FNCE30001 Investments

Semester 2, 2011

Introduction and L1: Risk Aversion and Capital Allocation

Subject Administration Issues

See the Study Guide on LMS for details! Lectures given in two streams: Wednesdays, 12:00pm - 2:00pm (The Spot, Basement Theatre) Fridays, 10:00am - 12:00pm (The Spot, Basement Theatre) First five lectures (on stocks) given by Dr Joachim Inkmann Consultation time: Fridays, 1:00pm 3:00pm Remaining six lectures (on bonds) given by Professor Rob Brown Consultation time: Tuesdays, 1:00pm 3:00pm The Tutorials start in the second lecture week. See the Study Guide on how to enroll in tutorials.
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Subject Administration Issues

Assessment: One 1-hour mid-term exam covering the first 5 lectures (20%) One 3-hour end-of-semester exam covering all lectures with greater weight given to those lectures not covered by the mid-term exam (70%) Two assignments (due 30 August and 14 October) (2 x 5%) Textbook: Bodie, Ariff, da Silva Rosa, Kane and Marcus: Investments, 1st edition, McGraw-Hill, 2007. All materials (except the textbook) are available on the LMS web site.

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Introduction to Investments
Who cares about investments? Almost everyone! Private investors like households save for retirement. In principle, they could accumulate retirement wealth in their bank account. Using investment theory, they are likely to achieve a higher expected return on their savings for their given risk appetite. Institutional investors like insurance companies and superannuation funds invest the fee income from their clients. Using investment theory, they should be able to achieve a higher expected return on their fee income for their given risk appetite. This lecture gives an introduction to investment theory. We will see how to optimally allocate financial wealth to different asset classes (securities) like stocks, bonds, and a money market account.
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Introduction to Investments
Terminology: I will use the terms investments, asset allocation and portfolio choice interchangeably. All three terms describe the allocation of wealth to different asset classes (securities). What can you do with your investment knowledge? Save more efficiently for retirement (or a house, or your next car) Be prepared for the Advanced Investments subject in the Honours course Be prepared for a career in the financial services industry: Portfolio manager in an asset management company Investment advisor for high net worth individuals or institutional investors (thats what I did before I joined academics) Analyst supporting portfolio managers with industry-specific knowledge (e.g., about the alcoholic beverages industry)
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Overview of the first part (on stocks)

Lecture 1: Risk Aversion and Capital Allocation Lecture 2: Optimal Risky Portfolios Lecture 3: Capital Asset Pricing Model Lecture 4: Index Models Lecture 5: Arbitrage Pricing Theory and Multifactor Models

Lectures 1 and 2 deal with the construction of an optimal portfolio of risky (usually stocks) and risk-free assets while taken as given the expected returns, standard deviations and correlations of the returns on different securities portfolio choice models. Lectures 3 to 5 derive the expected returns we can expect from investing in certain stocks asset pricing models. The remaining six lectures focus on bonds.

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Lecture Overview
1. Introduction to Investments 2. Risk and risk aversion Utility function Indifference curves 3. Capital allocation across risky and risk-free portfolios The complete portfolio 4. Portfolios of one risky asset and a risk-free asset The capital allocation line The Sharpe ratio 5. Risk tolerance and asset allocation The optimal complete portfolio Reading: Bodie et al., Chapters 6 and 7.
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Expected return
Lets start with some fundamental statistical properties of returns. Lets consider the return on a stock for this purpose. There is considerable uncertainty about the future price of a stock and the dividend income that it pays. Thus, the return is uncertain. To quantify our beliefs about future states of the economy and the stock market, we usually assign probabilities to each scenario that we might have for the economy and stock market. Then, the expected return is given by:

E (r ) = p( s )r ( s )
s

where s is a scenario and p(s) is the probability of each scenario.

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Example: Expected return

You have a portfolio invested in the stock market. The return of your stock portfolio will change depending on the state of the economy prevailing one year from today. You come up with the following three scenarios:
State of the Economy Good Normal Bad Probability 0.30 0.40 0.30 Portfolio Return 12% 4% -2%

The expected return of your portfolio is, then:

E(r) = (0.30)(0.12) + (0.40)(0.04) + (0.30)(-0.02) = 4.6%
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Standard deviation
To find the standard deviation of a return when probabilities are present, we use the following formula:

p(s)[r (s) E (r )]
s

Continuing with the previous example, the standard deviation of the return is:

= (0.30)(0.12 0.046) 2 + (0.40)(0.04 0.046) 2 + (0.30)(0.02 0.046) 2 = 5.44%

The standard deviation is a measure of risk while the expected return is a measure of reward.

