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    Capital Allocation Between The Risky and The Risk-Free Asset

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    anushreego
    The document discusses capital allocation between risky and risk-free assets. It examines how different levels of risk aversion will affect the proportion of funds allocated to the risky asset versus the risk-free asset. The optimal allocation depends on the expected return and variance of each asset as well as the individual's risk tolerance. Well-diversified portfolios can reduce risk through correlation effects between the assets. The efficient frontier shows dominant combinations that offer the highest return for a given risk level.

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    Capital Allocation Between The Risky and The Risk-Free Asset

    Uploaded by

    anushreego
    76 views32 pages
    The document discusses capital allocation between risky and risk-free assets. It examines how different levels of risk aversion will affect the proportion of funds allocated to the risky asset versus the risk-free asset. The optimal allocation depends on the expected return and variance of each asset as well as the individual's risk tolerance. Well-diversified portfolios can reduce risk through correlation effects between the assets. The efficient frontier shows dominant combinations that offer the highest return for a given risk level.

    Original Title

    Risky-Riskfee Asset Allocation

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    © Attribution Non-Commercial (BY-NC)

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    The document discusses capital allocation between risky and risk-free assets. It examines how different levels of risk aversion will affect the proportion of funds allocated to the risky asset versus the risk-free asset. The optimal allocation depends on the expected return and variance of each asset as well as the individual's risk tolerance. Well-diversified portfolios can reduce risk through correlation effects between the assets. The efficient frontier shows dominant combinations that offer the highest return for a given risk level.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    76 views32 pages

    Capital Allocation Between The Risky and The Risk-Free Asset

    Uploaded by

    anushreego
    The document discusses capital allocation between risky and risk-free assets. It examines how different levels of risk aversion will affect the proportion of funds allocated to the risky asset versus the risk-free asset. The optimal allocation depends on the expected return and variance of each asset as well as the individual's risk tolerance. Well-diversified portfolios can reduce risk through correlation effects between the assets. The efficient frontier shows dominant combinations that offer the highest return for a given risk level.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 32

    Capital Allocation Between The

    Risky And The Risk-Free Asset


     It’s possible to split investment funds between
    safe and risky assets.
     Risk free asset: proxy; T-bills
     Risky asset: stock (or a portfolio)
    Issues
     Examine risk/return tradeoff.
     Demonstrate how different degrees
    of risk aversion will affect
    allocations between risky and risk
    free assets.
    rf = 7% rf = 0%

    E(rp) = 15% p = 22%

    y = % in p (1-y) = % in rf
    E(rc) = yE(rp) + (1 - y)rf

    rc = complete or combined portfolio

    For example, y = .75


    E(rc) = .75(.15) + .25(.07)
    = .13 or 13%
    E(r)

    E(rp) = 15%
    P
    E(rc) = 13%
    C

    rf = 7%
    F

    0 
    c 22%
    Since  r = 0, then
    f

     c = y p
    If y = .75, then
     c = .75(.22) = .165 or 16.5%
    If y = 1
     c = 1(.22) = .22 or 22%
    If y = 0
     c = (.22) = .00 or 0%
    Borrow at the Risk-Free Rate and invest in stock.
    Using 50% Leverage,
    rc = (-.5) (.07) + (1.5) (.15) = .19

    c = (1.5) (.22) = .33


    E(r)

    P
    E(rp) = 15%

    E(rp) - rf = 8%
    ) S = 8/22
    rf = 7%
    F

    0

    p = 22%
    E(r)

    ) S = .27

    9%
    ) S = .36
    7%


    p = 22%
     Greater levels of risk aversion lead to larger
    proportions of the risk free rate.

     Lower levels of risk aversion lead to larger


    proportions of the portfolio of risky assets.

     Willingness to accept high levels of risk for


    high levels of returns would result in
    leveraged combinations.
    U = E ( r ) - .005 A 2
    Where
    U = utility
    E ( r ) = expected return on the asset or
    portfolio
    A = coefficient of risk aversion
     = variance of returns
    E(r) The lender has a larger A when
    compared to the borrower

    Borrower

    7%
    Lender


    p = 22%
    Optimal Risky Portfolios
    St. Deviation

    Unique Risk

    Market Risk

    Number of
    Securities
    Range of values for 1,2
    + 1.0 >  > -1.0
    If = 1.0, the securities would be
    perfectly positively correlated
    If = - 1.0, the securities would be
    perfectly negatively correlated
    rp = W1r1 + W2r2 + W3r3

    2p = W1212 + W2212 + W3232


    + 2W1W2 Cov(r1r2)
    + 2W1W3 Cov(r1r3)
    + 2W2W3 Cov(r2r3)
    E(rp) = W1r1 + W2r2

    p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

    p = [w1212 + w2222 + 2W1W2 Cov(r1r2)]1/2


    E(r)

    13%
     = -1

     = .3

     = -1 =1
    %8

    12% 20% St. Dev


     The relationship depends on correlation
    coefficient.
     -1.0 <  < +1.0
     The smaller the correlation, the greater the
    risk reduction potential.
     If = +1.0, no risk reduction is possible.
    Sec 1 E(r1) = .10  1 = .15
    12 = .2
    Sec 2 E(r2) = .14  2 = .20
    22 - Cov(r1r2)
    W1 =
    21 + 22 - 2Cov(r1r2)
    W2 = (1 - W1)
    (.2)2 - (.2)(.15)(.2)
    W1 =
    (.15)2 + (.2)2 - 2(.2)(.15)(.2)

    W1 = .6733
    W2 = (1 - .6733) = .3267
    rp = .6733(.10) + .3267(.14) = .1131

     p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
    1/2
    2(.6733)(.3267)(.2)(.15)(.2)]

     p = [.0171]
    1/2
    = .1308
    (.2)2 - (.2)(.15)(.2)
    W1 =
    (.15)2 + (.2)2 - 2(.2)(.15)(-.3)

    W1 = .6087
    W2 = (1 - .6087) = .3913
    rp = .6087(.10) + .3913(.14) = .1157

     p = [(.6087)2(.15)2 + (.3913)2(.2)2 +
    1/2
    2(.6087)(.3913)(.2)(.15)(-.3)]

     p= [.0102]
    1/2
    = .1009
     The optimal combinations result in lowest
    level of risk for a given return.

     The optimal trade-off is described as the


    efficient frontier.

     These portfolios are dominant.


    E(r)

    Efficient
    frontier

    Individual
    Global
    assets
    minimum
    variance
    portfolio
    Minimum
    variance
    frontier

    St. Dev.
     The optimal combination becomes linear.

     A single combination of risky and riskless


    assets will dominate.
    E(r) CAL (P) CAL (A)

    M
    M
    P
    P CAL (Global
    minimum variance)
    A A

    P P&F M A&F 
    E(r) U’’’ U’’ U’

    Efficient
    S frontier of
    P risky assets

    Q
    Less
    risk-averse
    More investor
    risk-averse
    investor
    St. Dev
    CAL
    E(r)
    B
    Q
    P

    A
    rf F

    St. Dev

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