CHAPTER 5 RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETS

1. a. The expected cash flow is: (0.5 x $70,000) + (0.5 x 200,000) = $135,000 With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is 14%. Therefore, the present value of the portfolio is: $135,000/1.14 = $118,421 b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of $135,000, then the expected rate of return [E(r)] is derived as follows: $118,421 x [1 + E(r)] = $135,000 Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return with the required rate of return. c. If the risk premium over T-bills is now 12%, then the required return is: 6% + 12% = 18% The present value of the portfolio is now: $135,000/1.18 = $114,407 d. For a given expected cash flow, portfolios that command greater risk premia must sell at lower prices. The extra discount from expected value is a penalty for risk. When we specify utility by U = E(r) .005A2, the utility from bills is 7%, while that from the risky portfolio is U = 12 .005A x 182 = 12 1.62A. For the portfolio to be preferred to bills, the following inequality must hold: 12 1.62A > 7, or, A < 5/1.62 = 3.09. A must be less than 3.09 for the risky portfolio to be preferred to bills. Points on the curve are derived as follows: U = 5 = E(r) .005A2 = E(r) .0152 The necessary value of E(r), given the value of 2, is therefore: 0% 5 10 15 2 0 25 100 225

2.

3.

E(r) 5.0% 5.375 6.5 8.375 5-1

20 25

400 625

11.0 14.375

The indifference curve is depicted by the bold line in the following graph (labeled Q3, for Question 3). 4. Repeating the analysis in Problem 3, utility is: U = E(r) .005A2 = E(r) .022 = 4 leading to the equal-utility combinations of expected return and standard deviation presented in the table below. The indifference curve is the upward sloping line appearing in the graph of Problem 3, labeled Q4 (for Question 4).

E(r)

U(Q4,A=4) U(Q3,A=3)

5 4

U(Q5,A=0)

U(Q6,A<0)

5-2

 0% 5 10 15 20 25

2 0 25 100 225 400 625

E(r) 4.00% 4.50 6.00 8.50 12.00 16.50

The indifference curve in Problem 4 differs from that in Problem 3 in both slope and intercept. When A increases from 3 to 4, the higher risk aversion results in a greater slope for the indifference curve since more expected return is needed to compensate for additional . The lower level of utility assumed for Problem 4 (4% rather than 5%), shifts the vertical intercept down by 1%. 5. The coefficient of risk aversion of a risk neutral investor is zero. The corresponding utility is simply equal to the portfolio's expected return. The corresponding indifference curve in the expected return-standard deviation plane is a horizontal line, drawn in the graph of Problem 3, and labeled Q5. A risk lover, rather than penalizing portfolio utility to account for risk, derives greater utility as variance increases. This amounts to a negative coefficient of risk aversion. The corresponding indifference curve is downward sloping, as drawn in the graph of Problem 3, and labeled Q6. 3. [Utility for each portfolio = E(r) .005 x 4 x 2. We choose the portfolio with the highest utility value.) 4. [When investors are risk neutral, A = 0, and the portfolio with the highest utility is the one with the highest expected return.] b The portfolio expected return can be computed as follows: Portfolio stan ar $.20" 5-3 $.20" Portfolio e!iation
x17.12%)___
market

6.

7.

8. 9. 10.

Wbills x 0.0

Wmarket x = 5" #.0

_______________________________________________________________(=w

#%.#2"

.2 .4 .( .& #.0 ##.

5 5 5 5 5

.& .( .4 .2 0.0

$.20 $.20 $.20 $.20 $.20

&.'( %.52 (.(& 5.&4 5.00

#'.%0 #0.2% (.&5 '.42 0

Computing the utility from U = E(r) .005 x A2 = E(r) .0#52 (because A = 3), we arrive at the following table. Wbills Wmarket E(r) )2 U(A=') U(A=5) ******************************************************************* 0. .2 .4 .6 .8 1.0 1.0 .8 .6 .4 .2 0 9.20% 8.36 7.52 6.68 5.84 5.0 17.12 13.7 10.27 6.85 3.42 0 293.09 187.69 105.47 46.92 11.70 0 4.80 5.54 5.93 5.97 5.66 5.0 1.87 3.67 4.88 5.51 5.55 5.0

The utility column implies that investors with A = 3 will prefer a position of 60% in the market and 40% in bills over any of the other positions in the table; those with A = 5 will prefer 20% in the market and 80% in bills. The column labeled U(A = 5) in the table above is computed from U = E(r) .005 A2 = E(r) .0252 (since A = 5). It shows that the more risk averse investors will prefer the position with 20% in the market index portfolio, rather than the 40% market weight preferred by investors with A = 3. Expected return = .' &" + .% #&" = 15% per year. Standard deviation = .% 2&" = #$.(" +n!estment ,ro,ortions.% 2%" = .% ''" = .% 40" = #5. Your reward-to-variability ratio '0.0" #&.$" 2'.#" 2&.0" in ./bills in sto0k A in sto0k 1 in sto0k 2

12.

