Thematic Area 3

UTILITY FUNCTION
PORTFOLIO RISK AND RETURN

Reading:
Bodie, Kane and Marcus, Chapters 5, 6
Sharpe, Alexander and Bailey, Chapter 6
Utility function. Portfolio risk
and return
Definitions of:
 Utility function, Diminishing marginal utility,
Diminishing marginal substitutability.
Expected utility model under uncertainty
 Risk aversion, risk seeking and risk neutrality,
Indifference curves, Quadratic utility function,
Absolute and relative risk aversion.
Mean-variance (Markowitz) approach for
evaluation of risky securities
 Calculation of expected return and standard
deviation of a portfolio, Covariance, Correlation
coefficient, Variance-Covariance matrix
 Utility function
Utility is derived from consumption of goods and
services: level of satisfaction expressed in utils
 Under certainty: no risk and no disutility
Increase in wealth, derived from investing in
assets, is a source of utility
Risk averse investors face disutility from
uncertainty of outcomes – measured through the
dispersion in expected returns
Common characteristics of utility functions
 1. Nonsatiation - individuals prefer higher to lower
levels of wealth
 Utility function, cont.
Common characteristics of utility functions,
 2. diminishing marginal utility - as wealth increases,
utility increases but at a decreasing rate
U

Wealth (X)

 Investors with diminishing marginal utility are risk averse

Expected utility function of the risk averse investor
Initial investment of $100.
Investor is offered:
E.g. U=X0.5 • the choice of 105 for certain, giving
him utility U3,
U
• a 50% chance for 110 and a 50%
chance of 100. Thus, expected value
U4 is 105, with utility U2.
U3
U2
U1
• Reason for lower utility (U2<U3) is
risk averse preferences. A risk
premium is required for uncertainty

100 105 110 Wealth(X)

The straight line is the expected utility line

Concave utility function of rational risk-averse investor
Expected utility function of the
risk seeking investor
Increasing marginal utility: U = X2

22.5K

12.5K
10K
2.5K

50 100 111.30 150 Wealth (X)

Not a rational behaviour

Expected utility function of the risk
neutral investor
Considers only the expected return, not the risk levels
U = X, expected utility line is the same as utility function

150

100

50

50 100 150 X

Not a rational behaviour

Selecting an optimal portfolio under
uncertainty
Utility function from investment in risky securities
(+) (-)
U = ƒ[E(r), σ]
Portfolios examined in terms of rewards and risks
Opportunity to choose the most desirable portfolio
Indifference curves - investors preferences related to
risk and return
Map or family of indifference curves
 Indifference curves of a risk
averse investor
Utility from higher return, disutility from higher risk
Positive marginal rate of substitution for all levels of risk
U1 preferred to U2 preferred to U3
E(r)

U1
U2
U3

σ
 Indifference curves
All portfolios that are on one indifference curve
provide the investor with the same level of utility,
although they have different expected returns and
standard deviations
Indifference curves do not intersect, as portfolios
on the same indifference curve are equivalent
Portfolios that lie on the indifference curve
furthest ‘northwest’ are the most desirable ones
There is an infinite number of indifference curves
for any investor
 Indifference curves of a risk
seeking investor
Investors that choose portfolios with higher standard
deviation

E(r)

U1
U2
U3

σ
The most desirable curve is the furthest northeast
 Indifference curves of a risk
neutral investor
Standard deviation is not important when evaluating
portfolios
Preferred portfolio is on the curve that is furthest north
E(r)
U1

U2

U3

σ
 Risk aversion
It is assumed that all investors are risk averse
The steeper the indifference curves the higher is the degree of
risk aversion
E(r) E(r)

