FTX3044F_2023

Part 1: Risk aversion

and capital
Modern Portfolio Theory allocation to risky
assets
1
 Context
• Portfolio Theory (PT) is derived from the work of Harry Markowitz in 1952.
• PT provides a framework for investors to be able to create portfolios with
the highest return and the lowest possible risk. The extensions to this
theory give us a model for measuring the expected returns and risk of
individual assets.
• Some interesting points about PT include:
• It provides the foundation of a large part of investment finance and, while
it has been criticised, there is no other theory that has replaced it.
• At the time, it was extremely novel because it represented the first time
that risk had been measured quantitatively.
• The work of Markowitz, combined with that of Miller and Sharpe, changed
the way people invest and they were rewarded for this with the 1990
Nobel Prize in Economics.
• In FTX2024, you were introduced to several key concepts underpinning PT.
In particular, you learnt to calculate:
• expected return
• risk (as measured by variance and standard deviation), and
• the Sharpe ratio (also known as the reward-to-risk ratio).

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 Learning Objectives
The learning objectives for this section are to:

understand the apply the concept of work with a portfolio understand how
concepts of risk risk aversion in that allocates funds leverage can be used
aversion and utility measuring a utility between a risky in capital allocation
function and asset and a risk-free
understand how risk asset
aversion affects
capital allocation

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 Background
Portfolio construction comprises two components:
1. The capital allocation decision: the allocation of the complete
portfolio to a riskless asset and a risky portfolio.
2. The asset allocation decision: the composition of the risky
portfolio of the complete portfolio.
This section focuses on the capital allocation decision, which depends
on the risk-return trade-off offered by the risky portfolio but also the
investor’s risk aversion. MPT Part 2 focuses on the asset allocation
decision.

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 1. Risk Aversion and Utility

• We need to distinguish between the varying degrees of risk aversion of

investors:
• A risk-averse investor is one that prefers less risk to more risk. Given
two investments that have equal expected returns, a risk-averse
investor will choose the one with less risk.
• A risk-seeking/ risk-loving investor prefers more risk to less. Given
equal expected returns, risk-seeking investors will choose the more
risky investment.
• A risk-neutral investor has no preference regarding risk and would
be indifferent between two investments with the same expected
return.
• Semantics: Risk aversion versus risk tolerance

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 • Consider the following: A coin will be flipped; if it comes up heads, you
receive R1000; if it comes up tails, you receive nothing. The expected
payoff is 0.5(R1000) + 0.5(R0) = R500.
• A risk-averse investor would choose a payment of R500 (a certain
outcome) over the gamble.
• A risk-seeking investor would prefer the gamble to a certain payment
of R500.
• A risk-neutral investor would be indifferent between the gamble and
a certain payment of R500.

• The assumption of portfolio theory: investors are risk averse

• Varying degrees of risk aversion
• Semantics: risk aversion versus risk tolerance
• Evidence of risk aversion?
• What factors affect your level of risk aversion?

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 • A risk-averse investor will only hold a risky portfolio if the extra return
that he earns is adequate compensation for the additional risk (i.e. a
+ve risk premium).
• Portfolios with higher expected returns and lower risk are considered
more attractive and will therefore be ranked higher in terms of
preference.
• BUT, risk generally increases with expected returns implying that the
investor must be prepared to accept more risk in exchange for a higher
return.
• How will an investor choose between these portfolios? We need to
consider Utility Theory.
Portfolios E(r) rf E(r) - rf σ
Low Risk 5% 3% 2% 7%
Medium Risk 10% 3% 7% 12%
High Risk 15% 3% 12% 20%
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 • An investor’s utility function represents the investor’s preferences
in terms of risk and return (i.e. his/her degree of risk aversion).
• We assume that expected return and risk are the only portfolio
characteristics that investors care about.
• An indifference curve (IC) is a tool from economics that, in this
application, plots combinations of expected return and risk
(standard deviation) among which an investor is indifferent.
• The investor’s utility is the same for all points along a single IC.
• IC I1 represents the most preferred portfolios; the investor will
prefer any portfolio along I1 to any portfolio on either I2 or I3.

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 For a risk-averse investor:

I1 Higher Utility
Expected Return

I2

I3 Lower Utility

C B
E(r)2
A
E(r)1

Same measure
of utility
σ3 σ1 σ2 Standard Deviation

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 • ICs slope upward for risk-averse investors as they will only take on
more risk if they are compensated with greater expected returns.
This is known as the risk-return trade-off.
• A more risk averse investor requires a greater increase in expected
return to compensate for a given increase in risk so their ICs will be
steeper reflecting a higher risk aversion coefficient (see next figure).
• A less risk averse investor requires a smaller increase in expected
return to compensate for a given increase in risk so their ICs will be
flatter reflecting a lower risk aversion coefficient (see next figure).

• Although we focus only on risk-averse investors going forward, it is

worth noting:
• As a risk-neutral investor is not concerned about risk but only the rate
of return, their indifference curves will be flat.
• A risk-loving investor is prepared to accept lower expected returns as
risk increases so their indifference curves will be downward sloping.

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 Risk-averse vs risk-loving vs risk-neutral investors

More Risk
Averse Moderately Risk
steeper Averse
Less Risk Averse
E(r)
flatter
E(r1)

Risk Neutral

Risk Loving

σ1 σ2 σ

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 • To rank investment portfolios, it is necessary to assign them a level or
measure of utility which is based on expected return and variance.
This is defined by:
Returns and std dev MUST BE
1 2 expressed as decimals (and
𝑈𝑈 = 𝐸𝐸 𝑟𝑟 − 𝐴𝐴𝐴𝐴 not as a whole number) in
2
this equation.

where: U is utility (also known as the certainty equivalent rate of

return) and A is the coefficient of risk aversion.

As the formula shows, utility is enhanced by higher expected returns

(𝐸𝐸 𝑟𝑟 ) and reduced by higher risk (𝜎𝜎2) and higher risk aversion (𝐴𝐴).
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 • For risk-free portfolios, σ2 = 0, so U = 𝐸𝐸 𝑟𝑟 .
• For a risk-averse investor, A > 0. The greater the value of A, the more
risk averse the investor and hence the more severely risky
investments are penalised.
• The utility score of risky portfolios represents the certainty equivalent
rate of return (CERR) that the risk free asset would need to offer to
provide the same utility score as the risky portfolio. A portfolio will
only be chosen if the CERR > rf.

• For a risk-neutral investor, A = 0, and thus they judge risky prospects

based only on their expected return (CERR = E(r)). The level of risk is
irrelevant meaning that there is no penalty for risk.
• For a risk-loving investor, A < 0, the expected return is adjusted
upwards to account for the fun of confronting the prospect’s risks. As
such, they will always take a fair game because their upward
adjustment of utility for risk gives the fair game a CERR > rf.

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 • Example 1: Assume an investor with a risk aversion of 3 has a choice
between two shares with expected return and standard deviation as
shown in the table. Which share should he invest in?

Vodacom MTN
E (r ) 10% 12%
σ 9% 13%
1
𝑈𝑈 = 𝐸𝐸 𝑟𝑟 − 𝐴𝐴𝜎𝜎 2 Note, returns and std dev
2 are expressed as decimals
UV = 0.1 – ½*3*0.092 = 0.0879 (and not %s) in this
UM = 0.12 – ½*3*0.132 = 0.0947 equation.
Therefore choose MTN as it results in higher utility based on the
investor’s coefficient of risk aversion.
We can convert these utility scores to %s by multiplying by 100, which represents
the certainty equivalent rate of return (CERR). Thus, the respective CERRs for
Vodacom and MTN are 8.79% and 9.47%
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 • Example 2: A portfolio has an expected return of 15% and a standard
deviation of 17%. The risk-free rate is 3.44%. Investor X has a coefficient
of risk aversion of 4 and investor Y has a coefficient of risk aversion of 8.
Which investor is indifferent between the risky portfolio and the risk-
free asset?