13.

#4.

= = .'5%#

Client's reward-to-variability ratio = = .'5%# 16.

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30 25 20 E( r) 15 % 10 5 0 0 10 20 30 40

CA L (Slope = .3571) P

Client

( % )

17. a. E(r2) = rf + 3E(rP) rf4 5 = 8 + l0y If the expected return of the portfolio is equal to 16%, then solving for y we get: #( = & + l05, an 5 = = .&

Therefore, to get an expected return of 16% the client must invest 80% of total funds in the risky portfolio and 20% in T-bills. b. Investment proportions of the client's funds: 20% in T-bills, .& 2%" = 2#.(" in sto0k A .& ''" = 2(.4" in sto0k 1 .& 40" = '2.0" in sto0k 2 C = .& P = .& 2&" = 22.4" ,er 5ear

0.

#&. a. C = 5 2&". If your client wants a standard deviation of at most 18%, then y = 18/28 = .6429 = 64.29% in the risky portfolio.

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b. #$. a.

E(r2) = & + #05 = & + .(42$ #0 = & + (.42$ = #4.42$"

56 = = = = .'(44 So the client's optimal proportions are 36.44% in the risky portfolio and 63.56% in Tbills. b. E(r2) = & + #056 = & + .'(44 #0 = ##.(44" C= .'(44 2& = #0.20"

20. a. Slope of the CML = = .20 The diagram is on the following page. b. My fund allows an investor to achieve a higher mean for any given standard deviation than would a passive strategy, i.e., a higher expected return for any given level of risk.

CML and C AL
18 16 14 12 10 8 6 4 2 0 0 10 Standard Deviation 20 30 Expected Retrun

CA L: Slope = .3571

CML: Slope = .20

21. a. With 70% of his money in my fund's portfolio the client gets a mean return of 15% per year and a standard deviation of 19.6% per year. If he shifts that money to the passive 5-6

portfolio (which has an expected return of 13% and standard deviation of 25%), his overall expected return and standard deviation become: E(r2) = rf + .%3E(r 7) rf4 In this case, rf = 8% and E(rM) = 13%. Therefore, E(r2) = & + .% (#' &) = ##.5" The standard deviation of the complete portfolio using the passive portfolio would be: C = .% M = .% 25" = #%.5" Therefore, the shift entails a decline in the mean from 14% to 11.5% and a decline in the standard deviation from 19.6% to 17.5%. Since both mean return and standard deviation fall, it is not yet clear whether the move is beneficial or harmful. The disadvantage of the shift is that if my client is willing to accept a mean return on his total portfolio of 11.5%, he can achieve it with a lower standard deviation using my fund portfolio, rather than the passive portfolio. To achieve a target mean of 11.5%, we first write the mean of the complete portfolio as a function of the proportions invested in my fund portfolio, y: E(r2) = & + 5(#& &) = & + #05 Because our target is: E(rC) = 11.5%, the proportion that must be invested in my fund is determined as follows: ##.5 = & + #05, 5 = = .'5

The standard deviation of the portfolio would be- C = 5 2&" = .'5 2&" = $.&". Thus, by using my portfolio, the same 11.5% expected return can be achieved with a standard deviation of only 9.8% as opposed to the standard deviation of 17.5% using the passive portfolio. b. The fee would reduce the reward-to-variability ratio, i.e., the slope of the CAL. Clients will be indifferent between my fund and the passive portfolio if the slope of the after-fee CAL and the CML are equal. Let f denote the fee. 8lo,e of 2A9 :it; fee = = Slope of CML (which requires no fee) = = .20. Setting these slopes equal we get: = .20

5-7

#0 f = 2& .20 = 5.( f = #0 5.( = 4.4" ,er 5ear

22. a. The formula for the optimal proportion to invest in the passive portfolio is: 56 = Wit; E(r7) = #'"< rf = &"< M = 25"< A = '.5, :e =et y* = = .2286 b. The answer here is the same as in 9b. The fee that you can charge a client is the same regardless of the asset allocation mix of your client's portfolio. You can charge a fee that will equalize the reward-to-variability ratio of your portfolio with that of your competition. 23. If rf = 5" b>t r= $", then the CML and indifference curves are as followsE(r)

borrow lend
13

CAL CML

25

24.

For y to be less than 1.0 (so that the investor is a lender), risk aversion must be large enough that: 5= ? # 5-8

 > = #.2& For y to be greater than 1.0 (so that the investor is a borrower), risk aversion must be small enough that: 5= @ #

< = .(4 For values of risk aversion within this range, the investor neither borrows nor lends, but instead holds a complete portfolio comprised only of the optimal risky portfolio: 5 = # for .(4 #.2&

25.

a. b.

