FINA 3080

Investment Analysis and

Portfolio Management
Prof. Chao Ying
Lecture 7A
Risk Aversion and Capital Allocation

FINA 3080 Prof. Chao Ying 1

 Lecture 7A Outline
• Properties of the investment environment

• Preview of the portfolio choice algorithm

• Investors’ preferences (Utility )

• Combining assets into portfolios

– One risky and one safe asset

• Find optimal complete portfolio

– One risk-free and one risky asset
FINA 3080 Prof. Chao Ying 2
 Assessing the Investment Environment
• Calculate the future return using past returns
– Arithmetic average: Best estimate of future expected return
𝑛𝑛
1
𝐸𝐸(𝑟𝑟) = � 𝑟𝑟(𝑠𝑠)
𝑛𝑛
𝑠𝑠=1
– Geometric average: Hypothetical past annual return

(1+ g )n = (1 + r 1)(1 + r 2)(1 + r n) = Terminal Value

Geometric Average is less than Arithmetic average

holds
equality when h=rs= . _
.
-

rn

3
FINA 3080 Prof. Chao Ying
 Assessing the Investment Environment
• Volatility of returns: Standard deviation of returns
N variance
,
Cal var .
then take
square root

• Correlation of returns of multiple assets (−1 ≤ 𝜌𝜌 ≤ 1)

𝐸𝐸 𝑟𝑟 𝑖𝑖 −𝑟𝑟 𝑓𝑓 risk
)= &÷¥
• Sharpe ratio= =
premium
𝜎𝜎 𝑖𝑖 G. D. of return
volatility
– Reward-risk ratio for the investment environment
For each unit of risk how much return ?
,

• Risk Premium = Excess Return = 𝐸𝐸 𝑟𝑟 𝑖𝑖 − 𝑟𝑟 𝑓𝑓

4
FINA 3080 Prof. Chao Ying
 Preview of Portfolio Choice
↑K ↓↓
• Investors care about real portfolio returns and risk

• Diversification helps investors minimize risk

• Investors want the best reward-risk ratio

( i. e.
highest sharp ratio )

• Risk aversion determines overall risk exposure

mm
mm

FINA 3080 Prof. Chao Ying 5

 ¥4B
Investors’ Preferences
• Utility ultimately comes from consuming goods
me

– For simplicity, we’ll consider a two-period model

↑ ↓
• Investors like expected return E(rp) and dislike
risk σp2
risk
Variance
aversion
Etpeotedntnrn
1
\ ↑
• Returns are normal: E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝐴𝐴𝜎𝜎𝑝𝑝2
2
FINA 3080 Prof. Chao Ying 6
 CARA Utility Function
1 2
E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝐴𝐴𝜎𝜎𝑝𝑝 ≡ 𝑓𝑓(𝐴𝐴, 𝐸𝐸 𝑟𝑟𝑝𝑝 , 𝜎𝜎𝑝𝑝 )
2
Where U = utility;
𝐸𝐸 𝑟𝑟𝑝𝑝 = expected return on the asset or portfolio
𝐴𝐴 = coefficient of risk aversion
𝜎𝜎𝑝𝑝2 = variance of returns (measure for risk)
For given assets, only the means and variances are
relevant for utility

FINA 3080 Prof. Chao Ying 7

 Graphing Investors’ Indifference Curves
40.0%

35.0%

U = 0.04 for A = 2
30.0%
U = 0.06 for A = 2
E(r) 25.0%
U = 0.04 for A = 3
U = 0.06 for A = 3

20.0%

15.0%

10.0%

5.0%

0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

↑
risk the σ
• All points along the indifference curve offers the same utility.
• The higher the IC, the higher the utility level
1 2
E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝐴𝐴𝜎𝜎𝑝𝑝
2
FINA 3080 Prof. Chao Ying 8
 Indifference Curves (ICs)
The slopes of ICs are different across investors
with different risk aversion
– The higher the risk aversion, the steeper the IC.

