Preliminaries

The risk-return tradeoff

Utility functions

Lecture 2: Risk and return

SAPM [Econ F412/FIN F313 ]

Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15

1/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Agenda

1 Preliminaries

Introduction
2 The risk-return tradeoff

Example
Indifference curves
3 Utility functions

Quadratic utility
Example revisited

2/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Introduction

Investments
Households (people like you and me), earn income. Typically, there

are two things we can do with our income:

consume
save (and invest)

Why invest?
because we want to trade consumption inter-temporally (across

periods)
in the absence of investment alternatives, we would simply store

rupees under ones mattress

we earn a return on our investment, and make our money work for us

Bottom Line: Saving (and investment) is simply a way of postponing

todays consumption to tomorrow

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Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Introduction

Investments trade consumption across time

Consumption tomorrow

Trading consumption across time

117

Not suprisingly, there are

many alternative
investments available

110
17% rate of return

10% rate of return

Early chapters of BKM(M)

describe details of some
available financial
instruments and markets
This picture hides a key
issue: the differing risk of
the investments

100

Consumption today

INVA - Term 4 - 2007 - Indian School of Business

Not seen in the above figure: the risk and return of the investments

4/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Introduction

Investments trade consumption across time

Consumption tomorrow

Trading consumption across time

117

Not suprisingly, there are

many alternative
investments available

110
17% rate of return

10% rate of return

Early chapters of BKM(M)

describe details of some
available financial
instruments and markets
This picture hides a key
issue: the differing risk of
the investments

100

Consumption today

INVA - Term 4 - 2007 - Indian School of Business

Not seen in the above figure: the risk and return of the investments

4/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Trade-off between risk and return: An example

Consider the investment choices facing an investor with
100,000
Choice 1: A risk-free investment which will grow to 105,000 in one

period
Choice 2: A risky investment which will grow to 150,000 with a

probability 0.6, or decrease to 80,000 with a probability 0.4

Return comparison
The risk-free rate here is rf =

105,000
100,000

1 = 5%

The returns of the risky investment in each state are

150,000
100,000

1 = 50% and

80,000
100,000

1 = 20% respectively

The expected return on the risky investment is

(0.6 50%) + (0.4 20%) = 22%
5/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Trade-off between risk and return: An example

Consider the investment choices facing an investor with
100,000
Choice 1: A risk-free investment which will grow to 105,000 in one

period
Choice 2: A risky investment which will grow to 150,000 with a

probability 0.6, or decrease to 80,000 with a probability 0.4

Return comparison
The risk-free rate here is rf =

105,000
100,000

1 = 5%

The returns of the risky investment in each state are

150,000
100,000

1 = 50% and

80,000
100,000

1 = 20% respectively

The expected return on the risky investment is

(0.6 50%) + (0.4 20%) = 22%
5/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Risk and decision making

Traditional risk measures
Variance of the risky return = 0.6(0.50 0.22)2 + 0.4(0.20 0.22)2 = 0.1176

Standard deviation= (0.1176) = 34.29%

Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?

Choice depends upon...

Investors attitude towards risk which we need to specify: this is the domain of utility
theory

Models that facilitate mathematical comparison of risk and return of different

investment choices are known as asset pricing models
6/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Risk and decision making

Traditional risk measures
Variance of the risky return = 0.6(0.50 0.22)2 + 0.4(0.20 0.22)2 = 0.1176

Standard deviation= (0.1176) = 34.29%

Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?

Choice depends upon...

Investors attitude towards risk which we need to specify: this is the domain of utility
theory

Models that facilitate mathematical comparison of risk and return of different

investment choices are known as asset pricing models
6/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Risk and decision making

Traditional risk measures
Variance of the risky return = 0.6(0.50 0.22)2 + 0.4(0.20 0.22)2 = 0.1176

Standard deviation= (0.1176) = 34.29%

Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?

Choice depends upon...

Investors attitude towards risk which we need to specify: this is the domain of utility
theory

Models that facilitate mathematical comparison of risk and return of different

investment choices are known as asset pricing models
6/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example

Investor behavior
Basic assumptions
Assumption 1: Investors like more returns with less risk, i.e., we are

greedy
Assumption 2: Investors are risk averse

The essence of risk aversion

Consider a gamble where you flip a coin and get 15 if it turns up

heads, and 5 if it turns up tails. Clearly, the expected payoff of the

gamble is 10
Question: How much would you pay as an entry fee to be able to
play this gamble?
If you are willing to pay 12 (> 10): you are risk preferred
If you are willing to pay 10 (= 10): you are risk neutral
If you are willing to pay 8 (< 10): you are risk averse
7/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Indifference curves

A general indifference curve

All combinations of the two goods that result in the same utility (or

happiness) lie on an indifference curve

12
10

Beer

8
6
4
2
0
0

Pizza

8/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Indifference curves

Risk-return indifference curves

U3
Expected
Return, E(r)

U2

U1

Increasing
utility

Standard Deviation, (r)

Observations

9/12

Assumption 1 (non-satiation) means that utility increases as we proceed in the northwesterly

direction

Assumption 2 (risk aversion) means that at lower levels of risk, it takes a small amount of return to
induce the investor to take a given amount of risk. Since risk averse investors want to be
increasingly compensated with increasing risk, the curve is steeper as you climb

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Indifference curves

Risk-return indifference curves

U3
Expected
Return, E(r)

U2

U1

Increasing
utility

Standard Deviation, (r)

Observations

9/12

Assumption 1 (non-satiation) means that utility increases as we proceed in the northwesterly

direction

Assumption 2 (risk aversion) means that at lower levels of risk, it takes a small amount of return to
induce the investor to take a given amount of risk. Since risk averse investors want to be
increasingly compensated with increasing risk, the curve is steeper as you climb

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Indifference curves

Comparing different investors

E(r)

19%

More risk-averse
investors have
steeper
indifference curves

E(r)

Less risk-averse
investors have
flatter indifference
curves

14%
12%

15% 20%

10/12

(r)

Lecture 2: Risk and return

15% 20%

(r)

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Quadratic utility

The quadratic utility function

Utility functions are ways of representing investor preferences
We shall use the quadratic utility function

1
U(E(r), (r)) = E(r) A 2 (r)
2

A is called the coefficient of risk aversion

A > 0: Risk averse investor
A = 0: Risk neutral investor
A < 0: Risk loving investor

Note that the quadratic utility function satisfies our assumptions of

non-satiation and risk aversion

Confirm for yourself that with this utility function,
indifference curves with increasing utility move to the north-west
More risk averse investors (with greater values of A) have steeper indifference curves

11/12

Lecture 2: Risk and return

Ramana Sonti

Preliminaries

The risk-return tradeoff

Utility functions

Example revisited

Back to our example

Recall the parameters of our earlier example:

rf = 0.05, E(r) = 0.22, (r) = 0.3429
Lets calculate the utility of a particular investor with A = 3 for

investment choices 1 and 2

Utility with risk-free asset = 0.05 (0.5 3 02 ) = 0.05
Utility with risky asset = 0.22 (0.5 3 0.34292 ) = 0.0436

Clearly, for this investor, the risk-free asset is the better choice
Verify that for A = 2.0, the risky asset is the better choice
In practice, choices are not binary, of course we have the ability to

form portfolios of these assets

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Lecture 2: Risk and return

Ramana Sonti