σ σ
Utility Function and Risk Aversion Coefficient, A
1
U E (r ) − Aσ
= 2

2
Where
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
σ2 = variance of returns
 Estimating Risk Aversion
Observe individuals’ decisions when
confronted with risk
Observe how much people are willing to
pay to avoid risk
 Insurance against large losses
Spreadsheet Calculations of
Indifference Curves
 Indifference Curves for
U =0.05 and U =0.09 with A = 2 and A = 4
 When can we use the mean - variance
approach to evaluate risky alternatives?
When there is a normal distribution of asset returns
 normal distribution is bell shaped and symmetric around
the mean
 mean and standard deviation perfectly describe normal
distribution
 mathematical transformations may be used to convert
skewed and other non-normal distributions into a
normal one
 for the right skewed distribution we add 1 to the
return and compute the natural logarithm of this
value - lognormal distribution
The Normal Distribution
Normal and Skewed Distributions
(mean = 6%, SD = 17%)
Normal and Fat-Tailed Distributions
(mean = 0.1, SD = 0.2)
Probability of Investment Outcomes After 25
Years with A Lognormal Distribution
Frequency Distributions of Rates of
Return for 1926-2005
History of Rates of Returns of Asset Classes
for Generations, US, 1926- 2005
Annually Compounded, 25-Year HPRs from
Bootstrapped History and
A Normal Distribution (50,000 Observation)
Annually Compounded, 25-Year HPRs from
Bootstrapped History(50,000 Observation)
 Quadratic utility functions
When investors have quadratic utility functions
U (X) = b X + c X2
Where, U(X) is the utility from wealth, X is the wealth of
the investor and b and c are coefficients
The first derivative of quadratic utility function is showing
the marginal utility: b + 2 c X
 negative c: diminishing marginal utility
The second derivative is showing the changes in marginal
utility with respect to wealth: 2c
Quadratic utility function declines after a certain level, but
the declining part is not relevant - insatiability assumption
fails
Constraint: b + 2 c X > 0
Appropriate for investments with modest returns
 Absolute risk aversion
Measures how the investors preferences towards investing
in risky assets change when there is a change in wealth.
Assume that an investor has utility function U and wealth
X and a fair gamble Z whose expected value is: E(Z) = 0.
To be indifferent between the wealth and the risky gamble
on one side, and certain amount on the other side, the
investor must be paid the risk premium:
π = (1/2) σz2 [ - (U’’(X) / U’(X))]
ARA = - (U’’(X) / U’(X))
Decreasing ARA: more is invested in risky asset as wealth
increases and vice versa
 Relative risk aversion
Shows the percentage change of investment in the
risky asset as wealth increases
The proportion of the risk premium would be:
p = (1/2) σz2 [ - x * (U’’(x) / U’(x))]
RRA = x * ARA = - x * (U’’(x) / U’(x))
As wealth (x) increases, the proportion of wealth
invested in the risky asset will decrease and vice
versa.
RRA can be constant
 Mean-variance
(Markowitz) approach to
portfolio formation
 Modern portfolio theory
Markowitz, 1952
Single period approach
Investors are Risk Averse
There is a trade off between return and risk
Asset returns follow normal distributions – therefore
can use expected returns and variances as decision
variables
Selecting an optimal portfolio from a set of portfolios
- portfolio selection problem
Maximise expected returns and minimise risk -
diversification concept
 Probability Distributions
Price changes vs. Normal distribution
Microsoft - Daily % change 1990-2001
0.14

0.12
Proportion of Days

0.1

0.08

0.06

0.04

0.02

0
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9

Daily % Change
 Probability Distributions
Standard Deviation VS. Expected Return
Investment A
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
 Probability Distributions
Standard Deviation VS. Expected Return
Investment B
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
 Probability Distributions
Standard Deviation VS. Expected Return
Investment C
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
 Probability Distributions
Standard Deviation VS. Expected Return
Investment D
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
Theory of choice under uncertainty
The existence of risk means that there
are more than one possible outcomes
from investing in a single asset.
A probability distribution describes such
variables. For a single share example:
State of nature Probability(Pi) R1
1 0.3 10
2 0.4 20
3 0.3 30
 Probability Distributions & Summary
Statistics. Example
Expected Value - Mean, E(Ri)=μ:
E(R) = Σ Ri P(Ri)
= 0.3 x 10 + 0.4 x 20 + 0.3 x 30 = 20%
Variance, V(R) = σ2:
σ2 = E{[R - E(R)]2} = E(R2) - [E(R)]2
= Σ[Ri - E(R)]2 Pi = ΣRi2 Pi - [E(R)]2
=(10-20)2 x0.3 +(20-20)2 x0.4 +(30-20)2 x0.3=60
or σ2 =(0.3 x 100 + 0.4 x 400 + 0.3 x 900) - 202 =60
Standard Deviation: σ = 7.75%
 The expected return of a
portfolio of assets
Portfolio consists of a set of securities:
Rp = w1R1 + w2R2 + ... + wnRn = Σ wi Ri
Ri is the return on security i,
wi is % of portfolio value invested in the i-th security, where
Σwi = 1
Expected return of the portfolio, E(Rp), is calculated as:
E(Rp) = E[w1R1 + ... + wnRn]
= w1 E(R1) + w2 E(R2) + ... + wn E(Rn)
= Σ wi E(Ri)
 Expected return of portfolio;
example
An investor has a total wealth of £10,000
and buys a portfolio with two securities.
He invests £7,000 in security A which
offers an expected return of 18%.
The remaining £3,000 are invested in
security B to produce a 12% return.
The expected return of this portfolio is:
E(Rp) = 0.7 x 18% + 0.3 x 12% = 16.2%
 The expected return of a
portfolio with short selling
In the previous example, the two weights are
positive because the investor bought (is long on)
assets in the hope of selling them later at a
higher price - long position
Negative weights represent the opposite strategy
- short selling or short position
 The investor borrows shares from a broker, sells
them at the current market price and buys back the
shares later (hopefully) at the lower price
Short selling incurs unlimited losses
In reality, only large financial institutions invest
proceeds from sale.
The Variance of the sum of two variables
Consider the sum of two variables: RP= R1+ R2
The variance of Rp is defined as:
σp2 = V(Rp) = E{[R-E(R)][R-E(R)]’},
where R = (R1 R2)’ is the vector of R1 and R2
σp2 = V(Rp) = V(R1+R2) = σ12 + σ22 + 2 σ12,
= σ12 + σ22 + 2 ρ12 σ1 σ2
where σ12 and σ22 are the variances of R1 and R2,
-∞<σ12<+∞ is the covariance between R1 and R2, defined
σ12=E{[R1-E(R1)][R2-E(R2)] = Σ[R1i-E(R1)][R2i-E(R2)]Pi
-1 ≤ ρ12 ≤ +1 is the correlation coefficient defined as
ρ12=σ12/σ1σ2
 The Variance-Covariance Matrix
σp2 = V(Rp) = E{[R- E(R)] [R- E(R)]’}

 R1 − E ( R1 )  [ R1 − E ( R1 )][ ( R2 − E ( R2 )]
= E   
 2R − E ( R 2 
) 
 E{[ R1 − E ( R1 )] 2 } E{[ R1 − E ( R1 )][ R2 − E ( R2 )]}
= 
 E{[ R2 − E ( R2 )][ R1 − E ( R1 )]} E{[ R 2 − E ( R 2 )] 2
} 
σ 1 2 σ 12 
= 2
σ 21 σ 2 
 Calculating the Covariance
State of Nature Probability(Pi) R1 R2
1 0.3 10 -20
2 0.4 20 30
3 0.3 30 50
E(R1) = 20%, E(R2) = 21%
σ12 = E{[R1-E(R1)]2} = Σ[X1i-E(R1)]2 Pi = 60, σ22 = 789
Hence, σ1 = 7.75%, σ2 = 28.09%
Covariance:
σ12= E{[R1-E(R1)][R2-E(R2)]}=Σ[R1i-E(R1)] [R2i-E(R2)] Pi
= (10-20)(-20-21)x0.3+(20-20)(30-21)x0.4+(30-20)(50-21)x0.3
= 123 + 0 + 87 = 210
Correlation Coefficient:
ρ12 = σ12 / σ1 σ2 = 210 / (7.75 x 28.09) = 0.97
 In matrix form
Expected Re turns :
 E ( R1 )   20 
 E ( R )  =  21
 2   
Variance − Co var iance Matrix :
σ 12 σ 12   60 210 
=Σ = 2  
σ 21 σ 2   210 789 
Correlation Matrix :
 1 ρ12   1 0.97 
ρ  = 
 21 1   0.97 1 
 The Variance of a weighted portfolio
When weights are attached to the shares of the
portfolio, that is for Rp = w1R1 + w2R2
σp2 = w12 σ12 + w22 σ22 + 2 w1w2 σ12
= w12 σ12 + w22 σ22 + 2w1w2 ρ12 σ1 σ2

