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1、RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETSLecture 3Allocation to Risky AssetsInvestors will avoid risk unless there is a reward.The utility model gives the optimal allocation between a risky portfolio and a risk-free asset.Risk and Risk AversionSpeculationTaking considerable risk for a com

2、mensurate gainParties have heterogeneous expectationsRisk and Risk AversionGamble Bet or wager on an uncertain outcome for enjoymentParties assign the same probabilities to the possible outcomesRisk Aversion and Utility ValuesInvestors are willing to consider:risk-free assetsspeculative positions wi

3、th positive risk premiumsPortfolio attractiveness increases with expected return and decreases with risk.What happens when return increases with risk?Table 6.1 Available Risky Portfolios (Risk-free Rate = 5%)Each portfolio receives a utility score to assess the investors risk/return trade offUtility

4、 FunctionU = utilityE ( r ) = expected return on the asset or portfolioA = coefficient of risk aversions2 = variance of returns = a scaling factorTable 6.2 Utility Scores of Alternative Portfolios for Investors with Varying Degree of Risk AversionMean-Variance (M-V) CriterionPortfolio A dominates po

5、rtfolio B if:AndEstimating Risk AversionUse questionnairesObserve individuals decisions when confronted with riskObserve how much people are willing to pay to avoid riskCapital Allocation Across Risky and Risk-Free Portfolios Asset Allocation:Is a very important part of portfolio construction.Refers

6、 to the choice among broad asset classes.Controlling Risk:Simplest way: Manipulate the fraction of the portfolio invested in risk-free assets versus the portion invested in the risky assetsBasic Asset AllocationTotal Market Value$300,000Risk-free money market fund$90,000Equities$113,400Bonds (long-t

7、erm)$96,600Total risk assets$210,000Basic Asset AllocationLet y = weight of the risky portfolio, P, in the complete portfolio; (1-y) = weight of risk-free assets:The Risk-Free AssetOnly the government can issue default-free bonds.Risk-free in real terms only if price indexed and maturity equal to in

8、vestors holding period.T-bills viewed as “the risk-free assetMoney market funds also considered risk-free in practiceFigure 6.3 Spread Between 3-Month CD and T-bill Rates Its possible to create a complete portfolio by splitting investment funds between safe and risky assets.Let y=portion allocated t

9、o the risky portfolio, P(1-y)=portion to be invested in risk-free asset, F.Portfolios of One Risky Asset and a Risk-Free AssetExample Using Chapter 6.4 Numbersrf = 7%rf = 0%E(rp) = 15%p = 22%y = % in p(1-y) = % in rfExample (Ctd.)The expected return on the complete portfolio is the risk-free rate pl

10、us the weight of P times the risk premium of PExample (Ctd.)The risk of the complete portfolio is the weight of P times the risk of P:Example (Ctd.)Rearrange and substitute y=sC/sP:Figure 6.4 The Investment Opportunity Set Lend at rf=7% and borrow at rf=9%Lending range slope = 8/22 = 0.36Borrowing r

11、ange slope = 6/22 = 0.27CAL kinks at PCapital Allocation Line with LeverageFigure 6.5 The Opportunity Set with Differential Borrowing and Lending RatesRisk Tolerance and Asset AllocationThe investor must choose one optimal portfolio, C, from the set of feasible choicesExpected return of the complete

12、 portfolio:Variance:Table 6.4 Utility Levels for Various Positions in Risky Assets (y) for an Investor with Risk Aversion A = 4Figure 6.6 Utility as a Function of Allocation to the Risky Asset, yTable 6.5 Spreadsheet Calculations of Indifference CurvesFigure 6.7 Indifference Curves for U = .05 and U

13、 = .09 with A = 2 and A = 4 Figure 6.8 Finding the Optimal Complete Portfolio Using Indifference Curves Table 6.6 Expected Returns on Four Indifference Curves and the CALPassive Strategies: The Capital Market LineThe passive strategy avoids any direct or indirect security analysisSupply and demand f

14、orces may make such a strategy a reasonable choice for many investorsPassive Strategies: The Capital Market LineA natural candidate for a passively held risky asset would be a well-diversified portfolio of common stocks such as the S&P 500.The capital market line (CML) is the capital allocation line

15、 formed from 1-month T-bills and a broad index of common stocks (e.g. the S&P 500).Passive Strategies: The Capital Market LineThe CML is given by a strategy that involves investment in two passive portfolios: virtually risk-free short-term T-bills (or a money market fund) a fund of common stocks that mimics

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