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Transcript of 1 Fin 2802, Spring 10 - Tang Chapter 6: Asset Allocation Fina2802: Investments and Portfolio...
1Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Fina2802: Investments and Portfolio Analysis
Spring, 2010Dragon Tang
Fina2802: Investments and Portfolio Analysis
Spring, 2010Dragon Tang
Lecture 9
Capital Allocation
February 9, 2010
Readings: Chapter 6
Practice Problem Sets: 1-5,12-14,26-28
2Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Asset AllocationAsset Allocation
Objectives:
• Characterize the risk and return of portfolios containing risky and risk-free assets.
1. Evaluate the performance of a passive strategy.
3
Portfolio SelectionPortfolio Selection
1. Asset allocation
2. Security selection
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
4
Asset AllocationAsset Allocation
• John Bogle: “Asset allocation accounts for 94% of the differences in pension fund performance”
• Identify investment opportunities (risk-return combinations)
• Choose the optimal combination according to investor’s risk attitude
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
5Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Portfolios: Basic Asset AllocationPortfolios: Basic Asset Allocation
The complete portfolio is composed of:
• The risk-free asset: Risk can be reduced by allocating more to the risk-free asset
• The risky portfolio: Composition of risky portfolio does not change (market portfolio)
This is called Two-Fund Separation Theorem.
The proportions depend on your risk aversion.
6
Risk-free Investment Risk-free Investment
0.00
0.20
0.40
0.60
0.80
1.00
-5% 0% 5% 10% 15%
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
7
Stock Returns Are Uncertain Stock Returns Are Uncertain
Example: Risky investment with ten possible rates of return
0.00
0.20
0.40
0.60
0.80
1.00
-40% -20% 0% 20% 40%
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
8Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Risk and Risk PremiumRisk and Risk Premium
• Risk-free rate: determined by demand/supply and intermediaries (such as Fed)
• Risk premium (=Risky return –Risk-free return)Example
The expected return on the S&P500 is 9%The return on a 1-month T-bill is 3%The risk premium is 6% (9%-3%)
• Risk aversionE(rP) – rf = ½ A σp
2
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
9Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Complete Portfolio Expected ReturnComplete Portfolio Expected Return
Example: Let the expected return on the risky portfolio, E(rP), be 15%, the return on the risk-free asset, rf, be 7%. What is the return on the complete portfolio if all of the funds are invested in the risk-free asset? What is the risk premium?
7%0
What is the return on the portfolio if all of the funds are invested in the risky portfolio?
15%8%
10Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Complete Portfolio Expected ReturnComplete Portfolio Expected Return
Example: Let the expected return on the risky portfolio, E(rP), be 15%, the return on the risk-free asset, rf, be 7%. What is the return on the complete portfolio if 50% of the funds are invested in the risky portfolio and 50% in the risk-free asset? What is the risk premium?
0.5*15%+0.5*7%=11%
4%
11Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Complete Portfolio Risk PremiumComplete Portfolio Risk Premium
fffPfC rryrrEyrrE )1(
assetrisky on the premiumrisk
portfolio complete on the premiumrisk
assetrisky in the invested funds offraction
fP
fC
rrE
rrE
y
In general:Equal to 0
12Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Portfolio Standard DeviationPortfolio Standard Deviation
0 if
121 22222
f
fff
rPC
rPPrrPC
y
yyyy
where
c - standard deviation of the complete portfolioP - standard deviation of the risky portfoliorf - standard deviation of the risk-free rate y - weight of the complete portfolio invested in the risky asset
13Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Portfolio Standard DeviationPortfolio Standard Deviation
Example: Let the standard deviation on the risky portfolio, P, be 22%. What is the standard deviation of the complete portfolio if 50% of the funds are invested in the risky portfolio and 50% in the risk-free asset?
22%*0.5=11%
14Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Capital Allocation LineCapital Allocation Line
We know that given a risky asset (p) and a risk-free asset, the expected return and standard deviation of any complete portfolio (c) satisfy the following relationship:
c portfolio completeevery for )()(
))(()(
p
fp
c
fc
pc
fpfc
rrErrE
y
rrEyrrE
Where y is the fraction of the portfolio invested in the risky asset
15Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Capital Allocation LineCapital Allocation Line
Risk Tolerance and Asset Allocation: •More risk averse - closer to point F
•Less risk averse - closer to P
16Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Slope of the CALSlope of the CAL
S
E r rP f
P
S is the increase in expected return per unit of additional standard deviation
S is the reward-to-variability ratio or Sharpe Ratio
17Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Example: Let the expected return on the risky portfolio, E(rP),
be 15%, the return on the risk-free asset, rf, be 7% and the
standard deviation on the risky portfolio, P, be 22%. What is
the slope of the CAL for the complete portfolio?
S = (15%-7%)/22% = 8/22
Slope of the CALSlope of the CAL
18
Historical Risk-Return Trade-offHistorical Risk-Return Trade-off
Risk Real Sharp
Asset Class Prem.(%) Retn(%) Ratio
Sm Stk 13.9 14.6 0.35
Lg Stk 9.3 8.9 0.45
LT Gov 1.9 2.6 0.23
T-Bills --- 0.7 ---
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
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Measuring Risk-Return Trade-offMeasuring Risk-Return Trade-off
• Mean-Variance Plot
0
2
4
6
8
10
12
14
16
18
20
0 5 10 15 20 25 30 35 40 45
Standard Deviation ()
Exp
ecte
d R
etur
n (E
(r))
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
20Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
BorrowingBorrowing
S
E r rP B
P
where rB is the borrowing rate
y > 1
Usually borrowing rate > lending rate
21Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Borrowing ExampleBorrowing Example
Example: Let the expected return on the risky portfolio, E(rP), be 15%, the return on the risk-free asset, rf, be 7%, the borrowing rate, rB, be 9% and the standard deviation on the risky portfolio, P, be 22%. What is the slope of the CAL for the complete portfolio for points where y > 1?
S=(15%-9%)/22%=6/22
Note: For y 1, the slope is as indicated above if the lending rate is rf.
22Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Investment Opportunity Set with Differential Borrowing and Lending Rates
Investment Opportunity Set with Differential Borrowing and Lending Rates
23Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Passive StrategiesPassive Strategies
•Assumes securities are fairly priced
•Avoids cost of security analysis
•Indexing - value-weighted portfolio
•Assume that the search for mispriced securities (performed by active strategies) keeps prices fair
24Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
Capital Market Line (CML)Capital Market Line (CML)
SPECIAL CASE OF CAL (I.e., P=MKT)
The line provided by one-month T-bills and a broad index of common stocks (e.g. S&P500)
Consequence of a passive investment strategy based on stocks and T-bills
25
Which Portfolio to Choose?Which Portfolio to Choose?
E(r)
E(Rm) = 12%
rf = 3%
20%0
M
F
S=0.45P1?
P3?
P2?
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
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Key Determinant of Asset Allocation:Attitude towards Risk
Key Determinant of Asset Allocation:Attitude towards Risk
• Risk Preference – Risk averse
» Require compensation for taking risk
– Risk neutral
» No requirement of risk premium
– Risk loving
» Pay to take risk
• Utility Values: A is risk aversion parameter
25.0)( ArEU
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
27
Utility FunctionUtility Function
U = E ( r ) – 1/2 A 2
Where
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
= variance of returns
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
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Utility Scores of Alternative Portfolios for Investors with Varying Risk Aversion
Utility Scores of Alternative Portfolios for Investors with Varying Risk Aversion
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
29
The Trade-off Between Risk and Returns of a Potential Investment Portfolio
The Trade-off Between Risk and Returns of a Potential Investment Portfolio
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
30
Utility Values of Possible Portfolios for an Investor with Risk Aversion, A = 4
Utility Values of Possible Portfolios for an Investor with Risk Aversion, A = 4
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
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Figure 6.2 The Indifference Curve Figure 6.2 The Indifference Curve
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
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Utility Indifference CurvesUtility Indifference CurvesUtility Indifference Curves
0
2
4
6
8
10
12
14
16
18
20
0 5 10 15 20 25 30 35 40 45
Standard Deviation ()
Exp
ecte
d R
etur
n (E
(r))
A=5
A=2
U1
U2
Increasing utility
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
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33
Risk Aversion and Asset AllocationRisk Aversion and Asset 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.
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
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Investor’s Willingness to Pay for Catastrophe Insurance Investor’s Willingness to Pay for Catastrophe Insurance
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
35
Spread Between 3-Month CD and T-bill Rates Spread Between 3-Month CD and T-bill Rates
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
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Find the Optimal AllocationFind the Optimal Allocation
• Solve the maximization problem:
• Two approaches:
1. Try different w1
2. Use calculus:
• Solution:
211
2
)(5.0)(
5.0)(Max
mfmf wArrwr
ArEU
01
21 mfm Awrr
dwdU
21m
fm
A
rRw
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
37
Asset Allocation Rules:Asset Allocation Rules:
• When rm-rf increases, w1 increases
• When A increases, w1 decreases
• When m increases, w1 decreases
• W1 is constant when all three are fixed
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
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Illustration of SolutionIllustration of Solution
E(r)
E(Rm) = 12%
rf = 3%
20%0
M
F
S=0.45P1!
P3
P2
Utility indifference curves (A=4)
If A=4 then w1=0.56
11.2%
8%
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
39
Which Portfolio to Choose?Which Portfolio to Choose?
• For Jack, risk aversion A = 2, the optimal choice is 112.5% (of total capital) in the market, financed by selling short 12.5% (of total capital) in T-bills
• For Jill, risk aversion A = 5, the optimal choice is 45% in the market and 55% in T-bills.
• The weight in the market:
21m
fm
A
rRw
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
40
Utility ComparisonUtility Comparison
-20
-15
-10
-5
0
5
10
0% 50% 100% 150% 200% 250%
Weight in Market
Uti
lity
Va
lue
Jack
Jill
45% 113%
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
41
Utility Levels for Positions in Risky Assets for an Investor with Risk Aversion A = 4
Utility Levels for Positions in Risky Assets for an Investor with Risk Aversion A = 4
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
42
Utility as a Function of Allocation to the Risky Asset, yUtility as a Function of Allocation to the Risky Asset, y
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
43
Finding the Optimal Complete Portfolio Using Indifference Curves Finding the Optimal Complete Portfolio Using Indifference Curves
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
44
Expected Returns on Four Indifference Curves and the CALExpected Returns on Four Indifference Curves and the CAL
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
45
Average Annual Return on Stocks and 1-Month T-bills;
S. Dev. and Reward to Variability of Stocks Over Time Average Annual Return on Stocks and 1-Month T-bills;
S. Dev. and Reward to Variability of Stocks Over Time
Fin 2802, Spring 08 - TangChapter 6: Asset Allocation
Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
46Fin 2802, Spring 10 - TangChapter 6: Asset Allocation
SummarySummary
•Capital allocation line (CAL) All combinations of the risky and risk-free asset Slope is the reward-to-variability ratio
•Capital market line (CML) Passive strategy Market index portfolio as the risky asset
•Risk aversion determines position on the capital allocation line
•Next: Market Efficiency