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 The Mean-Variance Criterion

E(r) • A risk-averse investor will

prefer portfolio A to any
other portfolio in quadrant
I II IV (e.g. B) because its E(r) is
equal to or greater than any
portfolio within that
E(rA) quadrant and its std dev. is
Portfolio A equal to or smaller than any
portfolio in quadrant IV.
III IV
Portfolio B • Any portfolio in quadrant I
therefore dominates A.

σA σ

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 • The criterion by which the choice of portfolio A is made is the mean-
variance (M-V) criterion. It can be stated as follows:

Portfolio A will be superior to portfolio B if:

𝐸𝐸(𝑟𝑟𝐴𝐴) ≥ 𝐸𝐸(𝑟𝑟𝐵𝐵 ) and 𝜎𝜎𝐴𝐴 ≤ 𝜎𝜎𝐵𝐵

• For the M-V criterion to hold, at least one inequality is strict (so as
to rule out indifference between the two portfolios). Thus:
• If 𝐸𝐸 𝑟𝑟𝐴𝐴 = 𝐸𝐸(𝑟𝑟𝐵𝐵), then 𝜎𝜎𝐴𝐴 < 𝜎𝜎𝐵𝐵
• If 𝜎𝜎𝐴𝐴 = 𝜎𝜎𝐵𝐵 then, 𝐸𝐸 𝑟𝑟𝐴𝐴 > 𝐸𝐸(𝑟𝑟𝐵𝐵).

• What about quadrants II and III? It depends on:

• the investor’s risk aversion and
• their willingness to trade off risk against return.

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 • It is possible for the investor to identify other portfolios that are
equally desirable as portfolio A (see figure on next slide):
• Moving from A, an increase in σ, lowers utility and must be
compensated for by an increase in E(r). Thus C is equally desirable as
A.
• A decrease in σ raises utility and thus results in a lower E(r) as with
Portfolio D.
• The investor will be indifferent between portfolios C, A and D (and all
others) that plot on that IC and the choice between them will depend
on the trade-off between risk and return.

• Any portfolio to the left of the IC e.g. E or F is preferred to

portfolios identified by the indifference curve because they have a
higher return and lower risk. They are said to dominate. Likewise
any portfolio on the IC will be preferred to a portfolio to the right
of the indifference curve e.g. B.

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 According to the M-V criterion:
• A, C, D, E & F dominate B.
• The investor would be indifferent
between D, A & C but there is a trade-
off between risk and return.
• F & E dominate D, A, C & B.
E(r)
I II

Portfolio E Portfolio C

Portfolio F
E(rp)
Portfolio A
Portfolio D
Portfolio B

III IV

σp σ
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 2. Capital Allocation

• The easiest way to control the risk of a portfolio is through the

fraction of the portfolio invested in Treasury bills or other safe
money market securities.
• The capital allocation choice: what fraction of the portfolio should
be invested in risk-free securities versus other risky asset classes?

Risk-free asset

Risky assets

Level of Risk
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 3. Portfolios of One Risky Portfolio & a
Risk-Free Asset
• The investment in risky assets can be viewed as a single risky portfolio
that comprises many risky securities. As we move in and out of safe
assets, we alter our holdings of the risky portfolio accordingly.
• The portfolio comprising the risk-free asset and the risky portfolio is
known as the complete portfolio.
• For the risky portfolio:
• The uncertain expected return: E(rp)
• The risk associated with the expected return: σp
• The % of funds invested in the risky portfolio: y
• For the risk-free asset:
• The certain return: rf.
• No risk: σrf = 0%
• The % of funds invested in the risk-free asset: 1 - y

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 **Note: r refers to the total return

• The expected return for the complete portfolio:

𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦𝐸𝐸(𝑟𝑟𝑝𝑝 ) + (1 − 𝑦𝑦)𝑟𝑟𝑓𝑓

Rearranging:
[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ] =
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ] Risk premium

• The risk of the complete portfolio:

𝜎𝜎𝑐𝑐 = 𝑦𝑦𝜎𝜎𝑝𝑝

• We can rearrange this equation to solve for the proportion invested in

the risky asset as follows:
𝜎𝜎𝑐𝑐
𝑦𝑦 =
𝜎𝜎𝑝𝑝
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 • Consider the following:
• rf = 7%, E(rp) = 15% and σp = 22%.

• The expected return and std dev of the complete portfolio will be:
E(rc) = 7 + y[15 – 7] and σc = y22

The basic rate earned The risk premium the The std dev of the
on this portfolio is portfolio is expected to complete portfolio is the
the risk free rate of earn is 8% if 100% is std dev of the risky
7%. invested in the risky portfolio multiplied by
portfolio (i.e. y = 1) or the weight of the risky
less than 8% if y < 1. portfolio (y) in the
complete portfolio.

The expected return depends on the amount

invested in the risky portfolio (y) which is
determined by the investors’ level of risk aversion.
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 • The next step is to plot the portfolio in the expected return-std dev
space (see next figure):
• Portfolio P is 100% invested in the risky portfolio (y = 1).
• Portfolio F is 100% invested in the risk-free asset (y = 0).
• When y ranges between 0 and 1, the portfolio comprises a combination
of the risk-free asset and risky portfolio and lies between F and P.

• The graph shows the investment opportunity set, which is the set of
feasible expected return and std dev pairs of all portfolios resulting
from different values of y.

• The straight line is known as the capital allocation line (CAL) which
plots the expected return and std dev of the complete portfolio
comprising different weightings in the risky portfolio and risk-free
asset.

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 E(r)
Capital Allocation Line (CAL)

P
E (rp) = 15%

Slope = E (rp) - rf = 8%
8/22
rf = 7%
F

σp = 22% σ

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 • The slope of the CAL (rise/ run):
This is the Sharpe Ratio and shows the
increase in expected return per unit of
[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ]
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = additional std dev (i.e. incremental
𝜎𝜎𝑝𝑝 return per incremental risk).

For our example, the slope = (15 – 7)/22 = 0.36

• The equation for the CAL is thus:

[𝐸𝐸(𝑟𝑟𝑝𝑝 )−𝑟𝑟𝑓𝑓 ]
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝜎𝜎𝑐𝑐
𝜎𝜎𝑝𝑝

𝜎𝜎
Note: this can also be derived by substituting in the std dev equation for y (𝑦𝑦 = 𝜎𝜎𝑐𝑐 ) into
𝑝𝑝
the expected return formula: (𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ]) as follows:
𝜎𝜎
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑐𝑐 [𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ]
𝜎𝜎𝑝𝑝

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 i.e. 50% is invested in the risky portfolio and 50% is
invested in the risk-free asset.

• Example 3: From the information given on slide 22, consider a

portfolio which has y = 0.5. What would be the expected return, std
dev. and reward-to-risk ratio (Sharpe ratio) for the portfolio?

𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ] = 7 + 0.5*(15 – 7) = 11%

OR
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦𝐸𝐸(𝑟𝑟𝑝𝑝 ) + (1 − 𝑦𝑦)𝑟𝑟𝑓𝑓 = 15*0.5 + (1 – 0.5)*7 = 11%

𝜎𝜎𝑐𝑐 = 𝑦𝑦𝜎𝜎𝑝𝑝 = 0.5*22 = 11%

𝐸𝐸 𝑟𝑟𝑐𝑐 −𝑟𝑟𝑓𝑓
𝑆𝑆𝑐𝑐 = 𝜎𝜎𝑐𝑐
= (11 – 7)/11 = 0.36

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 • Portfolios to the left of P are lending portfolios as an investor “lends” money by
investing in the risk-free asset.
• What about points to the right of P? To get to points beyond P, an investor must
borrow at the risk-free rate and invest more in the risky portfolio (i.e. use leverage).
Hence these are borrowing portfolios.
• Whether an investor has a borrowing or lending portfolio depends on their level of
risk aversion (as captured by their IC).

