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Lecture 2: Risk Aversion

BKM: 6.16
BMAN20072 Investment Analysis

Hening Liu

Outline

Mean-variance utility function and mean-variance criterion Indierence curve Combining risk-free and risky assets Capital allocation line (CAL) Risk tolerance and asset allocation

Risk-return trade-o

Gamble
risk taking for no purpose but enjoyment of risk itself

Speculation
undertaking of risk involved because one perceives a favorable risk-return trade-o

Risk averse investors


only want risk-free investment opportunities or speculative prospects with positive risk premium penalizes expected rate of return of risky investment by accounting for risks involved

Risk-return trade-o
Utility score 1 U = E (r ) A 2 2 Notation: U is utility value; E (r ) is expected return; A is investors coecient of risk aversion; 2 is variance of returns. Investors risk attitude:
risk averse (A > 0): variance of returns contributes negatively to utility value risk neutral (A = 0): cares only about the level of expected return risk lover (A < 0): adjust utility upward for the fun of risk

We focus on risk averse investors (A > 0)

Risk-return trade-o

Risk-return trade-o

Mean-variance criterion Consider two portfolios A and B A dominates B if E (rA ) E (rB ) and A B and at least one inequality is strict (rules out the equality).

Risk-return trade-o

Risk-return trade-o
Indierence curve links all points with same utility value on a diagram that plots E (r ) (on the vertical co-ordinate) against (on the horizontal co-ordinate) steeper for more risk averse investors a small increase in must be accompanied by a large increase in E (r ) to yield the same utility value higher (in northwest direction) for greater utility level

Risk-return trade-o

Combining risk-free and risky assets


Expected return from combining the risk-free asset and risky assets rC C = yrp + (1 y ) rf = y p

E (rC ) = yE (rp ) + (1 y ) rf = rf + y [E (rp ) rf ] C = rf + [E (rp ) rf ] p rC : returns of the combined portfolio rp : returns of the risky portfolio (a portfolio of many risky assets) rf : risk-free rate y : weight on the risky portfolio C : standard deviation of returns of the combined portfolio p : standard deviation of returns of the risky portfolio

Combining risk-free and risky assets

Combining risk-free and risky assets


Capital allocation line (CAL) E (rC ) = rf + C E (rp ) rf p

depicts all the risk-return combinations available for a risk free asset and a risky portfolio P slope of CAL ( E (rp ) rf ) equals p

increase in returns of the combined portfolio per unit of additional standard deviation incremental return per incremental risk reward to variability ratio Sharpe ratio

Combining risk-free and risky assets


CAL kinks when investors borrow to invest more in risky asset (y > 1) and borrowing rate>lending rate

Risk tolerance and asset allocation


For a risk aversion A, as the weight (y ) on the risky portfolio increases utility increases up to a certain level but eventually declines this is because volatility catches up to oset gains in expected returns

Risk tolerance and asset allocation

Which combination of the risk-free asset and the risky portfolio gives maximum utility? The optimal portfolio weight is y = E (rp ) rf 2 Ap

rp : returns of the risky portfolio (a portfolio of many risky assets) rf : risk-free rate y : weight on the risky portfolio p : standard deviation of returns of the risky portfolio

Risk tolerance and asset allocation

Risk tolerance and asset allocation


Optimal combined portfolio depends on risk aversion

Passive investment strategy

Why passive strategy?


avoids any direct or indirect security analysis achieves diversication. For example, a well-diversied portfolio of common stocks could be S&P500, NYSE or CRSP value-weighted portfolio

Capital market line (CML)


is a CAL where the risky portfolio P comprises of a well-diversied market portfolio depicts combinations available between the risk-free asset and the market portfolio

Passive investment strategy

Passive investment strategy


What is an average value of investors risk aversion coecient? Assume S&P500 to be the market portfolio (portfolio P ) Assume a risk premium of 8.4% and a standard deviation of 20.5% (19262005) Assume that S&P500 carries 76% of all invested wealth E (rp ) rf 2 Ap 0.084 0.76 = A 0.2052 A = 2.6 y =

Exercise Question I
Consider a portfolio that oers an expected rate of return of 12% and a standard deviation of 18%. T-bills oer a risk-free 7% rate of return. What is the maximum level of risk aversion for which the risky portfolio is still preferred to bills? The investor can only invest in either the risky portfolio or the risk-free T-bills. The utility value of the risky investment is 1 u = 0.12 A 0.182 2 The utility value of the risk-free investment is urf = 0.07 We are looking for A such that u = urf . This gives us Amax = 3.086. If A > Amax , the risk-free investment is strictly preferred. If A < Amax , the risky portfolio is strictly preferred.