The graph of problem 23 has to be redrawn here with E(r) = 11% and = #5" Aor a len in= ,osition, > = 2.(% Aor a borro:in= ,osition, < = .&$ +n bet:een, 5 = # for .&$ A 2.(%

5-9

E(r)

M
13 11 9

CML CAL

15 25

2(.

.;e maxim>m feasible fee, enote f, e,en s on t;e re:ar /to/!ariabilit5 ratio. Aor 5 ? #, t;e len in= rate, 5", is !ie:e as t;e rele!ant risk/free rate, an :e sol!e for f from= f = ( = #.2" Aor 5 @ #, t;e borro:in= rate, $", is t;e rele!ant risk/free rate. .;en :e noti0e t;at e!en :it;o>t a fee, t;e a0ti!e f>n is inferior to t;e ,assi!e f>n be0a>se= .#' < = .#( 7ore risk tolerant in!estors (:;o are more in0line to borro:) t;erefore :ill not be 0lients of t;e f>n e!en :it;o>t a fee. (+f 5o> sol!e for t;e fee t;at :o>l make in!estors :;o borro: in ifferent bet:een t;e a0ti!e an ,assi!e ,ortfolio, as :e i abo!e for len in= in!estors, 5o> :o>l fin t;at f is ne=ati!e- t;at is, 5o> :o>l nee to pay t;em to 0;oose 5o>r a0ti!e f>n .) .;e reason is t;at t;ese in!estors esire ;i=;er risk/;i=;er ret>rn complete portfolios and thus are in the borrowing range of the relevant CAL. In this range the reward to variability ratio of the index (the passive fund) is better than that of the managed fund. 5-10

27. a. If 1957 - 2009 is assumed to be representative of future expected performance, A = 2, E(rM) rf = 4.20%, and M = 17.74% (we use the standard deviation of the risk premium from the last column of Table 6.8), then y* is given by: y* = = 4.20/(.01 x 2 x 17.742)= .6672 That is, 66.72% should be allocated to equity and 33.28 % to bills. b. If 1993 - 2009 is assumed to be representative of future expected performance, A = 2, E(rM) rf = 7.56%; and M = 18.89%, then y* is given by: y* = 7.56/(.01x2x18.892)= 1.0593 Therefore, 105.93% of the complete portfolio is allocated to equity and -5.93% to bills. c. In (a) the market risk premium is expected to be lower while the market risk is expected to be at a lower level than in (b). The fact that the reward-to-variability ratio is expected to be much lower in (a) (4.20/17.74 = 0.2368) versus 7.56/18.89=0.40) explains the much smaller proportion invested in equity. 28. Assuming no change in tastes, that is, an unchanged risk aversion coefficient, A, the denominator of the equation for the optimal investment in the risky portfolio will be higher. The proportion invested in the risky portfolio will depend on the relative change in the expected risk premium (the numerator) compared to the change in the perceived market risk. Investors perceiving higher risk will demand a higher risk premium to hold the same portfolio they held before. If we assume that the risk-free rate is unaffected, the increase in the risk premium would require a higher expected rate of return in the equity market. The expected return of your fund = T-bill rate + risk premium = 6% + 10% = 16%. The expected return of the client's overall portfolio is .6 16% + .4 6% = 12%. The standard deviation of the client's overall portfolio is .6 14% = 8.4%. Reward to variability ratio = = = .71. [.6 50,000 + .4 (30,000) 5,000 = 13,000] b a) Curve 2 b) Point F

29.

30. 31.

32. 33.

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Appendix
1.

5A

Your $50,000 investment will grow to $50,000(1.06) = $53,000 by year end. Without insurance your wealth will then be: Probabilit5 .$$$ .00# Wealt; C25',000 C 5',000

Bo fireAire-

which gives expected utility .00#x)lo=e(5',000) + .$$$ x lo=e(25',000) = #2.4'$5&2 and a certainty equivalent wealth of exp(12.439582) = $252,604.85 With fire insurance at a cost of $P, your investment in the risk-free asset will be only $(50,000 P). Your year-end wealth will be certain (since you are fully insured) and equal to (50,000 P) x 1.06 + 200,000. Setting this expression equal to $252,604.85 (the certainty equivalent of the uninsured house) results in P = $372.78. This is the most you will be willing to pay for insurance. Note that the expected loss is "only" $200, meaning that you are willing to pay quite a risk premium over the expected value of losses. The main reason is that the value of the house is a large proportion of your wealth. 2. a. With 1/2 coverage, your premium is $100, your investment in the safe asset is $49,900 which grows by year end to $52,894. If there is a fire, your insurance proceeds are only $100,000. Your outcome will be: Probabilit5 .00# .$$$ Wealt; C#52,&$4 C252,&$4

Aire Bo fire

Expected utility is .00#xlo=e(#52,&$4) + .$$$xlo=e(252,&$4) = #2.440222 an W2E = ex,(l2.440222) = C252,%(%

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