Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Lecture 3:
Portfolio choices and asset allocation

MFIN6214 Financial Theory and Policy – T3 2020

Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The art of building a model

I Framework for analyzing a given problem.

I Tradeoff between realism and tractability.
I Level of complexity:
I Keep it simple: a model need not be comprehensive. The goal
is to isolate and highlight one effect.
I Be aware and beware of simplifying assumptions.
I The “everything is endogenous, everything is possible” pitfall.
I Stylized model vs. model to be taken to the data (calibration
or estimation).
I Test a model: test the predictions generated by the model.
Out-of-sample tests (need two subsets of data).
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Portfolio choice

I Portfolio choice problem: allocate wealth to a set of available

assets.
I Investors are assumed to be risk averse and expected utility
maximizers.
I Simplest problem: investors can invest in a riskfree asset and
in a risky asset, whose payoffs are realized at the end of the
period (the problem is static, not dynamic).
I Think of the risky asset as a stock market index, while
Treasury bonds may be viewed as the riskfree asset.
I Determine the best trade-off between risk and expected
return.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The portfolio choice problem

I An individual with utility function u can invest his wealth w0

in two assets: the risky asset with return x̃,and the riskfree
asset with return rf .
I Denote by z the $ investment in the risky asset.
I There are no short sales constraints or credit constraints: z is
allowed to be larger than w0 or less than 0.
I For now, we take returns (or asset prices) as given.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The portfolio choice problem

I The investor’s objective is to max the expected utility of his

end-of-period wealth w1 . The optimization problem is


max V (z) = E u (w0 − z)(1 + rf ) + z(1 + x̃)
z

I The first-order condition (FOC) is

V 0 (z ? ) = E x̃ − rf u 0 w˜1 = 0




I V is strictly concave: the FOC is necessary and sufficient.

I z ? > 0 iff E [x̃] > rf . Hint: calculate V 0 (0).
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The portfolio choice problem

I Proposition 1: The amount invested in the risky asset is

positive (resp. negative) if and only if its expected excess
return is positive (resp. negative).
I Risk aversion is a second order effect for very small risks,
whereas the superior expected return is a first order effect.
I A FOC candidate may not exist. The first-order condition is
not satisfied for any value of z if x > rf for any x, or x < rf
for any x.
I What is the optimal investment in the risky asset? Let’s
determine this!
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The portfolio choice problem

The effects of changes in risk aversion and in wealth

I Proposition 2: If u2 is a concave transformation of u1 ,

then the optimal exposure to any risk independent of initial
wealth is lower under u2 than under u1 .
I Intuition: Share in risky assets decreases with risk aversion.
I Proposition 3: An increase (resp. decrease) in wealth
always increases (resp. decreases) the amount invested in the
risky asset if and only if absolute risk aversion is decreasing.
I Implication: Richer agents with CRRA utility invest more in
risky assets.
I What happens with CARA preferences?
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Approximate solution to the portfolio choice problem (1)

I Let us derive the optimal asset allocation.

I Decompose the risky return into three components:
x̃ = rf + k + ˜. Notice that E [x̃] = rf + k
I where k is the risk premium and ˜ is the source of risk with
E [˜
] = 0.
I The optimal investment in the risky asset is z ? (k), with
z ? (0) = 0 (see Proposition 1 above). Suppose that k > 0.
The FOC is:

−rf u 0 (w0 −z ? (k))(1+rf )+z ? (k)(1+rf +k+˜




E rf +k+˜ ) = 0

Or
E k + ˜ u 0 w0 (1 + rf ) + z ? (k)(k + ˜) = 0



Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Approximate solution to the portfolio choice problem (2)

I This condition is satisfied at the optimum. It should be

satisfied for any value of the parameter k. Remember that the
FOC is:

E k + ˜ u 0 w0 (1 + rf ) + z ? (k)(k + ˜) = 0




I Take the total derivative of the FOC w.r.t. k:

