5.

5 Asset Allocation Across

Risky and Risk Free
Portfolios

5-1
 Allocating Capital Between Risky &
Risk-Free Assets
◼ Possible to split investment funds between safe and
risky assets
◼ Risk free asset Rf : proxy;T-bills or money market fund
________________________
◼ Risky asset or portfolio Rp:______________________
risky portfolio

◼ Example. Your total wealth is $10,000. You put $2,500

in risk free T-Bills and $7,500 in a stock portfolio
invested as follows:
– Stock A you put $2,500
______
– Stock B you put $3,000
______
– Stock C you put $2,000
______
$7,500

5-2
 Allocating Capital Between Risky &
Risk-Free Assets Stock A $2,500
Weights in Rp Stock B $3,000
– WA = $2,500 / $7,500 = 33.33% Stock C $2,000

– WB = $3,000 / $7,500 = 40.00%

– WC = $2,000 / $7,500 = 26.67%
100.00%
The complete portfolio includes the riskless
investment and Rp (risky portfolio).
WRf = 25% ; WRp = 75%
In the complete portfolio
WA = 0.75 x 33.33% = 25%; WB = 0.75 x 40.00% = 30%

WC = 0.75 x 26.67% = 20%; Wrf = 25%

5-3
 Example

rf = 5% srf = 0%

E(rp) = 14% srp = 22%

y = % in Rp (1-y) = % in Rf

5-4
Expected Returns for Combinations

E(rC) = yE(rp) + (1 - y)rf

sc = ysrp + (1-y)srf

E(rC) = Return for complete or combined portfolio

rf = 5% srf = 0%
For example, let y = 0.75
____
E(rp) = 14% srp = 22%
E(rC) = (.75 x .14) + (.25 x .05)
y = % in Rp (1-y)
- = % in Rf
E(rC) = .1175 or 11.75% p

sC = ysrp + (1-y)srf
sC = (0.75 x 0.22) + (0.25 x 0) = 0.165 or 16.5%

5-5
 Complete portfolio
E(rc) = yE(rp) + (1 - y)rf
sc = ysrp + (1-y)srf

Varying y results in E[rC] and sC that are ______

linear
___________ of E[rp] and rf and srp and srf
combinations
respectively.
This is NOT generally the case for
the s of combinations of two or
more risky assets.

5-6
 Possible Combinations
E(rc) CAL
(Capital
Allocation
Line)

E(rc) = 14%
E(rc) = 11.75% Rp
y=1

y =.75

rf = 5%
Rf
y=0

0 16.5% 22% sc
5-7
 Combinations Without Leverage
rf = 5% srf = 0%

E(rp) = 14% srp = 22%

(1-y)- = % in Rf
Since σrf = 0 y = % in Rp
rp

σc= y σrp E(rc) = yE(rp) + (1 - y)rf

If y = .75, then y = .75
σc= 75(.22) = 16.5% E(rc) = (.75)(.14) + (.25)(.05) = 11.75%

If y = 1 y=1
σc= 1(.22) = 22% E(rc) = (1)(.14) + (0)(.05) = 14.00%

If y = 0 y=0
σc= 0(.22) = 0% E(rc) = (0)(.14) + (1)(.05) = 5.00%

5-8
 Using Leverage with Capital
Allocation Line
Borrow at the Risk-Free Rate and invest in stock
Using 50% Leverage y = 1.5
E(rc) = (1.5) (.14) + (-.5) (.05) = 0.185 = 18.5%
(1.5) (.22) = 0.33 or 33% rf = 5% srf = 0%
sc = Possible Combinations
E(r) E(r ) = 14% p srp = 22%

E(r )= 18.5% y = % in rp (1-y) = % in rf

E(rCc) =18.5%
E(rcp) = 14%
y = 1.5
E(rc) = 11.75% P
y=1

y =.75

rf = 5%
F
y=0

0 16.5% 33% sc
22% 33% 5-9
Risk Premium & Risk Aversion
• The risk free rate is the rate of return that can be
earned with certainty.
• The risk premium is the difference between the
expected return of a risky asset and the risk-free rate.
Excess Return or Risk Premiumasset = E[rasset] – rf

Risk aversion is an investor’s reluctance to accept

risk.

How is the aversion to accept risk overcome?

By offering investors a higher risk premium.
5-10
 Risk Aversion and Allocation
◼ Greater levels of risk aversion lead investors to
choose larger proportions of the risk free rate
Lower levels of risk aversion lead investors to
◼ choose 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 Possible Combinations
E(r
E(r)c)

E(rc) =18.5%
E(rc) =14% y = 1.5
E(rcp) =11.75% P
y=1

y =.75

rf = 5%
F
y=0

0 16.5% 22% s
33% 5-11
 P or combinations of
E(r) P & Rf offer a return CAL
per unit of risk of (Capital
9/22. Allocation
Line)
P
E(rc) = 14%

E(rc) - rf = 9%
) Slope = 9/22
rf = 5%
F

0 src= 22% s
5-12
Quantifying Risk Aversion
E (rc ) − rf = 0.5  A  s c
2

E(rp) = Expected return on portfolio p

rf = the risk free rate
0.5 = Scale factor
A x sp2 = Proportional risk premium
The larger A is, the larger will be the
investor’s added return required to bear risk
_________________________________________

5-13
Quantifying Risk Aversion
Rearranging the equation and solving
for A
E (rc ) − rf
A=
0.5  σ c2
Many studies have concluded that
investors’ average risk aversion is
between _______
2 and 4

5-14
 Using A
E (rc ) − rf
A=
0.5  σ c2
E(r)
E(r) CAL
What is the maximum (Capital
Allocation
A that an investor P
Line)

could have and still E(rcp) = 14%

choose to invest in the E(rc) - rf = 9%

risky portfolio P? rf = 5%
) Slope = 9/22
FF

0.14 − 0.05
A= = 3.719
0.5  0.22 2 0 src
rp = 22%
src

Maximum A = 3.719
5-15
 Sharpe Ratio
• Risk aversion implies that investors will accept a
lower reward (portfolio expected return) in
exchange for a sufficient reduction in risk (std
dev of portfolio return)
• A statistic commonly used to rank portfolios in
terms of the risk-return trade-off is the Sharpe
measure (also reward-to-volatility measure)
• The higher the Sharpe ratio the better
• Also the slope of the CAL
 Sharpe ratio

portfolio risk premium E (rc ) − rf

S= =
std dev of portfolio excess return sc

• Example: You manage an equity fund with

an expected return of 16% and an expected
std dev of 14%. The rate on treasury bills is
6%.
Risk premium 16 − 6
S= = = 0.71
Standard deviation 14
5.6 Passive Strategies and
the Capital Market Line

5-18
 A Passive Strategy
• Investing in a broad stock index and a risk
free investment is an example of a passive
strategy.

– The investor makes no attempt to actively find

undervalued strategies nor actively switch
their asset allocations.

– The CAL that employs the market (or an index

that mimics overall market performance) is
called the Capital Market Line or CML.

5-19
Active versus Passive Strategies
• Active strategies entail more trading costs than
passive strategies.
• Passive investor “free-rides” in a competitive
investment environment.
• Passive involves investment in two passive
portfolios
– Short-term T-bills
– Fund of common stocks that mimics a broad
market index
– Vary combinations according to investor’s
risk aversion.

5-20