risk increase want same utility 1 2

required return §E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 2 𝐴𝐴𝜎𝜎𝑝𝑝
,

✗ care abt risk, A :O

-
ve risk admin
( some ppl like risk
(abnormal in
reality ) 9
FINA 3080 Prof. Chao Ying
 Test in final
Example of a Risky Asset
• Suppose the asset pays either -20% or +60% 2

– Both events are equally likely ]

• Thus, expected return is 20%; volatility is 40%
• How much is this asset worth to an investor? (compare
utilities of different assets)
– It depends on the investor’s risk aversion parameter
– With A = 2, it’s worth a risk-free return of 4%, how?
1 2 1
E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝐴𝐴𝜎𝜎𝑝𝑝 = 0.2 − ∗ 2 ∗ 0.42 = 4%
2 2
– With A = 3, it’s not worth any positive risk-free rate
1 2 1
E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑝𝑝 − 𝐴𝐴𝜎𝜎𝑝𝑝 = 0.2 − ∗ 3 ∗ 0.42 = −4%
2 2
10
FINA 3080 Prof. Chao Ying
 Can the Investor Do Better by Capital
Allocation Across Risky and Risk-free Assets?
• Could combine the risk-free 𝑟𝑟𝑓𝑓 and the risky asset 𝑟𝑟𝑝𝑝
– The combination may provide higher utility
hmmm

• Need to compute the portfolio reward and risk

– Both are linear in the weight on the risky asset (y)
– y can be larger than 1: borrow money to buy stock
I borrow $ from risk t.ee assets maybe)
𝑟𝑟𝑐𝑐 = complete or combined portfolio
E ( rc ) = yE ( r p ) + (1 − y ) E ( rf )
-4hr risk variance
σ c = yσ p
no

[ weight of risky asset

11
FINA 3080 Prof. Chao Ying
 Expected Returns & Risk for Combinations
𝑟𝑟𝑐𝑐 = complete or combined portfolio
E ( rc ) = yE ( r p ) + (1 − y ) E ( rf )
σ c = yσ p note: standard deviation **
weight itiok
(15%) (7%)
For example, 𝑟𝑟𝑝𝑝 =.15, Std(𝑟𝑟𝑝𝑝 )=22% , 𝑟𝑟𝑓𝑓 =.07
• Without leverage (y<=1): y = 0.75
E(𝑟𝑟𝑐𝑐 ) = .75(.15) + .25(.07)=.13, Std(𝑟𝑟𝑐𝑐 )=.75*22%=16.5%
• With leverage (y>1): y = 1.5 (borrow $)
E(𝑟𝑟𝑐𝑐 ) = 1.5(.15) + (-0.5)(.07)=.19, Std(𝑟𝑟𝑐𝑐 )=1.5*22%=33%
↳
higher returns
FINA 3080 Prof. Chao Ying 12
 Q: Risk and Risk Premium
You have $500,000 available to invest. The
risk-free rate, as well as your borrowing rate,
is 8%. The return on the risky portfolio is
16%. If you wish to earn a 22% return, you
should ________. 0,1
by -1 ( g) 0.08=0.22
1-

Y =7J 1.

A) invest $125,000 in the risk-free asset

B) invest $375,000 in the risk-free asset
C) borrow $125,000
0
D) borrow $375,000

FINA 3080 Prof. Chao Ying

 Q: Risk and Risk Premium
You have $500,000 available to invest. The risk-free rate, as well as
your borrowing rate, is 8%. The return on the risky portfolio is 16%. If
you wish to earn a 22% return, you should ________.
A) invest $125,000 in the risk-free asset
B) invest $375,000 in the risk-free asset
C) borrow $125,000
D) borrow $375,000

E(𝑟𝑟𝑐𝑐 ) = 0.16y + 0.08(1-y)=0.22 =>y=1.75.