Optimal CAL
Expected Complete
Return Portfolio

P
Optimal
Complete
Portfolio

rf

Standard
Deviation

Lending Portfolio Borrowing Portfolio

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 • We want to consider two scenarios:

Scenario 1: Borrow at the risk-free rate and invest in the risky portfolio.

Using the info from the previous example and assuming leverage of
50%, what is the expected return, std dev and Sharpe ratio of the
complete portfolio?
Leverage of 50% means that an
y = 1.5 and 1 – y = -0.5 investor borrows 50% of their
investment total. The total
proportion invested in the risky
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ] = 7 + 1.5*8 = 19% portfolio is 150% (y = 1.5). As the
OR investor borrows at the risk-free
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦𝐸𝐸(𝑟𝑟𝑝𝑝 ) + (1 − 𝑦𝑦)𝑟𝑟𝑓𝑓 = 1.5*15 + -0.5*7 = 19% rate (rather than investing), 1- y
is negative.
𝜎𝜎𝑐𝑐 = 𝑦𝑦𝜎𝜎𝑝𝑝 = 1.5*22 = 33%
𝐸𝐸 𝑟𝑟𝑐𝑐 −𝑟𝑟𝑓𝑓
𝑆𝑆𝑐𝑐 = = (19 – 7)/33 = 0.36
𝜎𝜎𝑐𝑐

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 E(r) Capital Allocation Line (CAL)

C
E (rc) = 19%
P
E (rp) = 15%

Slope = E (rp ) - rf =
8/22 8%
rf = 7%
F

σp = 22% σc = 33% σ

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 Scenario 2: Borrow and invest in the risky portfolio but the borrowing
rate is greater than the risk-free rate.

In this case, we need to adjust our expected return formula:

𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓𝐵𝐵 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓𝐵𝐵 ]

Using the info from the previous example but with risk-free borrowing
at 9% (risk-free lending is still 7%) and assuming leverage of 50%, what
is the expected return, std dev and Sharpe ratio of the complete
portfolio?

𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓𝐵𝐵 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓𝐵𝐵 ] = 9 + 1.5*(15 – 9) = 18%

OR
𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦𝐸𝐸(𝑟𝑟𝑝𝑝 ) + (1 − 𝑦𝑦)𝑟𝑟𝑓𝑓𝐵𝐵 = 1.5*15 + -0.5*9 = 18%
𝜎𝜎𝑐𝑐 = 𝑦𝑦𝜎𝜎𝑝𝑝 = 1.5*22 = 33%
𝐸𝐸 𝑟𝑟𝑐𝑐 −𝑟𝑟𝑓𝑓
𝑆𝑆𝑐𝑐 = = (18 – 9)/ 33 = 0.27
𝜎𝜎𝑐𝑐
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 E(r)

CAL
E (rc) = 19%
P S (y > 1) = 0.27
E (rp ) = 15%

rB = 9% S (y ≤ 1) = 0.36
rf = 7%
F

σp = 22% σc = 33% σ

Therefore the CAL is “kinked” at portfolio P. To the left of P, the investor lends at
7% and the slope of the CAL is 0.36. To the right of P, the investor borrows at
9% to finance extra investments in the risky asset and the slope is 0.27. 32
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 4. Risk Tolerance and Asset Allocation
• The CAL plots all feasible risk-return combinations available for
capital allocation. The investor must now choose one optimal
complete portfolio, C, from the set of feasible choices.
• This choice entails a trade-off between risk and return.
• Individual differences in risk aversion lead to different capital
allocation choices even when facing an identical investment
opportunity set.
• Investors with higher levels of risk aversion choose to hold a
lower proportion of their investment in the portfolio of risky
assets (i.e. a lower y value) and more in the risk-free asset.
• Investors with lower levels of risk aversion choose to hold a
higher proportion of their investment in the portfolio of risky
assets (i.e. a higher y value) and less in the risk-free asset.

