Investment Analysis and

Portfolio Management
Lecture 5
Gareth Myles
Organisation

 No class on Monday
 Exercise 4 plus lecture on Thursday
Risk
 An investment is made at time 0
 The return is realised at time 1
 Only in very special circumstances is the
return to be obtained at time 1 known at time 0
 In general the return is risky
 The choice of portfolio must be made taking
this risk into account
 The concept of states of the world can be used
Choice with Risk
 State Preference
 The standard analysis of choice in risky situations
applies the state preference approach
 Consider time periods t = 1, 2, 3, 4, ...
 At each time t there is a set of possible events
(or "states of the world")

et  1t ,2t ,3t ,4t ,

Choice with Risk
 When time t is reached, one of these states is
realized
 At the decision point (t = 0), it is not known
which
 Decision maker places a probability on each
 
event pt  pt1 , pt2 , pt3 , p 4t ,
 The probabilities satisfy
E

p
i 1
i
t 1
Choice with Risk
t=0 t=1 t=2

12
11
22
10
32
42

21 52

Event tree
Choice with Risk
 Each event is a complete description of the
world
i
 Let ret = return on asset i at time t in state e
then
 1 2

et  ret , ret , 

 This information will determine the payoff in

each state
 Investors have preferences over these returns
and this determines preferences over states
Choice with Risk
 Expected Utility
 Assume the investor has preferences over wealth in
each state described by the utility function U  U W 
U
U=U(W )

 Preferences can be defined over different sets of

probabilities over the states
Choice with Risk
 Assume 1 time period and 2 states
 Let wealth in state 1 be W1 and in state 2 W2
 Let p denote the lottery {p, 1-p} in which state
1 occurs with probability p
 Lottery q is defined in the same way
Example
 Let W  10 , W  5, p   0.9,0.1 , q   0.1,0.9
1 2
 Then any investor who prefers a higher return to a
lower return must rank p strictly preferable to q
Choice with Risk
 We now assume that an investor can rank
lotteries
 1. Preferences are a complete ordering
 2. If p is preferred to q, then a mixture of p and r is
preferred to the same mixture of r and q
 3. If p is preferred to q and q preferred to r, then
there is a mixture of p and r which is preferred to q
and a different mixture of p and r which is strictly
worse then q
 The investor will act as if they maximize the
expected utility function
EU  p1U W1   p 2U W2 
Choice with Risk
 This approach can be extended to the general
state-preference model described above
 For example, with two assets in each state
        
EU  p1U a1 1  r11  a2 1  r12  p2U a1 1  r21  a2 1  r22 
where ai is the investment in asset i
 Summary
 Preferences over random payoffs can be described
by the expected utility function
Risk Aversion
 Consider receiving either
 A fixed income M
 A random income M[1 + r] or M[1 – r], each
possibility occurring with probability ½
 An investor is risk averse if
U(M) > ½ U(M[1 + r]) + ½ U(M[1 – r])
 The certain income is preferred to the
random income
 This holds if the utility function is concave
Risk Aversion
 A risk averse investor
will pay to avoid risk Utility
 The amount the will pay U W0  h2 
is defined as the solution
UW0     EU
to
U(M - ) = ½U(M[1 + r]) U W0  h1 

+ ½U(M[1 – r])
  is the risk premium
W0  h1 W0   W0  h2 Wealth
 The more risk averse is
the investor, the more
they will pay
Portfolio Choice
 Assume a safe asset with return rf = 0
 Assume a risky asset
 Return rg > 0 in “good” state
 Return rb < 0 in “bad” state
 Investor has amount W to invest
 How should it be allocated between the
assets?
Portfolio Choice
 Let amount a be placed in risky asset, so W – a
in safe asset
 After one period
 Wealth is W - a + a[1 + rg] in good state
 Wealth is W - a + a[1 + rb] in bad state
 A portfolio choice is a value of a
 High value of a
 More wealth if good state occurs
 Less wealth if bad states occurs
Portfolio Choice
 Possible wealth levels are illustrated on a
“state-preference” diagram
Wealth in
bad state

W a=0

W[1+rb] a=W

Wealth in
good state
W W[1+rg]
Portfolio Choice
 Adding indifference curves shows the choice
 Indifference curves from expected utility function
EU = pU(W - a + a[1 + rg]) + (1-p)U(W - a + a[1 + rb])
 The investor chooses a to make expected utility
as large as possible
 Attains the highest indifference curve given the
wealth to be invested
Portfolio Choice

Wealth in
bad state

a=0
W
a*

W[1+rb] a=W

Wealth in
good state
W W[1+rg]
Portfolio Choice
 Effect of an increase in risk aversion
 What happens if rb > 0 or if rg < 0?
 When will some of the risky asset be
purchased?
 When will only safe asset be purchased?
 Effect of an increase in wealth to be invested?
Mean-Variance Preferences
 There is a special case of this analysis that is
of great significance in finance
 The general expected utility function
constructed above is dependent upon the
entire distribution of returns
 The analysis is much simpler if it depends on
only the mean and variance of the distribution.
 When does this hold?
Mean-Variance Preferences
~
 Denote the level of wealth by W. Taking a
Taylor's series expansion of utility around
expected wealth

~
  ~
  
~ ~ ~
U W U E W U' E W W  E W     
1
2
  
~ ~ ~
 U '' E W W  E W   2
 R3
 
~
EW
~
W

 Here R3 is the error that depends on terms

involving W~  E W~  3and higher
Mean-Variance Preferences
 Taking the expectation of the expansion
      
~ ~ 1
    
~ ~2
E U W  U E W  U ' ' E W  W  E  R3 
2
 The expected error is
    

1  n ~ n ~
E  R3    U E W m W
n  3 n!
 The expectation involves moments (mn) of all orders
(first = mean, second = variance, third)
 The problem is to discover when it involves only the
mean and variance
Mean-Variance Preferences
 Expected utility depends on just the mean and
variance if either
 1. U  n
  
~
E W = 0 for n > 2. This holds if utility is
quadratic
 Or
 2. The distribution of returns is normal since then all
moments depend on the mean and variance
 In either case
  
~  ~
   
~ 2
E U W  U  E W , W 
 
Risk Aversion
 With mean-variance rp
preferences
 Risk aversion implies
the indifference Less risk
curves slope upwards averse

 Increased risk
aversion means they More risk
averse
get steeper
p
Markowitz Model
 The Markowitz model is the basic model of
portfolio choice
 Assumes
 A single period horizon
 Mean-variance preferences
 Risk aversion
 Investor can construct portfolio frontier
Markowitz Model
 Confront the portfolio frontier with mean-
variance preference
 Optimal portfolio is on the highest indifference
curve
 An increase in risk aversion changes the
gradient of the indifference curve
 Moves choice around the frontier
Markowitz Model
Optimal Less risk
Expected portfolio averse
return

Xa = 1, Xb = 0

rMVP

Xa = 0, Xb = 1
More risk
averse

 MVP
Standard
deviation
Choice with risky assets
Markowitz Model
Less risk
Optimal
averse
Expected portfolio
return
Borrowing

Xa = 1, Xb = 0

More risk
averse Xa = 0, Xb = 1
Lending

Standard
Choice with a risk-free asset deviation
Markowitz Model
 Note the role of the tangency portfolio
 Only two assets need be available to achieve
an optimal portfolio
 Riskfree asset
 Tangency portfolio (mutual fund)
 Model makes predictions about
 The effect of an increase in risk aversion
 Which assets will be short sold
 Which investors will buy on the margin
 Markowitz model is the basis of CAPM