Since y>1, borrow (1.75-1)*500,000=375,000

FINA 3080 Prof. Chao Ying

 The Investment Opportunity Set with a Risky Asset
and a Risk-free Asset
invest on

leverage
1=1 ↓
↓

data from

→ ( per
example)
.

Ty :O
"w↑÷y sina.pe ratio

• Between F and P (y<=1); Above P (y>1, leverage)

𝐸𝐸 𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓 15%−7%
• Slope of CAL = = = 𝐒𝐒𝐒𝐒𝐒𝐒𝐒𝐒𝐒𝐒𝐒𝐒 𝐑𝐑𝐒𝐒𝐑𝐑𝐑𝐑𝐑𝐑
𝜎𝜎𝑝𝑝 22%
• All points on the CAL share the same Sharpe Ratio
FINA 3080 Prof. Chao Ying 15
CLA not straight: Differential Borrowing and Lending Rates

• y<=1, you lend; y>1, you m

borrow at a m
higher rate (9%)
𝐸𝐸 𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓 15%−7%
• Slope of CAL (y<=1) = = = 0.36
𝜎𝜎𝑝𝑝 22%

𝐸𝐸 𝑟𝑟𝑝𝑝 −𝑟𝑟𝑓𝑓𝐵𝐵 15%−9%

• Slope of CAL (y>1) = = = 0.27
𝜎𝜎𝑝𝑝 22%
FINA 3080 Prof. Chao Ying 16
 E(u] y[E(rp)-rf] -Op"yTIA)
=

Maximizing Utility from the Portfolio

• Utility depends on the weight on the risky asset
ALOc
"

(v,]
↓

#
1 1 2
E 𝑈𝑈 = 𝐸𝐸 𝑟𝑟𝑐𝑐 − 𝐴𝐴𝜎𝜎𝑐𝑐2 = 𝑦𝑦𝐸𝐸 𝑟𝑟𝑝𝑝 + (1 − 𝑦𝑦)𝑟𝑟𝑓𝑓 − 𝐴𝐴 𝑦𝑦𝜎𝜎𝑝𝑝
2 2
---
• Maximizing with respect to y gives:
(E(rp) -rf] -A Op
y
– y* = [E(rp) - rf] / Aσp 2 O -

y
-
EFh
• An investor’s optimal weight on the risky asset
a A
– Increases with expected excess return
I &
– Decreases with volatility
I &
– Decreases with risk aversion
17
FINA 3080 Prof. Chao Ying
 2
( ✗ d)
Y
=
ax + ( tx) b- ± c

od
-

1¥ = a -

b -
×

For Max .

y,
sub .
ᵈ*× = 0

-
-
✗ =

-
9¥ -
-
-

E- fu]
-

=
E- [if { Aoi -

=
yEEP-iltylrf-IACYG.pt
d¥=Ekp ] -

rf -

Aging
For wax .
E- fu ] ,
sub .

ᵈf¥ :O

y =⇐¥;→
 Back to Our Example
• Suppose A = 2, rf = 4%, 𝑟𝑟𝑝𝑝 = 0.2, 𝜎𝜎𝑝𝑝 = 0.4
=

M(F0.2- [(2)(0.4) 0.04 (10): 4%

• Risky and safe asset give U(1) = U(0) = 0.04
y
=
0.04 =
0.5

• But combining them gives greater utility

– Optimal weight y* = [E(rp) - rf] / Aσp2 y* =
50.0
– So y* = 50% and U(y*) = 0.08 = 0.5
– Equivalent to an extra 4% per year! x(0.5)
[(z)(1)-p.4)
2 2(0.0x)
-

+
=
18
FINA 3080 Prof. Chao Ying =0.08
 0.04
E(rp) -

1 =

3 24%)2 (rp) 21.28%

# =

Q: Risk and Risk Premium

Treasury bills are paying a 4% rate of return. A
risk-averse investor with a risk aversion of A =
3 should invest entirely in a risky portfolio with a
standard deviation of 24% only if the risky
portfolio's expected return is at least ________.
rf
=
4%Op=24%
A) 8.67%
B) 9.84%
1 (E(r,)
= -

