Risk averse: A > 0 (usual case)
• Risk neutral: A = 0
• Risk loving: A < 0

3
Utility Indifference: Risk Averse
Utility Indifference: The return-risk combinations
that are equally agreeable (i.e., generate the same
utility level) to a given investor.
8.0%
E(r)
6.0%
E[r] = U + ½Aσ2
4.0%
The risk-averse
2.0%
investor
σ A U E[r ] demands more
0.0% 0% 4 2% 2.0% return as risk
5% 4 2% 2.5% increases.
-2.0% 10% 4 2% 4.0%
15% 4 2% 6.5%
-4.0%
0.0% 2.5% 5.0% 7.5% 10.0% 12.5% σ 15.0% 4
Utility Indifference: Risk Neutral
8.0%
E(r)
The risk-neutral investor
6.0%
demands neither more nor
less return as risk increases.
4.0%
E[r] = U + ½Aσ2
2.0%
σ A U E[r ]
0.0%
0% 0 2% 2.0%
5% 0 2% 2.0%
-2.0% 10% 0 2% 2.0%
15% 0 2% 2.0%
-4.0%
0.0% 2.5% 5.0% 7.5% 10.0% 12.5% σ 15.0% 5
Utility Indifference: Risk Loving
8.0%
E(r) The risk-loving investor
demands less return as σ A U E[r ]
6.0%
risk increases! 0% -4 2% 2.0%
4.0%
5% -4 2% 1.5%
E[r] = U + ½Aσ2 10% -4 2% 0.0%
2.0% 15% -4 2% -2.5%

0.0%

-2.0%

-4.0%
0.0% 2.5% 5.0% 7.5% 10.0% 12.5% σ 15.0% 6
 Utility Indifference Curve
8.0%
E(r) E[r] = U + ½Aσ2
6.0%

same
4.0% utility

2.0%
same
std dev

0.0%

Risk Averse, A = 4
-2.0%
Risk Neutral, A = 0
Risk Loving, A = -4
-4.0%
0.0% 2.5% 5.0% 7.5% 10.0% 12.5% σ 15.0% 7
 Mean-Variance Criterion
Which direction makes you happy?
Return
E(r)

E(rP) 
•

Risk
σP σ
8
 Outline of Today’s Lecture
• Risk & Return for Security Portfolios
• Allocation Decision Levels
• Complete Portfolio Return & Risk
• The Capital Allocation Line

9
 Expected Portfolio Return
• Expected Portfolio Return, E(rP)
E(rP) = w1E(r1) + w2E(r2)

where w1 and w2 are portfolio weights, or the fraction

of wealth the investor puts into each security.
• E.g., Invest $25 in r1 and $75 in r2:
w1 = 25/100, w2 = 75/100

10
 Example
• Suppose you have $100 to invest, which you split
equally between stocks 1 & 2:
w1 = $50/$100 = 50% = w2

E(rP) = w1E(r1) + w2E(r2)

E(rP) = 0.50(4%) + 0.50(8%) = 6%

This portfolio is expected to return 6%.

11
 Portfolio Variance

• Portfolio Variance, σP2 = E[rP – E(rP)]2

σP2 = E[w1r1 + w2r2 – E(w1r1 + w2r2)]2

= E[w1r1 – E(w1r1) + w2r2 – E(w2r2)]2

= E[w1r1 – E(w1r1)]2 + E[w2r2 – E(w2r2)]2

+ 2E[(w1r1 – E(w1r1))(w2r2 – E(w2r2))]

12
 Portfolio Variance

σP2 = Var(w1r1) + Var(w2r2) + 2Cov(w1r1,w2r2)

= w12Var(r1) + w22Var(r2) + 2w1w2Cov(r1,r2)

σP2 = w12σ12 + w22σ22 + 2w1w2σ12

where σ12 = Cov(r1,r2), which we call
the covariance of the securities.

13
 Covariance
• Measures if two variables move together
σ12 = Cov(r1,r2) = E[((r1-E(r1))((r2-E(r2))]
If σ12 > 0, they are positively related
If σ12 < 0, they are negatively related
If σ12 = 0, they are unrelated

• Note that σ22 = σ22 = E[(r2-E(r2)]2 means variance is a

variable’s own covariance

14
 Correlation: ρ
• A normalized measure of covariance
σ12
• ρ12 =
σ1σ2

0 < ρ12 ≤ 1 → Variables are positively correlated

ρ12 = 0 → Variables uncorrelated
-1 ≤ ρ12 < 0 → Variables are negatively correlated
15
 Outline of Today’s Lecture
 Risk & Return for Security Portfolios
• Allocation Decision Levels
• Complete Portfolio Return & Risk
• The Capital Allocation Line

16
 Allocation Decision Levels

Complete Portfolio

Risky Assets Security

Optimal Selection
Weights
Stocks Optimal
between
Weights
Risky &
Bonds within
Riskfree Risky
Assets Assets
(Chapter 6) Others (Chapter 7)
Asset Riskfree Assets
Allocation
17
 Allocation Weights Example

$100 Complete Portfolio What are the optimal y & w?

$80 Risky Assets y = 80/100 = 80%

$40 Stocks wS = 40/80 = 50%

$20 Bonds wB = 20/80 = 25%

$20 Others wO = 20/80 = 25%

$20 Riskfree Assets 1 - y = 20/100 = 20%

18
 Outline of Today’s Lecture
 Risk & Return for Security Portfolios
 Allocation Decision Levels
• Complete Portfolio Return & Risk
• The Capital Allocation Line

19
 Complete Portfolio Return

E(rC) = yE(rP) + (1 – y)rf

 E(rC) = rf + y[E(rP) – rf]

Riskfree return: Risk

reward for inflation and Risk premium:
weight reward for taking
deferred consumption (quantity
without risk. risk (price of risk)
of risk
taken) 20
 Complete Portfolio Risk
σC2 = y2σP2 + (1 – y)2σf2 + 2y(1 – y)σPf

But σPf = σf2 = 0 by definition, so:

σC2 = y2σP2  σC = yσP

• Suppose E(rP) = 15%, σP = 22%, rf = 7%:

1. E(rC) = rf + y[E(rP) – rf] = 7% + y8%, and
2. σC = y22%
21
 Possible Complete Portfolios
Return
E(r) Unlevered Portfolio Levered Portfolio
(Margin buying) Capital
0←y 0≤y≤1 y →1 1<y Allocation
Line (CAL)
→ rf ≤ E(rC) ≤ E(rP) → E(rC) > E(rP)
→ 0 ≤ σC ≤ σP → σ C > σP
σP ≡ Quantity of risk
E(rP)
•
15% P
E(rP) – rf = 8% ≡ Risk Premium
rf S = [E(rP) – rf] ÷ σP = 8/22
7% •F
S ≡ Reward-to-variability
S ≡ Sharpe Ratio
Risk
σP = 22% σ
22
 Outline of Today’s Lecture
 Risk & Return for Security Portfolios
 Allocation Decision Levels
 Complete Portfolio Return & Risk
• The Capital Allocation Line

23
 The Capital Allocation Line
Return
E(r) Unlevered Portfolio Levered Portfolio
(Margin buying) Capital
0≤y≤1 1<y Allocation
Line (CAL)

If
borrowing
E(rP)
• rate is
15% P higher,
Sb = [E(rP) – rb] ÷ σP
i.e., rb > rf
rf S = [E(rP) – rf] ÷ σP
7% •F = 8/22
Risk
σP = 22% σ
24
 Reference
• Investments book
• Chapters 5-6

25