Portfolio Management and Performance Evaluation: 4321

University of Minnesota October 29, 2019

Professor Erik Loualiche (eloualic@umn.edu) Handout 4b

Portfolio Management and Performance Evaluation

This document summarizes the essential concepts and techniques of fina 4321. It is more detailed than the
syllabus but more condensed than the lecture notes. Anything in this document may appear in the final
exam. Some notations of this section may be slightly different from the lecture notes. Please note that this
document is not meant to replace the lecture notes but rather give you some hints on where to put your
emphasis.

TOPIC 2: Mean Variance Portfolio Analysis: Selecting Securities

EXERCISE 2.1 (Risk aversion and investment under uncertainty) Suppose there are two securities
in the market: a and b whose returns are summarized in the following table:

State Probability Value of ra Value of rb

1 : Boom p1 = 0.5 r1a = 4% r1b = 10%
2 : Recession p2 = 0.5 r2a = 4% r2b = 2%

Consider two investors in the market (Note: I index each investor by the subscript i = 1, 2). The preferences
of each investor i over risk and return are described by the following utility function
1 2
Ui = E[R] − × Ai × σ R for i = 1, 2
2
Each investor i has a different level of risk aversion (the Ai term in the utility function). Agent 1 has A1 = 0
and agent 2 has A2 = 5. Assuming that each investor can only choose one of these two securities, which
security will each investor choose? More generally, show that for this example, investors with a risk aversion
below 25 (i.e. Ai < 25) will choose asset b and investors with a risk aversion above 25 (Ai > 25) will choose
the risk free asset.
Solution: The first step that we need to do is to compute the returns and variance of the returns for these
portfolios. We need this because the preferences of the agents are specified over expected returns (E[R]) and
2
variance (σR ).
In this case, asset a is risk free because it gives the same return in each state (Boom or Recession): thus
there is no uncertainty about its returns. The ”expected” return of this asset is in fact a certain return and is
equal to 4%. The standard deviation of the returns is naturally 0% (why? Note that the returns don’t vary
across the two possible states of the economy, so naturally the variance is zero. Or just apply the formula
for the variance (see next paragraph) and see this for yourself. This should be completely obvious to you!).
For asset b, we have E[Rb ] = 0.5 × 10% + 0.5 × 2% = 6%. For the variance we apply the formula σR 2
b
=
2 2 2 2
E[(Rb − E[Rb ]) ] = 0.5 × (10 − 6) + 0.5 × (2 − 6) = (4%) .
Now, let’s see what each agent will choose. Agent 1 has a risk aversion of A1 = 0. This means that this
investor is risk-neutral: she doesn’t care about risk and thus will just pick the security with higher expected
returns. So she will choose security b (E[Rb ] > E[Ra ]).
When A2 = 5 , the investor is risk averse and to be able to find what this investor will choose, we need to
compare the utility that this investor derives from each security. In this case we have:

U2 (choose a) = 0.04 − 0.5 × 5 × 0 = 4

U2 (choose b) = 0.06 − 0.5 × 5 × 0.042 = 5.6%
2 Handout 4b: Portfolio Management and Performance Evaluation

so agent 2 will also choose security b since U2 (choose b) > U2 (choose a).
Regarding the second part of the question, to show that investors with Ai < 25 will choose asset b (i.e. the
relatively less risk averse agents will choose the more risky asset) and investors with Ai > 25 will choose
risk-free asset a, the trick is to find the level of risk aversion of an investor that is indifferent between the
two assets. Naturally, if this investor is indifferent between the two securities, then any investor that is less
risk averse than this agent will prefer the more risky asset and any investor that is more risk averse than
this agent will prefer the risk-free asset.
This indifferent agent (call it the asterisk investor and denote her risk aversion by A∗ ) will be indifferent
between the two assets if

U∗ (choose a) = U∗ (choose b)
4% = 6% − 0.5 × A∗ × (4%)2

and solving the previous equation for A∗ yields:

4% = 6 − 0.5 × A∗ × 4%2
−2%
A∗ =
−0.5 × 4%2
A∗ = 25

It thus follows that any investor with a risk aversion less than 25 will prefer the more risky asset (b) and
any investor with a risk aversion greater than 25 will prefer the less risky asset (asset a).

EXERCISE 2.2 (Risk aversion) A portfolio has an expected rate of return of 14% and a standard
deviation of 25%. The risk-free rate is 4%. An investor has the following utility function

2
Ui = E[R] − 0.5 × Ai × σR

Which value of the coefficient of risk aversion (A) makes this investor indifferent between the risky portfolio
and the risk-free rate asset?

Solution: To be indifferent between the two investments means that the utility that this investor derives
from each investment is the same. Since the T-Bill security is risk-free, the utility derived from this security is
2
simply the return of 4% (why? again, because it’s risk-free the variance is zero and thus the term 0.5×Ai ×σR
is zero). The utility derived from the risky asset (the portfolio) is

U (portfolio) = 14% − 0.5 × A × (25%)2

Therefore, to be indifferent we need

U (risk-free asset) = U (portfolio)

0.04 = 0.14 − 0.5 × A × 0.252
A = 3.2

From this analysis, we can also say that any investor with a risk aversion of A < 3.2 will choose the risky
security (portfolio) and any investor with a risk aversion of A > 3.2 will choose the risk-free asset.
Handout 4b: Portfolio Management and Performance Evaluation 3

EXERCISE 2.3 Consider an investor with mean-variance preferences defined by the following utility
function:
U = E[Ri ] − 0.5 × A × σ 2 (Ri )
where E[Ri ] and σ 2 (Ri ) are, respectively, the real expected return and the variance of the returns of security
i and A is the investor’s coefficient of risk aversion. The investor claims to be indifferent between a large
cap index with 17% expected real return and 20% standard deviation and a small cap index with 23% real
expected return and 28% standard deviation. Answer the following questions.
(a) What is more valuable to this investor: the large cap index or a riskfree asset that offers a 3% real return?
(b) Suppose there is inflation and the investor knows what the inflation rate will be for this period. The
investor has $100 in cash and suppose that the only security in which she can invest is the riskfree asset
(which offers a certain 3% real return). What is the level of inflation that makes this investor indifferent
between not investing and investing in the riskfree asset? (NOTE: the inflation can be negative (in which
case we typically call it deflation))
Solution:
(a) The indifference condition allows us to determine the risk aversion coefficient of the investor which is:
0.23 − 0.17
0.17 − 0.5 × A × 0.202 = 0.23 − 0.5 × A × 0.282 ⇒ A = = 3.125
0.5 × (0.282 − 0.202 )

For this level of risk aversion, the utility that this investor derives from the large cap index is 10.75%
(0.17 − 0.5 × 3.125 × 0.202 ). This is more than the utility of 3% (certain ) that the investor gets by investing
in the riskfree asset. Thus this investor prefers the large cap index.
Some of you thought that indifferent meant A = 0, and I don’t understand why. In any case, make sure you
look at the homeworks and lecture slides for the final.
(b) Since inflation is known, holding cash gives a certain real return (RR) that you can find using the Fisher
equation. Then, to be indifferent between the two investments (hold cash or riskfree rate), you just need to
find the inflation rate that makes the real rate of return of both investments the same.
1
The real return (RR) of holding cash is given by the Fisher equation, i.e., RR = 1+i − 1 (Why? The nominal
return (NR) of holding cash is zero: did you ever receive interest on holding cash?). Now, for this investor
to be indifferent between the two options we need

RR hold cash = RR Riskfree asset

1
− 1 = 0.03
1+i
1
i = −1
1.03
i = −0.0291 or i = −2.91%

i.e. inflation= −2.91% (deflation).