4%)/3(24%)"
O
C) 21.28% E(rp) =
21,28%
D) 14.68%

FINA 3080 Prof. Chao Ying

 Q: Risk and Risk Premium
Treasury bills are paying a 4% rate of return. A risk-averse investor with a
risk aversion of A = 3 should invest entirely in a risky portfolio with a
standard deviation of 24% only if the risky portfolio's expected return is at
least ________.

A) 8.67%
B) 9.84%
C) 21.28%
D) 14.68%

y* = [E(rp) - rf] / Aσp2

1= [E(rp) – 0.04] / (3*0.24^2) ->21.28%

FINA 3080 Prof. Chao Ying

 FINA 3080
Investment Analysis and
Portfolio Management
Prof. Chao Ying
Lecture 7B
Portfolio Diversification

FINA 3080 Prof. Chao Ying 21

 Lecture 7B Outline
• CAPM
• Risk decomposition
– Systematic risk
– Idiosyncratic risk

FINA 3080 Prof. Chao Ying 22

Risk Decomposition: Single Factor Model
𝑟𝑟𝑖𝑖 − 𝑟𝑟𝑓𝑓 ) = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟�
(� 𝑀𝑀 − 𝑟𝑟𝑓𝑓 + 𝑒𝑒
�𝑖𝑖

Excess Return Market Excess Return

𝛼𝛼𝑖𝑖 = the stock’s expected excess return if the

�𝑀𝑀 − 𝑟𝑟𝑓𝑓 ) = 0
market’s excess return is zero (𝑟𝑟 &Ii=o

𝑀𝑀 − 𝑟𝑟𝑓𝑓 = the component of return due to

𝛽𝛽𝑖𝑖 𝑟𝑟�
movements in the market index
𝑒𝑒�𝑖𝑖 = firm specific component, not due to market
movements, Corr � 𝑟𝑟𝑀𝑀 , 𝑒𝑒�𝑖𝑖 = 0
FINA 3080 Prof. Chao Ying 23
Components of Risk and Diversification
• Market or systematic risk: risk related to the macro
economic factor or market index -Nondiversifiable
• Idiosyncratic or firm specific risk: risk not related
to the macro factor or market index - Diversifiable
• Total risk = Systematic risk + Idiosyncratic risk
• Portfolio variance falls with number of assets
– Idiosyncratic, asset (firm)-specific risk goes away
– Eventually, only systematic risk remains (index)

FINA 3080 Prof. Chao Ying 24

 def
By ,
✗i & Pi are constants

const
font
.
.

FINA 3080 Prof. Chao Ying 25

Measuring Components of Risk
𝜎𝜎𝑖𝑖2 = 𝛽𝛽𝑖𝑖2 𝜎𝜎𝑚𝑚
2
+ 𝜎𝜎 2 𝑒𝑒𝑖𝑖
where;
2
𝜎𝜎𝑖𝑖 = total variance (risk)
2 2
𝛽𝛽𝑖𝑖 𝜎𝜎𝑚𝑚 = systematic variance (risk)
𝜎𝜎 2 𝑒𝑒𝑖𝑖 = idiosyncratic variance (risk)

Note: & not a

risk
is

FINA 3080 Prof. Chao Ying 26

 Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio

𝜎𝜎𝑖𝑖2 = 𝛽𝛽𝑖𝑖2 𝜎𝜎𝑚𝑚

2
+ 𝜎𝜎 2 𝑒𝑒𝑖𝑖 : the idiosyncratic variance
vanishes when we increase the number of stocks
FINA 3080 Prof. Chao Ying 27
 Mean and Variance of Portfolio
• Asset A: E ( rA ) = rA , Var( rA ) = σ 2
A