This utilizes the following general properties:

V(w Rp) = w2 V(Rp)
V(w1R1 ± w2R2) = w12 σ12 + w22 σ22 ± 2 w1 w2 σ12
= w12 σ12 + w22 σ22 ± 2 w1 w2 ρ12 σ1 σ2
 Portfolio Risk
The variance of a two stock portfolio is the sum of
these four boxes:
Stock 1 Stock 2
w 1 w 2 σ12 =
Stock 1 w 12 σ12
w 1 w 2 ρ12 σ1σ 2
w 1 w 2 σ12 =
Stock 2 w 22 σ 22
w 1 w 2 ρ12 σ1σ 2
 Portfolio Risk - Example
In earlier example, for portfolio of two shares,
with 60% and 40% in shares 1 & 2:
Total return on portfolio is: R =0.6R1 + 0.4R2
Expected return of the portfolio:
E(Rp)=E(0.6 R1+0.4 R2) =0.6 E(R1)+0.4 E(R2)
= 0.6 x 20 + 0.4 x 21 = 20.4%
Risk: V(Rp) = V(0.6 R1 + 0.4 R2)
=0.62 σ12 + 0.42 σ22 + 2 x 0.6 x 0.4 x σ12
=0.36 x 60 + 0.16 x 789 + 0.48 x 210 = 248.64
∴ σp = 15.77%
Effect of Diversification - Example
Stocks σ Avg Return % of Portfolio
ABC Corp 28% 15% 60%
Big Corp 42% 21% 40%
Correlation Coefficient = 0.4

Return = weighted avg = Portfolio = 17.4%

Standard Deviation = Portfolio = 28.1%

Let’s Add stock New Corp to the portfolio

Effect of Diversification - Example
Stocks σ Avg Return %of Portfolio
Portfolio 28.1% 17.4% 50%
New Corp 30% 19% 50%
Correlation Coefficient = 0.3

NEW Return = weighted avg = Portfolio = 18.20%

NEW Standard Deviation = Portfolio = 23.43%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION
Adding more stocks reduces portfolio risk
E.g. - Portfolio Expected Return
Suppose 55% of portfolio is invested in Bristol-
Myers and 45% in McDonald’s. Expected return in
first stock is 10%, while for the second it is 20%.
Expected return on BM is 0.55 x 10 =5.50%
and on McDonald’s it is 0.45 x 20 = 9.0%
Expected return on portfolio is
E(Rp) = 0.55 x 10 + 0.45 x 20 = 5.50 +9.0=14.50%

Further, assume σ1=17.1%, σ2=20.8%, ρ12=1.

 Example continued - Portfolio Risk
The variance covariance matrix of the portfolio is

Bristol - Myers McDonald' s

w 1 w 2 ρ12 σ1σ 2
Bristol - Myers w 12 σ12 = (.55) 2 × (17.1) 2
= .55 × .45 × 1 × 17.1 × 20.8
w 1 w 2 ρ12 σ1σ 2
McDonald' s w 22 σ 22 = (.45) 2 × (20.8) 2
= .55 × .45 × 1 × 17.1 × 20.8

Portfolio Variance = [(.55) 2 x (17.1) 2 ] + [(.45) 2 x (20.8) 2 ]

+ 2(.55 x .45 x 1 x 17.1 x 20.8) = 352.10
Standard Deviation = 352.1 = 18.7 %
Calculation of Return and Risk for
Portfolio of 3 stocks
Return and Risk for Portfolio of 3 stocks –
In Matrix form
Portfolio of 3 Shares, Pisteos, Boutaris, Klaoudatos
In Matrix form:
Returns, 3 shares Weights
Ri w'
0.0259 0.30 0.40 0.30
0.0011
0.0066

Variance-Covariance Matrix of 3 shares

VC w
PIST MPOK KLAO
PIST 0.0157 0.0067 0.0027 0.30
MPOK 0.0067 0.0399 0.0135 0.40
KLAO 0.0027 0.0135 0.0374 0.30

w' * VC
0 0 0

Portfolio Variance: Portfolio SD: Portfolio Return:

w' * VC * w =V(Rp)^0.5 w' * Ri
0.0165 0.1284 0.0102
 Portfolio Risk – N stocks
The shaded boxes contain variance terms; the remainder contain
covariance terms.

