CHAPTER 6 Risk Aversion and Capital Allocation to Risky Assets

 Top-down process with 3 steps:

1. Capital allocation between the risky portfolio – F (high risk, high return) and risk-free
asset – P (low risk, low return).
2. Asset allocation in the risky portfolio across broad asset classes.
3. Security selection of individual assets within each assest class.
I. Risk and Risk Aversion:
 Speculation (Đầu cơ)
– Taking considerable risk for a commensurate gain
– Parties have heterogeneous expectations (kì vọng ko đồng nhất)
 Gamble (Cá cược)
– Bet or wager on an uncertain outcome for enjoyment
– Parties assign the same probabilities to the possible outcomes
- Risky investment with risk premium of zero, called a fair game, amounts to a
gamble.
- A risk-averse investor will reject gamble.
 Investors are willing to consider:
- Risk-free assets.
- Speculative positions with positive risk premiums .
 Portfolio attractiveness increases with expected return and decreases with risk.
II. Utility Function: (Hàm ích lợi)
- Each portfolio receives a utility score to assess the investor’s risk/return trade off.

U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
2
σ = variance of returns
½ = a scaling factor
 Portfolio A dominates portfolio B if:
 And: