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Lecture 5 - Principles of Financial Economics

This document provides an overview of capital allocation between risky and risk-free assets. It defines key concepts like the capital allocation line (CAL) and indifference curves. The CAL shows different combinations of expected return and risk for allocating funds between a risky portfolio and risk-free asset. Indifference curves represent different levels of investor risk aversion, where more risk-averse investors prefer portfolios closer to the risk-free asset. The document also discusses how leverage, through borrowing at the risk-free rate, allows investing more in the risky portfolio and affects the slope of the CAL.

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78 views25 pages

Lecture 5 - Principles of Financial Economics

This document provides an overview of capital allocation between risky and risk-free assets. It defines key concepts like the capital allocation line (CAL) and indifference curves. The CAL shows different combinations of expected return and risk for allocating funds between a risky portfolio and risk-free asset. Indifference curves represent different levels of investor risk aversion, where more risk-averse investors prefer portfolios closer to the risk-free asset. The document also discusses how leverage, through borrowing at the risk-free rate, allows investing more in the risky portfolio and affects the slope of the CAL.

Uploaded by

rohanmungree
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Lecture 5

Capital Allocation between the Risky and the Risk-free Asset

Two-Security Portfolio: Return


rP w1 r1 w2 r2
w1 w2 r1 r2 = proportion of funds in Security 1 = proportion of funds in Security 2 = expected return on Security 1 = expected return on Security 2

w
i 1
Slide 6-2

Two-Security Portfolio: Risk


p w
2 2 1 2 1

w2 2 2w1w2Cov(r1, r2)

12 = variance of Security 1 22 = variance of Security 2

Cov(r1,r2) = covariance of returns for Security 1 and Security 2

Slide 6-3

Correlation Coefficients: Possible Values


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


Slide 6-4

Covariance
Cov(r1, r2) 1,2 1 2
1,2 = Correlation coefficient of returns 1 = Standard deviation of returns for
Security 1 2 = Standard deviation of returns for Security 2
Slide 6-5

Allocating Capital Between Risky & Risk Free Assets


Possible to split investment funds between safe and risky assets Risk free asset: proxy; T-bills Risky asset: stock (or a portfolio)

Slide 6-6

Allocating Capital Between Risky & Risk Free Assets


Examine risk/return tradeoff Demonstrate how different degrees of risk aversion will affect allocations between risky and risk free assets

Slide 6-7

The Risk-Free Asset


Perfectly price-indexed bond the only risk free asset in real terms; T-bills are commonly viewed as the risk-free asset; Money market funds - the most accessible risk-free asset for most investors.

Slide 6-8

Portfolios of One Risky Asset and One Risk-Free Asset


Assume a risky portfolio P defined by :
E(rp) = 15% and p = 22%

The available risk-free asset has:


rf = 7% and rf = 0%

And the proportions invested:


y% in P and (1-y)% in rf
Slide 6-9

Expected Returns for Combinations


E(rc) = yE(rp) + (1 - y)rf rc = complete or combined portfolio If, for example, y = .75

E(rc) = .75(.15) + .25(.07)


= .13 or 13%
Slide 6-10

Variance on the Possible Combined Portfolios


Since

= 0, then

= y * p

* Rule 4 in Chapter 5

Slide 6-11

Possible Combinations
E(r) E(rp) = 15%
E(rc) = 13% rf = 7%

C F

0
Slide 6-12

22%

CAL (Capital Allocation Line)


E(r) P
E(rp) - rf = 8%

E(rp) = 15%

rf = 7%

) S = 8/22

F
0

= 22%

Slide 6-13

Risk Aversion and Allocation


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

Slide 6-14

Combinations Without Leverage


If y = .75, then

c
c

= .75(.22) = .165 or 16.5%

If y = 1 = 1(.22) = .22 or 22%

If y = 0

Slide 6-15

=0(.22) = .00 or 0%

Using Leverage with Capital Allocation Line


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


Slide 6-16

Borrowing
If investors can borrow at the risk-free rate of rf= 7%, they can construct portfolios that may be plotted on the CAL to the right of P. The leveraged portfolio has a higher standard deviation than the unleveraged position in the risky asset.

Slide 6-17

Leveraged Position

Suppose the investment budget is $300,000 and the investor borrows an additional $120,000 investing the total available funds in the risky asset. This is a leveraged position in the risky asset which is financed in part by borrowing. This reflects a short position in the risk-free asset. Rather than lending at 7%, the investor borrows at the rate of 7%.

Slide 6-18

Effect of Leverage on the Rewardto-variability ratio


The distribution of the portfolio rate of return still exhibits the same reward-tovariability ratio. However the borrowing rate is likely to be higher.

Slide 6-19

Higher borrowing rate

Assume that the borrowing rate is 9 per cent. Calculate the reward-to-variability ratio if the expected return on the portfolio of risky assets is 15 per cent and its standard deviation is 22 per cent.

Slide 6-20

CAL with Higher Borrowing Rate


E(r)

P 9% 7%

) S = .27

) S = .36

p = 22%
Slide 6-21

CAL is kinked

With a higher borrowing rate (than the lending rate) the CAL is kinked at point P. To the left of P the investor is lending at 7 per cent and the slope of the CAL is 0.36 To the right of P, y>1, the investor is borrowing at 9 per cent to finance extra investments in the risky asset and the slope is 0.27

Slide 6-22

Indifference Curves and Risk Aversion


Certainty equivalent of portfolio Ps expected return E(r) for two different investors P

A=4 A=2

E(rp)=15%

rf=7%

Slide 6-23

p = 22%

Certainty Equivalent Rate of Return

More risk averse investors have a steeper ICs Less risk averse investors have flatter ICs Portfolios utility value is its certainty equivalent rate of return to the investor The certainty equivalent rate of return of the portfolio is the rate that risk-free investments would need to offer with certainty to be considered equally attractive as the risky portfolio.

Slide 6-24

CAL with Risk Preferences


E(r)

Borrower
7% Lender

p = 22%
Slide 6-25

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