EXERCISE 2.4 Suppose investors have mean variance preferences described by:

Ui = E[R] − 0.5 × Ai × σ 2 (R)

where Ui is the utility index level of agent i, Ai is the coefficient of risk aversion, E[R] and σ 2 (R) are the
expected return and variance of a certain investment respectively. Suppose there are three mutually exclusive
(i.e. you can’t combine them to form a portfolio) investment opportunities available:
(i) a small-cap index with expected real return of 12% and a standard deviation of 30%
(ii) a stock index with expected real return of 8% and a standard deviation of 20%
(iii) risk free asset with real return of 2%.
4 Handout 4b: Portfolio Management and Performance Evaluation

There are three investors in the market. Agents 1 and 2 are risk averse. Agent one has a risk aversion of
A1 = 2 and agent two has a risk aversion of A2 = 5. The third agent is risk neutral. Answer the following
questions.
(a) Rank these investment opportunities from best to worst for each investor.
(b) What must be the risk aversion of an investor who claims to be indifferent between the small cap index
(i) and the stock index (ii)?
(c) Suppose now that risk free asset is no longer offered and the risky investments are still mutually exclusive.
Assume no inflation. What would the more risk averse investor (with Ai = 5) chose to do if she has $1000
in cash? How inflation might change her choice?
Solution:
(a) In order to rank the different investment options, we need to compute the utility that each agent gets
from each investment option. This is presented in Table 1. For the investor with risk aversion A = 2, the
ranking (from best to worst) is (ii), (i), (iii). For the investor with risk aversion A = 5, the ranking (from
best to worst) is (iii), (ii), (i). For the risk neutral investor (A = 0) all that matters is the expected return
of the investment and thus the ranking of the investments (from best to worst) is (i), (ii), and (iii).

Investment Utility (in percent)

option A1 = 2 A2 = 5 A3 = 0
(i) 3.0 −10.5 12.0
(ii) 4.0 −2.0 8.0
(iii) 2.0 2.0 2.0

Rankings
A1 = 2 A2 = 5 A3 = 0
Best (ii) (iii) (i)
----- (i) (ii) (ii)
Worst (iii) (i) (iii)

Table 1: Utility and ranking of each investment option by each investor

(b) For an investor to be indifferent between the small cap index (i) and the stock index (ii) the two options
must yield the same level of utility. Let A∗ be the risk aversion of this investor. The following equality must
hold:

Utility (option i) = Utility (option ii)

∗
0.12 − 0.5 × A × 0.30 2
= 0.8 − 0.5 × A∗ × 0.202

Solving the equation, yields A∗ = 1.6. Thus, an investor with a coefficient of risk aversion of A∗ = 1.6 will
be indifferent between these two investment options.
(c) To answer this question, note that the information provided about the return characteristics of the
different investment options is in real terms. Agents care about real not nominal returns, and thus real
returns is what matters for computing the utility levels and compare alternatives.

1. Let’s first consider the case of no inflation. Since not investing is always an option (i.e. keep the
cash), the investor must compare the utility from this option with the existing alternatives. Without
inflation, not investing has an expected return of zero with zero risk (you save $1 in cash today, you get
$1 in cash tomorrow), and thus the utility of not investing is zero. For the other two risky investment
opportunities the utility level that the investor can achieve is negative (see Table 1). Thus, without
inflation, the investor prefers not to invest the $1,000 and keep the cash.
If there is inflation, the previous conclusion might change. This follows from the fact that inflation
Handout 4b: Portfolio Management and Performance Evaluation 5

affect the real return of holding cash by making it negative. To see this, recall the Fisher equation:
1 + NR
1 + RR =
1+i
where RR is the real return, NR is the nominal return and i is the inflation rate. Since the nominal
return on cash is zero (the interest payments on cash are zero), then the presence of inflation will make
the real return of holding cash negative (you save $1 today, but tomorrow, even tough you still receive
the $1 , this $1 cannot buy the same amount of goods as it did yesterday). Thus, if the inflation rate
is too high, the real return of investing on cash will be very negative in which case the investor might
prefer the least risky of the two indices in lieu of cash.