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK
Portfolio Risk in Matrix form
V(w’ R) = E{[w’ R – w’ E(R)] [w’ R – w’ E(R)]’}
= E{w’ [R - E(R)] w’[R - E(R)]’}
= w’ E{[R -E(R)] [R - E(R)]’} w
= w’ V(R) w  w1 
σ 12 σ 12 ... σ 1n   . 
  
= ( w1 ... wn )   . 
  
2 
σ n1 σ n 2 ... σ n   . 
w 
 n
=(w12σ12+...+wn2σn2) + (w1w2σ12 + w1w3σ13 + ...
+ wn-1wnσn-1,n + w2w1σ21 + w3w1σ31 + ... + wnwn-1σn,n-1)
n n n n n
σ p = ∑ wι σ ι + 2∑∑ w i w j σ i j = ∑∑ w i w j σ i j
2 2 2

i =1 i< j i =1 j =1
 The variance of the portfolio
There are n variances and n(n-1) covariances
which are added together to calculate the
portfolio variance.

Markowitz: as the number of securities in the

portfolio increases, the importance of
variances decreases and the importance of the
covariances increases.
Diversification and the number of
assets held in the portfolio
General formula for the variance of the portfolio of N assets:
σp2 = Σ wi2 σi2 + Σ Σ wi wj σij
If all assets in the portfolio are equally weighted, the weight of
each particular asset is 1/N
Variance equation can then be reformulated as:
σp2 = Σ(1/N)2 σi2 + Σ Σ (1/N)2 σij
There are N variance terms and N(N-1) covariance terms
Diversification and the number of
assets held in the portfolio
We can factor out 1/N from the variance term and (N-1)/N
from covariance term:
σp2 = (1/N) Σ σi2 /N + [(N-1)/N] Σ Σ σij / N(N-1)
The summation of the variance of asset i divided by the number
of assets is the average variance
The summation of the covariance term divided by N(N-1) is the
average covariance
Replacing the summations by averages gives:
σp2 = (1/N) Avg(σ2) + [(N-1)/N] Avg(σij)
Diversification and the number
of assets held in the portfolio
If all risk is company-specific, the covariance equals zero
As the number of assets in the portfolio increases the
portfolio variance approaches zero
In reality, assets are positively correlated and their total risk
has a market risk component as well
Therefore, the variance term will still approach zero, but the
covariance term will approach the average covariance as the
number of assets increases
Conclusion: company-specific risk can be driven to 0, while
the market risk cannot be diversified away as we increase
the number of assets in the portfolio
Diversification and the number of
assets held in the portfolio
Portfolio standard deviation

0
5 10 15
Number of Securities

Fama (1976): The relationship between portfolio risk and the

number of securities in the portfolio
Diversification and the number of
assets held in the portfolio
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
How many stocks make a diversified portfolio?
Risk Reduction of Equally Weighted Portfolios in Correlated (e.g.
shares in the same sector) and Uncorrelated (e.g. independent
insurance policies) Universes
 Portfolio variance–covariance matrices for 3
shares and 10 shares
(Population) Variance-Covariance Matrix
PIST MPOK KLAO
PIST 0.0157
MPOK 0.0067 0.0399
KLAO 0.0027 0.0135 0.0374