• Asset B: E ( rB ) = rB , Var( rB ) = σ B2
• Correlation: Corr(rA ,rB )=ρ AB
• Portfolio C has a proportion y on asset A
and (1-y) on asset B
• E(rC ) = yrA + (1 − y ) rB
Var( r ) = y σ
2 2 22
+ (1 − y )σ
𝑉𝑉𝑉𝑉𝑟𝑟(𝑟𝑟C𝑐𝑐 ) = 𝑦𝑦 𝜎𝜎A𝐴𝐴 + (1 − 𝑦𝑦)B +
22 2
𝜎𝜎𝐵𝐵2 + − y )σ
y (12𝑦𝑦(1 σ Bρ
− A𝑦𝑦)𝜎𝜎𝐴𝐴 𝜎𝜎
AB𝐵𝐵 𝜌𝜌𝐴𝐴𝐵𝐵
For risk this asset and risky asset
6,3=0 28
FINA 3080 Prof. Chao Ying
Consider two perfectly negatively correlated
risky securities, A and B. Security A has an
expected rate of return of 16% and a standard
deviation of return of 20%. B has an expected
rate of return of 10% and a standard deviation
of return of 30%. The weight of security B in the
minimum-variance portfolio is ________.
A) 10% Var ( re ) YYO 2) 2+(1-21210.3) -12yd y ) ( 0.2 )
2

-
-
:

B) 20% 10.37ft )
0
C) 40% ( 0.2g 0.34 g) I
-

-
=

D) 60% ( 0.3T 0
toy
-

= .

0.6
rarlrc ) weight of A
=
i. min .

y =
6oz
𝑉𝑉𝑉𝑉𝑟𝑟(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦 2 𝜎𝜎𝐴𝐴2 + (1 − 𝑦𝑦)2 𝜎𝜎𝐵𝐵2 + 2𝑦𝑦(1 − 𝑦𝑦)𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵 𝜌𝜌𝐴𝐴𝐵𝐵

FINA 3080 Prof. Chao Ying

Consider two perfectly negatively correlated risky securities, A and B.
Security A has an expected rate of return of 16% and a standard
deviation of return of 20%. B has an expected rate of return of 10% and
a standard deviation of return of 30%. The weight of security B in the
minimum-variance portfolio is ________.
A) 10%
B) 20%
C) 40%
D) 60%

𝑉𝑉𝑉𝑉𝑟𝑟(𝑟𝑟𝑐𝑐 ) = 𝑦𝑦 2 𝜎𝜎𝐴𝐴2 + (1 − 𝑦𝑦)2 𝜎𝜎𝐵𝐵2 + 2𝑦𝑦(1 − 𝑦𝑦)𝜎𝜎𝐴𝐴 𝜎𝜎𝐵𝐵 𝜌𝜌𝐴𝐴𝐵𝐵

= 𝑦𝑦 2 *0.2^2 +(1 − 𝑦𝑦)2 *0.3^2- 2𝑦𝑦(1 −
𝑦𝑦)*0.2*0.3
=(0.2y-0.3(1-y))^2 -> y=0.6; So weight of B=40%.

FINA 3080 Prof. Chao Ying

 Lecture 7: Assignments
• Start Homework 2: due by 11am on November 16th,
2022 (Wednesday)
• Final Exam: 7 pm to 9 pm on Nov. 28th (Monday)
at LSK LT5
• Finish reading Chapter 5.1-2&5, 6.1-5 in BKM (and
scanned pages of “Investments” on Course Website)
• Start reading Chapter 7.1&3-5, 8.1-3;
– Practice problems in BKM:
• PS: Ch. 7(1-3, 8-20, 12-19, 21-29, 35); Ch. 8(1-8, 13,
15, 17, 20).
• CC: Ch. 6 (4-6); Ch. 7(1-4); Ch. 8(1-2, 4).
FINA 3080 Prof. Chao Ying 31