Investment Decisions

Capital Allocation Between
capital allocation decision = choice of

The Risky And The Risk- proportion to be invested in risk-free versus
risky assets
Free Asset
asset allocation decision = choice of type of
assets to invest in (e.g., bonds, real estate,
stocks, foreign assets etc.)

security selection decision = choice of which
Chapter 7 particular security to invest in

1-2

Allocating Capital: Risky & Risk

The Risk-Free Asset
Free Assets

examine risk/return tradeoff
technically, the risk-free asset is default-free

demonstrate how different degrees of risk and without inflation risk (a price-indexed
aversion will affect allocations between risky default-free bond)
and risk free assets
in practice, Treasury bills come closest,

consider the optimal risky portfolio as given because:
and analyze the allocation decision between
shortterm means little interest-rate or inflation
“the” risky portfolio (treated as one asset) and risk
the risk-free asset (T-bills)
default risk is practically zero, since the
government would no default

rate of return:
P1 − P0 + D1
r=
P0
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Characterization of the Complete

Notation
Portfolio

rf = rate of return on the risk-free asset
rate of return

rp = rate of return on the risky portfolio rC = yrp + (1 – y)rf

rC = rate of return on the complete portfolio
expected rate of return
(including both the risk-free asset and the risky E(rC) = y E(rp) + (1 – y) E(rf) = y E(rp) + (1 – y)rf
portfolio) = rf + y[E(rp) – rf ]

y = proportion of the investment budget to be
variance
placed in the risky portfolio σC2 = y2σp2 + (1 – y)2 ⋅ 0 + 2y(1 – y) Cov(rp, rf)

σp = standard deviation of the return on the = y2σp2
risky portfolio
standard deviation

σC = standard deviation of the return on the σC = yσp
complete portfolio
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Available Complete Portfolios Capital Allocation Line

solve for y:
y = σC / σp E(r)

replace in the equation for the expected rate E(rp) P

of return
σC [ E ( rp ) − rf ]
E ( rC ) = rf +
[ E (rp ) − rf ] = rf + σ C
σp σp rf

this defines a line in the mean-variance space
– the capital allocation line (CAL)

slope of CAL: [E(rp) – rf ] / σp
σp σ
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Example Capital Allocation Line – Example

rf= 7%

E(rp) = 15% E(r)

σp = 22% 15% P

y = 0.75 13%

E(rC) = 0.75⋅15% + 0.25⋅7% = 13%

σC = y⋅σp = 0.75⋅22% = 16.5% 0.37
7%

slope of CAL = [E(rp) – rf ] / σp = 8 / 22 = 0.37

16.5% 22% σ
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Example – Different Borrowing and

Capital Allocation Line with Leverage
Lending Rates

what happens if y > 1 (points to the right of P)?
rf= 7%

it means that there is negative investment in
E(rp) = 15%
the risk-free asset  the investor borrowed at
σp = 22%
the risk-free rate
rb = 10%

this is called leveraged position in the risky

y = 1.25
asset – some of the investment is financed by

E(rC) = 1.25⋅15% – 0.25⋅10% = 16.25%
borrowing (e.g., buying on margin)

σC = y⋅σp = 1.25⋅22% = 27.5%

the complete portfolio will have higher
expected return, but also higher variance (risk)
slope of CAL (2) = [E(rp) – rb] / σp = 5 / 22 = 0.23

also, it is possible that the borrowing rate is

higher than the lending rate (risk-free rate)
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Capital Allocation Line – Example Risk Aversion and Allocation

E(r)
higher levels of risk aversion lead to larger

proportions of investment in the risk free asset
16.25% (lower y)
0.23
15%
lower levels of risk aversion lead to larger
P proportions of investment in the portfolio of
10% risky assets (higher y)
0.37
willingness to accept high levels of risk for
7%
high levels of returns would result in leveraged
combinations (y > 1)

22% 27.5% σ
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Utility Function Optimal Complete Portfolio

form of the utility function:
utility is maximized with respect to y:
U = E(rC) – 0.005A σC2 max U = rf + y[E(rp) – rf ] – 0.005A y2 σp2

different values of A would cause different
the solution is given by the first-order constraint
choices of the complete portfolio (i.e., setting the derivative of U with respect to y

remember that equal to 0)

E(rC) = rf + y[E(rp) – rf ] U’ = [E(rp) – rf ] – 0.005A ⋅ 2y σp2

σ C2 = y2 σp2
solving for y gives the optimal choice of

the utility function only as a function of y and investment in the risky portfolio
known (expected) returns and variances: E (rp ) − rf
U = rf + y[E(rp) – rf ] – 0.005A y2 σp2
y* =
0.01Aσ 2p
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Optimal Complete Portfolio (cont.) Optimal Complete Portfolio–Example

optimal choice for an investor is the point of
rf = 7%, E(rp) = 15%, σp = 22%
tangency of the highest indifference curve to
investor 1:
the Capital Allocation Line  slope of
A =4
indifference curve is equal to the slope of the
y = 8 / (0.01⋅222⋅4) = 0.41 = 41%
CAL
E(rC) = 0.41⋅15% + 0.59⋅7% = 10.28%

borrowers (investors with y > 1) are less risk-
σC = y⋅σp = 0.41⋅22% = 9.02%
averse than lenders (investors with y ≤ 1)

investor 2:

higher risk-aversion  steeper indifference

A = 1.5
curve
y = 8 / (0.01⋅222⋅1.5) = 1.10 = 110%

E(rC) = 1.10⋅15% – 0.10⋅7% = 15.8%

σC = y⋅σp = 1.10⋅22% = 24.2%

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Optimal Complete Portfolio and Risk
Capital Market Line
Aversion
E(r)
we assumed that the investor chooses an
optimal risky portfolio, which is given
15.8%
a passive strategy would be to invest in a
15% 2
P broad portfolio, like a market index

the resulting capital asset line is called capital
9.02% market line (CML)
1
7%

10.28% 22% 24.2% σ

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