There are very few people or organizations

who have any presumptive edge over a

low-cost, no-load set of indices, particularly
on a risk corrected basis. People used to say
that youre settling for mediocrity. Isnt it
interesting that the best brains on Wall
Street cant achieve mediocrity?

James Tobin, 1981

"for his analysis of
financial markets and
their relations to
expenditure decisions,
employment,
production and prices"

Investing with Risk-Free Asset

Wong Wei Kang
Do not circulate without permission

Outline
Investing with a risk-free asset
Borrowing and Lending

Capital Allocation Line (CAL)

The Optimal Risky Portfolio
The Tangent Portfolio
The Efficient Portfolio of Risky Assets

Expected Returns & the Efficient Portfolio

Separation Property or Separation Theorem
Utility, Risk Aversion and Indifference Curves
Passive Strategies and the Capital Market Line (CML)
4

Recall Figure 7.10 The Efficient Frontier with Multiple Risky Assets
It provides the best risk-return combinations with multiple risky assets

Introducing a Risk-Free Asset

Now suppose we introduce the opportunity to
invest in a risk-free asset.
How does this affect the investors portfolio choices?

By definition, a risk-free asset has

Zero variance and standard deviation
Zero covariance with all assets
Note: the risk-free rate is fixed (thats why its riskfree) and does not move with other assets
6

Risk-Free Asset
Only the government can issue default-free
securities
A security is risk-free in real terms only if its price
is indexed and maturity is equal to investors
holding period

T-bills viewed as the risk-free asset

Money market funds also considered risk-free
in practice
7

Figure 6.3 Spread Between 3-Month CD and T-bill Rates

The spread tends to increase with economic crises

Risk and Return with a Risk-Free Asset

Consider the following complete portfolio:
x = portfolio weight on the risky portfolio, P
(1 - x) = portfolio weight on the risk-free asset, F

The expected return on the complete portfolio:

E ( rc ) = (1 x ) rf + xE ( rP )
E ( rc ) = rf + x "# E ( rP ) rf $%
The standard deviation of the complete portfolio:

C = x P
9

Risk and Return with a Risk-Free Asset

Rearrange and substitute x = C/P

"# E ( rP ) rf $%
E ( rC ) = rf +
C
P

This equation is called the capital allocation line (CAL)

Slope =

( )

E rP rf

The slope is the reward-to-volatility ratio: it gives the

incremental return per incremental risk. It is also called the
Sharpe ratio (which corrects for leverage)
Note that the equation of a straight line is y = mx + c, where m
is the slope and c is the vertical intercept.
10

Figure 6.4 The Capital Allocation Line (CAL)

CAL to the right of point P: if investors can borrow at the risk-free rate

11

Figure 11.9B The RiskReturn Combinations from Combining a

Risk-Free Investment and a Risky Portfolio

12

Borrowing & Buying Stocks on Margin

Buying Stocks on Margin
Borrowing money to invest in a stock.
A portfolio that consists of a short position in the riskfree investment is known as a levered portfolio.
A short position in the risk-free asset = borrowing money at
the risk-free rate.

An investment financed at least partly by borrowing is

called a leveraged investment.
The larger the fraction of an investment financed by
borrowing, the greater the degree of leverage and the greater
the risk

Margin investing is a risky investment strategy.

13

Digression: Leverage is risky

Consider buying a house on mortgage. Lower down
payment means more borrowing
By owning a house, you become exposed to increases or
decreases in the price of that asset.
With a smaller down payment, you are said to be highly
leveraged, exposed to large potential changes in the value of
your investment.
Return on your investment / down payment as a result of
a 10 percent increase in
a 10 percent decrease in
Down Payment
the price of your house.
the price of your house.
100%
10%
10%
20

50

50

10

100

100

200

200
14

Digression: Leverage is risky

Suppose the price of the house was $1 million. If you
made 5% down payment and borrowed the remaining 95%
You paid $50k in cash and borrowed $950k
Suppose there is a 10% drop in housing price, i.e., a drop of
$100k
The return on your investment of $50k is 200%
The market price of the house is now $900k. You own a house
worth $900k but you still owe the bank $950k
The equity in your house = the market price of the house the
amount you owe on a loan = $900k $950k = $50k
You have negative equity, or are upside down or underwater
on your mortgage
You have incentive to default on your loans, e.g., by simply
moving out and abandoning your homes
15