2
E [u 0 (w˜1 )] + z 0? (k)E k + ˜ u 00 (w˜1 ) + z ? (k)E k + ˜ u 00 (w˜1 ) = 0
  

Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Approximate solution to the portfolio choice problem (3)

I Evaluating this expression at k = 0 (in which case z = 0 and
w1 = w0 (1 + rf )):
1 1
z 0? (0) =
var [˜
] A(w1 )
I Finally, use a first-order Taylor expansion of z ? (k) around k = 0:

z ? (k) ≈ z ? (0) + kz 0? (0) for small k

I The investment in the risky asset for a given k is
E [x̃] − rf 1
z? ≈
var [x̃] A(w1 )
I The share of wealth invested in the risky asset is
z? E [x̃] − rf 1
≈
w0 var [x̃] R(w0 )
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Approximate solution to the portfolio choice problem (4)

I Example: investor with log utility (R(w ) = 1).

I Consider an investment in the stock market vs. in Treasury
bonds. The stock market has an expected excess return of 6%
and a standard deviation of 18%.
I Portfolio allocation: 185% of wealth should be invested in the
stock market (!) Cf. the equity premium puzzle.
I What if RRA = 2?
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The CARA-normal case

Tractability at the expense of plausibility?
I The certainty equivalent approach: under the CARA-normal
case, solving the general problem is equivalent to solving the
CE , i.e.,
ρ
max Eu[w̃1 (z)] ⇐⇒ max {E(w̃1 (z)) − Var[w̃1 (z)]} .
z z
| {z2 }
CE
I The optimal z is defined by
E [x̃] − rf 1
z? =
σ2 ρ
I In particular, the amount invested in the risky asset is
independent of wealth (!)
I Only the mean and the variance of returns on the one hand,
and the coefficient ρ of absolute risk aversion on the other
hand, matter.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The mean-variance paradigm

Quite popular in academic circles in the 1950-60s, and still popular among practitioners

I The mean-variance hypothesis: Investors rank feasible

portfolios on the basis of their expected payoffs (+) and the
variance of their payoffs (−).
I The investor therefore selects a portfolio which is
mean-variance efficient: for a given variance of returns, the
expected return cannot be increased.
I Assume that there are N available assets with random future
payoffs {x̃i }i=1,...,N (possibly including the riskfree asset) and
exogenous prices {pi }i=1,...,N . The set of mean-variance
efficient portfolios is obtained by letting M vary in the
following problem:
XN XN N
X
min var [ zi x̃i ] s.t. E[ zi x̃i ] ≥ M pi zi = w0
{zi }i=1,...,N
i=1 i=1 i=1
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Mean-variance optimization

I We can work with returns and portfolio weights instead of

payoffs and dollars invested.
pi zi x̃i M
I Define ωi ≡ w0 , r˜i ≡ pi , and m ≡ w0 .
I The optimization problem can be rewritten as
XN
min var [ ωi r˜i ] s.t.
{ωi }i=1,...,N
i=1
N
X
ri ] ≥ m
ωi E [˜
i=1
N
X
ωi = 1
i=1
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Diversification
I Assume for simplicity that all assets have the same expected return r¯. No
riskfree asset is available. Denote the variance-covariance matrix by Σ:
N X
X N
var [ω T r˜] = ω T Σω = ωi ωj cov (˜
ri , r˜j )
i=1 j=1

I The problem of the investor is therefore to combine assets in a portfolio

in order to minimize its variance:

min ω T Σω s.t. 1T ω = 1
{ω}

I The optimal weights are given by (derive the solution as homework)

Σ−1 1
ω=
1T Σ−1 1
I Remarkably, this portfolio allocation rule applies to all investors: neither
the degree of risk aversion nor the level of wealth affect portfolio
allocation among risky assets.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Diversification