(Population) Variance-Covariance Matrix

PIST ELL MPOK EMP EEGA GTE KARE KLAO KLOK PAYL PETK TITK
PIST 0.0157
ELL 0.0121 0.0212
MPOK 0.0067 0.0070 0.0399
EMP 0.0165 0.0161 0.0093 0.0251
EEGA 0.0158 0.0157 0.0100 0.0212 0.0289
GTE 0.0114 0.0117 0.0099 0.0157 0.0146 0.0204
KARE 0.0078 0.0083 0.0113 0.0110 0.0110 0.0092 0.0147
KLAO 0.0027 0.0056 0.0135 0.0043 0.0077 0.0076 0.0075 0.0374
KLOK 0.0088 0.0137 0.0165 0.0104 0.0123 0.0099 0.0103 0.0121 0.0542
PAYL 0.0043 0.0025 0.0112 0.0049 0.0099 0.0061 0.0083 0.0123 0.0097 0.0402
PETK 0.0087 0.0123 0.0087 0.0118 0.0124 0.0115 0.0098 0.0124 0.0105 0.0081 0.0227
TITK 0.0123 0.0094 0.0061 0.0135 0.0152 0.0090 0.0077 0.0045 -0.0079 0.0041 0.0136 0.0335
Diversification - Concluding comments
Diversification is not minimising but averaging
market risk
Portfolio returns always depend on market
conditions
Unique or company specific risk can substantially
be reduced by diversification
20 or more randomly selected securities will form
a portfolio with small company specific risk
The lower the correlation between the assets in the
portfolio, the greater the possibility of risk
reduction
An example with real data from
ASE

Means, Variances, Standard

Deviations, Variance-
Covariance Matrix, Matrix of
Correlation Coefficients
 Sample summary statistics
Average return T
∑ Rt
R= t =1

T
Variance - Average value of squared deviations from
mean. A measure of volatility.
T

∑ t
( R − R ) 2

σˆ 2 = t =1

T −1
Standard Deviation – Square root of variance;
volatility in units of measurement of variable.
T

Covariance:
∑ (R 1t − R1 )( R2t − R2 )
σˆ 12 = t =1

T −1
Mean return & Variance-covariance matrix of returns for
3 ASE stocks. Period: 1990:1- 2001:6

PIST MPOK KLAO

St.Deviation 0.1259 0.2004 0.1940
Mean 2.59% 0.11% 0.66%
Variance 0.0157 0.0399 0.0374
(Population) Variance-Covariance Matrix
PIST MPOK KLAO
PIST 0.0157
MPOK 0.0067 0.0399
KLAO 0.0027 0.0135 0.0374
Correlation Coefficient Matrix
PIST MPOK KLAO
PIST 1
MPOK 0.2660 1
KLAO 0.1127 0.3500 1

Alpha Bank(PIST), Boutaris(MPOK), Klaoudatos(KLAO)

 Mean return & Risk for 3 ASE stocks and 3
portfolios. The benefits of portfolio formation
PIST MPOK KLAO PISTMPOK PISTKLAO MPOKKLAO
St.Deviation 0.1259 0.2004 0.1940 0.1318 0.1214 0.1620
Mean 2.59% 0.11% 0.66% 1.35% 1.62% 0.38%
Variance 0.0157 0.0399 0.0374 0.0174 0.0147 0.0263
Weights used: .5*PIST+.5*MPOK .5*PIST+.5*KLAO .5*MPOK+.5*KLAO

Risk-return profiles of 3 stocks and 3 portfolios

Alpha 3.00%
Bank(PIST), 2.59%, PIST
2.50%
Average Return

Boutaris 2.00%
(MPOK), 1.50%
1.62%,PISTKLAO
1.35%,PISTMPOK

Klaoudatos 1.00%
0.66%, KLAO
(KLAO) 0.50% 0.38%,MPOKKLAO
0.11%, MPOK
0.00%
0.0000 0.0500 0.1000 0.1500 0.2000 0.2500
Standard Deviation
Earlier portfolios were set with arbitrary weights
(50% in each stock).
 The benefits of diversification are obvious, as we
move northwesterly in relation to holding single
shares.
When weights are determined which minimize
the variance s.t. sum of weights =1 then the
global minimum portfolio is determined.
When variance is minimized s.t. sum of
weights=1 over a range of required rates of
return on the portfolio, then the efficient frontier
is determined.
We consider the last two problems later on.