Figure 6.5 Kinked CAL with Different Borrowing and Lending Rates

16

Optimal Risky Portfolio or Tangent Portfolio

or the Efficient Portfolio of Risky Assets
Investors will find the CAL with the highest reward-tovolatility ratio to find the optimal risky portfolio on the
efficient frontier
Maximize the slope of the CAL for any possible
portfolio, P
The objective function is the slope:

Sp =

E (rp ) rf

Recall that the slope is also called the Sharpe ratio

17

Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL
The tangent portfolio (portfolio P) is the optimal risky portfolio or the efficient portfolio

18

Efficient Frontier with Risk-Free Asset

With only risky assets, the efficient frontier (of risky
assets) provides the best risk-return tradeoffs
With a risk-free asset, the optimal CAL with the highest
reward-to-volatility ratio provides the best risk-return
tradeoffs
It is the efficient frontier including risk-free investment
The tangent portfolio is the efficient portfolio of risky
assets

Every investor should be on the efficient frontier

regardless of their preferences
Preferences will determine where on the optimal CAL (to
be shown precisely later)
19

Figure 11.10B The Tangent or Efficient Portfolio

P on this graph = the minimum variance portfolio, not the tangent portfolio

20

Efficient Portfolio & Required Returns

If every investor wants to be on the optimal CAL line (with the
highest reward-to-volatility ratio) to get the best risk-return
tradeoffs and will not settle for anything less, what are its
implications for a firms cost of capital?
Suppose a firm has a new investment i, what is an investors
required return for holding that investment?
If a firm wants to raise new capital, obviously investors must find
its rate of return attractive to invest in it
We will derive a condition to determine whether we can improve
a portfolio by adding more of a given security, and use it to
calculate an investors required return for holding an investment
21

Efficient Portfolio & Required Returns

Consider an arbitrary portfolio of risky securities, P.
To determine whether P has the highest possible Sharpe
ratio, consider whether we could raise its Sharpe ratio
by adding investment i to the portfolio P
Specifically, we will short the risk-free assets (i.e.,
borrow at the risk-free rate) and invest the proceeds in
investment i
If we do this, there are two consequences:
Our portfolio expected return will increase by E[Ri] rf
Our portfolio risk will increase by SD(Ri) Corr(Ri, Rp)
22

Efficient Portfolio & Required Returns

If we borrow to invest in investment i, we would earn the expected
return of investment i minus the risk-free rate
The contribution of investment i to the portfolio volatility depends
on the risk that i has in common with the portfolio
measured by i s volatility multiplied by its correlation with P
nondiversifiable risk with respect to portfolio P

Is the gain in return from investing in i adequate to make up for the

increase in risk or volatility?
The incremental-return to incremental-volatility ratio, i.e., the
Sharpe ratio of our investment strategy equals

E [Ri ] rf
SD(Ri ) Corr(Ri ,RP )

23

Efficient Portfolio & Required Returns

But instead of investing in investment i, we could also have
invested more in portfolio P itself.
In this case, the incremental reward to incremental risk ratio
would simply be the Sharpe ratio of portfolio P itself

E [RP ] rf
SD(RP )
Adding i to the portfolio P will improve our Sharpe ratio if

E [Ri ] rf
SD(Ri ) Corr(Ri ,RP )
!###
#"####
$

Incremental reward to risk ratio by investing in i

>

E [RP ] rf
SD(RP )
!#
#"##
$

Incremental reward to risk ratio by investing in P

24

Efficient Portfolio & Required Returns

Thus adding i to the portfolio P will improve our
Sharpe ratio if
Additional return from taking the same risk investing in P
%#######
#&########
'
E[RP ] rf
E [Ri ] rf > SD(Ri ) Corr(Ri ,RP )
!###
#"####
$
!#"#$
SD(RP )
!#"#$
Incremental volatility
Additional return
from investment i

from investment i

Return per unit of volatilty

available from portfolio P

25

Efficient Portfolio & Required Returns

Rewriting, we conclude that adding i to the portfolio
P will improve our Sharpe ratio if
SD(Ri ) Corr(Ri ,RP )
E [Ri ] rf >
E[RP ] rf
!#"#$
SD(RP )
!###
#"####
$
Additional return

from investment i

of investment i with portfolio P

26

Efficient Portfolio & Required Returns

Define Beta of Portfolio i with Portfolio P

P
i

SD(Ri ) Corr(Ri ,RP )