I In the simple case where returns are i.i.d., the

variance-covariance matrix is proportional to the identity
matrix. The optimal portfolio is then given by
1
ω= 1
N
I Portfolio allocation rule: invest the same amount in each
asset.
I See DeMiguel, Garlappi, and Uppal (RFS 2009) for an
evaluation of the out-of-sample performance of the 1/N
portfolio.
I Can this be an equilibrium if different assets are in different
net supply? Market prices = market clearing prices.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The two funds (mutual fund) theorem

I Theorem: All mean-variance efficient portfolios can be
constructed with a combination of the riskfree asset and a
single portfolio of risky assets.
I We introduce a riskfree asset, we let the risky assets have
different distributions of returns, and we rewrite the
optimization problem of the investor as
min ω T Σω s.t. ωrf rf + E [ω T r˜] ≥ m ωrf + 1T ω = 1
{ω}

with Lagrange multipliers respectively µ and λ.

I The FOC (w.r.t. ω and ωrf , respectively) are
Σω = µE [˜
r ] + λ1 and µrf + λ = 0
I Substituting for λ,
r ] − rf 1)
Σω = µ(E [˜
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

The two funds theorem

I If the expected return constraint is binding, µ > 0. The
optimum is
ω ? = µΣ−1 (E [˜
r ] − rf 1)
where µ is set so that the portfolio weights sum up to one.1
I This equation says that the allocation among risky assets is
independent of the expected return (or targeted return) m.
The expected return m determines the weight ωrf given to the
riskfree asset, which may be larger than one.
I Effect of risk preferences and wealth: allocation between the
riskfree asset (ωrf ) and the portfolio of risky assets (1 − ωrf ).
I If the expected return constraint is not binding (this requires
that m ≤ rf ), then µ = 0, the preceding equations give λ = 0
and ω = 0: optimal to invest only in the riskfree asset.
1
Method: substitute the optimal ω ? (which is a function of µ) into the
expected return constraint, and use the portfolio weights constraint to find the
optimal ω ? and ωrf as a function of the model parameters.
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Hedging in a CARA-normal framework

I Assume that the end-of-period wealth is
w̃ = ỹ + zrf (1 + rf ) + z T x̃, which is additive in an exogenous
random component ỹ (think about labor income) and the
payoff of a portfolio of assets, including the riskfree asset.
I The problem:
ρ
max − exp{−ρ(E [w̃ ] − var [w̃ ])} s.t. z T p + zrf = w0
z 2
I The FOC (we substitute for zrf in the objective function):
ρ 
E [x̃] − p(1 + rf ) − 2var [x̃]z + 2cov (x̃, ỹ ) = 0
2
 1

z ? = (var [x̃])−1 − cov (x̃, ỹ ) + E [x̃] − p(1 + rf )
ρ
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Hedging in a CARA-normal framework

I The demand for risky assets comprises two terms:
I The hedging portfolio: the investor uses financial assets to
partially hedge his exposure to shocks to his labor income, say.
Notice that this portfolio does not depend on risk aversion.
I The speculative demand for assets: the investor takes a long
(resp. short) position in assets whose expected return is larger
(resp. lower) than the riskfree rate. The magnitude of this
position is a function of the excess return, of the investor risk
aversion, and of the volatility of asset returns.
I The two funds theorem only applies to the speculative
portfolio. The hedging portfolio depends on individual
circumstances.
I In this model, even though investors may have different levels
of wealth and risk aversion, any difference in the composition
of portfolios of risky assets must stem from different
exposures to exogenous shocks ỹ .
Modelization Standard portfolio problem CARA-normal Mean-variance efficient portfolios Hedging

Exercises
Homework

I Derive the Global Minimum Variance Portfolio (slide 15)

I In the case of two risky assets (without a riskfree asset)
I In the case of N risky assets using matrix algebra
I 4.1 in the textbook
I 4.2 in the textbook
I 4.3 in the textbook