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 • Higher ICs correspond to higher levels of
utility. Thus, the investor attempts to find
the complete portfolio on the highest IC.
• The highest IC that is tangential to the CAL
(i.e. still touches the CAL) will yield the
E(r)
optimal complete portfolio (i.e. I2).

I1
I2
I3 CAL
P
E(rp)

C
E(rc)

rf
F

σc σp σ
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 To determine the complete portfolio mathematically:
• Investors choose the allocation to the risky asset, y, that maximises
1
their utility function 𝑈𝑈 = 𝐸𝐸 𝑟𝑟 − 𝐴𝐴𝐴𝐴2
2
• This results in the optimal position for risk-averse investors in the
risky asset, y*, as follows:
Returns and std dev MUST
𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝑟𝑟𝑓𝑓 BE expressed as decimals
𝑦𝑦 ∗ = and not whole numbers in
𝐴𝐴𝜎𝜎𝑝𝑝2 this equation.

• The optimal position in the risky asset is thus:

• inversely related to the level of risk aversion (A) and risk (𝜎𝜎𝑝𝑝2 ) and
• directly related to the risk premium on the risky portfolio (𝐸𝐸 𝑟𝑟𝑝𝑝 −
𝑟𝑟𝑓𝑓 ).

• Thus, the choice for y*, is determined by an investor’s risk aversion

(slope of their IC) and the Sharpe ratio (slope of the CAL).

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 • Example 4: If rf = 7%, E(rp) = 15% and σp = 22% and investors X and Y
have coefficients of risk aversion of 6 and 1 respectively, calculate the
E(rc), σc and the reward-to-risk ratio for each investor.
Note: returns and std dev
are expressed as decimals
and not as whole numbers
in this equation.

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 Investor X is more risk
averse than investor Y
We can also present this example graphically
and therefore their
indifference curves are
steeper.
E(r) Investor Y CAL

E(rc) = 20.2%

Investor X
P
E(rp) = 15%

E(rc) = 9.24%
rf = 7%
F

σc = 6.16% σp = 22% σc = 36.3% σ

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 • Example 5: If investor Y from example 4 cannot borrow at the risk-free
rate but instead at a rate of 9%, calculate the E(rc), σc and the reward-
to-risk ratio for the investor assuming all other info is the same.
Note, returns and std dev
are expressed as decimals
𝐸𝐸 𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓
𝑦𝑦 ∗ = = (0.15 – 0.09)/ (1*0.222) = 1.24 (and not %s) in this
𝐴𝐴𝜎𝜎𝑝𝑝2
equation.

𝐸𝐸(𝑟𝑟𝑐𝑐 ) = 𝑟𝑟𝑓𝑓 + 𝑦𝑦[𝐸𝐸(𝑟𝑟𝑝𝑝 ) − 𝑟𝑟𝑓𝑓 ] = 9 + 1.24 (15 – 9) = 16.44%

The investor’s optimal position
𝜎𝜎𝑐𝑐 = 𝑦𝑦𝜎𝜎𝑝𝑝 = 1.24*22 = 27.28% in the risky asset is > 1 meaning
that they borrow at the risk-free
𝐸𝐸 𝑟𝑟𝑐𝑐 −𝑟𝑟𝑓𝑓 rate.
𝑆𝑆𝑐𝑐 =
𝜎𝜎𝑐𝑐
= (16.44 – 9)/27.28 = 0.27

**The reward-to-risk ratio is lower than under example 4 as the investor now
faces a higher borrowing rate (9% versus 7%).

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 We can also present this example graphically:

E(r) CAL
Investor Y Slope = 0.36

E(rc) = 20.2% Borrowing rate of 7%

Investor Y Slope = 0.27

E(rc) = 16.44% Borrowing rate of 9%
P
E(rp) = 15%

rBf = 9%

rf = 7%
F

σp = 22% σc = 27.22% σc = 36.3% σ

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 5. The Capital Market Line

• The CAL is derived from the risk-free asset and a risky portfolio. If the
risky portfolio is the market portfolio (comprising all risky assets), then
it is referred to as the Capital Market Line (CML).

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