=
SD(RP )

P
i

SD(Ri )
Cov(Ri ,RP )
=

SD(RP )
SD(Ri )SD(Rp )

P
i

Cov(Ri ,RP )
=
Var(RP )

iP measures the sensitivity of the investment i to the fluctuations of

the portfolio P
For each 1% change in the portfolios return, investment is return is
expected to change by iP% due to risks that i has in common with P
27

Efficient Portfolio & Required Returns

Adding i to the portfolio P will improve our Sharpe ratio if:

E[Ri ] > rf +

P
i

(E[RP ] rf )

Let ri denote the required return of investment i

ri = rf +

P
i

(E[RP ] rf )

The expected return that is necessary to compensate for the risk

investment i will contribute to the portfolio

Increasing the amount invested in i will increase the Sharpe

ratio of portfolio P if its expected return E[Ri] exceeds the
required return ri
28

Expected Returns & the Efficient Portfolio

If a securitys expected return exceeds its required return, we will
add the security to improve the performance of portfolio P
As we buy security i, its correlation (thus its beta) with our portfolio
will increase, until E[Ri] = ri
When E[Ri] = ri for all i, no trade can improve the Sharpe ratio of
the portfolio P, so our portfolio P is the optimal, efficient portfolio
with the highest Sharpe ratio, i.e.,
A portfolio is efficient if and only if the expected return of every
available security equals its required return (defined with reference
to the portfolio).
Expected Return of a Security

E[ Ri ] = ri rf +

eff
i

(E[ Reff ] rf )

29

Expected Returns & the Efficient Portfolio

Reff is the return of the efficient / tangent portfolio
We can determine the appropriate risk premium for an
investment from its beta with the efficient or tangent
portfolio
The efficient or tangent portfolio, which has the highest
possible Sharpe ratio of any portfolio in the market,
provides the benchmark that identifies the systematic
risk present in the economy
30

Expected Returns & the Efficient Portfolio:

Alternative Expression
Alternatively, rewrite the expression. Then adding i to the
portfolio P will improve our Sharpe ratio if

E [Ri ] rf
SD(Ri ) Corr(Ri ,RP )
!###
#"####
$

Incremental reward to risk of investment i

>

E[RP ] rf
SD(RP )
!#"#$

Sharpe Ratio of Portfolio P

Then a portfolio is efficient if and only if for every available

security

E [Ri ] rf
SD(Ri ) Corr(Ri ,Reff )
!####"####
$

Incremental reward to risk of investment i

E[Reff ] rf
SD(Reff )
!#
#"##
$

Sharpe Ratio of Efficient Portfolio

31

Risk Aversion &

Mean-Variance (M-V) Criterion
Investors who are risk averse reject investment portfolios that
are fair games or worse.
A fair game is a risky investment with a risk premium or
expected excess return of zero
Risk Aversion Mean-Variance (M-V) Criterion: Portfolio A
dominates portfolio B if:

E(rA ) E(rB )
and

A B
32

Figure 6.1 Trade-off between risk and return

MV criterion: Any portfolio in quadrant I
is preferable to portfolio P for risk averse investors

33

Figure 6.2 The Indifference Curve

To be indifferent, an increase in must be compensated by an increase in E(r)

34

Figure 6.7 Indifference Curves for the less risk averse (A = 2)

and more risk averse (A = 4), where U = E(r) 0.5 A2

35

Figure 6.8 Portfolio C is the Optimal Complete Portfolio

36

Figure 7.8 Determination of the Optimal Overall Portfolio

37

The Separation Property / Theorem

Portfolio choice problem may be separated into two
independent tasks
Determination of the optimal risky portfolio is purely
technical
Everyone invests in P, regardless of their degree of risk
aversion

Allocation of the complete portfolio to risk-free versus

the risky portfolio depends on personal preference
More risk averse investors put more in the risk-free asset
Less risk averse investors put more in P
38

References
BD, Section 11.5, Section 11.6.
BKM, Chapters 6 and 7.

39