Portfolio Selection with a Riskless Security:

Professor Lasse H. Pedersen

Prof. Lasse H. Pedersen

Outline
Portfolio selection with a risk-free and 1 risky security Portfolio selection with a risk-free and 2 risky securities Next class: a risk-free and many risky securities

Prof. Lasse H. Pedersen

Properties of the Risk-Free Asset

The risk-free return is denoted Rf The risk-free return is known for sure:

E[Rf] = Rf f2=0 cov(Rf,Ri) =0 for any other asset i. f, =0 for any other asset i.

Prof. Lasse H. Pedersen

A Portfolio with a Risk-Free and a Risky Asset

Let be the fraction of wealth invested in the risky asset (the rest is invested in the risk-free asset) Expected portfolio return:

E[R p ] = E [ R i ] + (1 )R f = R f + E[R i R f ]
Variance of portfolio return:
2 p = 2 i2

The Standard deviation is: p = | | i

Prof. Lasse H. Pedersen 4

Investment Opportunity Set

with a Risk-free and a Risky Asset
Consider various portfolios p (which are long in the risky asset and long or short in the riskless asset). What is the risk-return relationship (combine the expressions for expected return and volatility given on previous slide):

E[R p ] = R f +

E[R i ] R f p i

= R f + (Sharpe ratio of i) p = R f + SR i p
The Capital Allocation Line.
Prof. Lasse H. Pedersen 5

Investment Opportunity Set: the Capital Allocation Line

Example:
Risky asset: US stock market : E[RUS]=13.55%, US=15.35% Risk-free : Rf=7%

Hence:

E[R p ] = 0.07 + SR p

SR =

E[RUS ] R f 0.13550.07 = = 0.4267 0.1535 US

Prof. Lasse H. Pedersen 6

SR (Sharpe Ratio) = return premium per unit of risk

Investment Opportunity Set: the Capital Allocation Line

E(R)

E(RUS) = 13.55% E(Rp) = 11% Rf = 7% US P Risk-Free

p
Prof. Lasse H. Pedersen

15.35%

Optimal Portfolio Choice

Portfolio K: Indifference Curves optimal choice for riskaverse investor

E[R]

long in the risky asset long in risk free Portfolio L:

K Rf
Long-in-risk-free Borrowing region

optimal choice for risktolerant investor borrow risk free asset to invest in risky asset

US

Prof. Lasse H. Pedersen

Two Risky and One Risk-Free Assets

US a nd Ja pa n with Ris k Free As s e t 0.16 B 0.15 0.14 0.13 0.12 Er 0.11 0.1 0.09 0.08 0.07 0.06 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 MVE US A JP

The tangency portfolio maximizes the Sharpe ratio:

SR i =

E[Ri ] R f i

Prof. Lasse H. Pedersen

Optimal Portfolio Selection with Two Risky and One Risk-Free Assets
1. Create the set of possible mean-SD combinations from different portfolios of risky assets 2. Find the tangency portfolio, that is, the portfolio with the highest Sharpe ratio:

SR i =

E[Ri ] R f i

3. Choose the combination of the tangency portfolio and the risk-free asset to suit your risk-return preferences.
Prof. Lasse H. Pedersen 10

Two-Fund Separation
All investors hold combinations of the same two mutual funds:
The risk-free asset The tangency portfolio

An investors risk aversion determines the fraction of wealth invested in the risk-free asset But, all investors should have the rest of their wealth invested in the tangency portfolio.
Prof. Lasse H. Pedersen 11