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Portfolio construction
There are two main steps in the process of construction a portfolio: Selection of risky assets, such as stocks and bonds. Decision of how much to invest in the risky portfolio and how much in the risk-free asset. We need to know the expected return of the portfolio and the degree of risk to decide how much to allocate between the risk-free asset and the risky portfolio. The decision of how much to invest ultimately depends on the individual investors personal preferences about risk and expected return.

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Concept of risk aversion

A risk averse individual is the one who prefers less risk for the same expected return. Most investors are risk averse. Risk-averse investors reject risky investment opportunities with a risk premium of zero or less. They want to be compensated for bearing risk. The risk premium is the difference between the expected return of a risky asset and a risk-free return (for example, the return on a short term government bond like a Treasury bill).

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Utility
We have to put some structure on the concept of risk aversion. In this way we will better understand the dynamics in the investment process. Although investors are presumed risk averse, each investor will face different trade-off decisions between different risk and expected returns. What will influence the trade-off decisions? Such factors as different degrees of unwillingness to bear risk (which will be reflected in how much additional expected return the investor requires for taking an additional unit of risk.) Another factor will be how much the investment could affect the investors total wealth. A potential loss of $1,000 would probably worry a millionaire less than someone with earnings of $100 per week.
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Why is the concept of utility important?

Knowledge of the investors utility function enables him/her to choose between securities. In a single measure we have the investors attitudes toward risk and return at each level of wealth. It is difficult without knowledge of the utility function to make decisions between different securities with different expected returns and different risks.

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Example
Portfolio Low Risk Medium Risk High Risk Risk Premium 2% 4 8 Expected Return 7% 9 13 Risk (SD) 5% 10 20

Notice that the risk is increasing along with the risk premium. How do investors choose among these portfolios? We need a rule or a utility function that can differentiate the portfolios based on the expected return and risk of these portfolios and maximize utility.

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Utility function
There are countless utility functions. An important example is:

U = E (r ) 1 A 2 2
where U = the utility value, A = coefficient of risk aversion, 2 = variance of portfolio return Utility increases with expected returns and decreases with risk. Utility of a risk-free portfolio is equal to its expected rate of return. More risk-averse investors will have larger values of A. Investors assign higher utility to more attractive risk-return portfolios. For the above utility function:
If A = 0, the investor is risk-neutral. These investors only look at the expected returns. If A > 0, the investor is risk-averse. If A < 0, the investor is risk-loving. These investors are ready to accept fair games or gambles.
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Example
Lets assume that an investor has the above mentioned utility function 2

U = E (r ) 1 A 2

Assume A = 2 and a risk-free rate of return of 4%.

Portfolio Low Risk Medium Risk High Risk Risk Premium 4% 6% 10% Expected Return 8% 10% 14% Risk (SD) 6% 12% 19% Utility 0.08-.5*2*0.062= 0.0764 0.10-.5*2*0.122= 0.0856 0.14-.5*2*0.192= 0.1039

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Trade-off between risk and return

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What about the quadrants II and III?

Portfolios in these two quadrants will depend on the nature of the investors risk and return preferences or risk aversion. Possible there are other portfolios in these quadrants that are equally attractive to the investor. This means other portfolios should have the same utility level and the investor is indifferent among such portfolios.

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Indifference curves
The indifference curves represent a set of risk and expected return combinations that provide the investor with the same level of utility. They indicate an investors preference for risk and return. Drawn in a two-dimensional graph where the horizontal axis gives risk and the vertical axis provides expected return. An indifference curve connects all portfolios with the same utility level. Some of these portfolios will be high risk and high return portfolios and others will be low risk and low return portfolios.

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Indifference curves

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Capital allocation
Investors construct portfolios by considering securities from many different asset classes. They will also choose how much to invest in each asset class. Example: Consider a portfolio with a value of $300,000. $90,000 is invested in risk-free securities and the rest is invested in risky securities. Lets denote the weight of the risky securities in the portfolio as y:
210,000 = 70% 300,000 90,000 1 y = = 30% 300,000 y=
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Example: Risky portfolio

Suppose that the investor in the previous example would like to reduce his allocation of risky securities from 70% to 40%. Also assume that the risky portfolio is made of two stocks; A and B. A and B have proportions of 60% and 40% in the risky portfolio. With 40%, the risky portfolio will be (0.40)($300,000) = $120,000. This requires the sale of $210,000 120,000 = $90,000 of the original risky portfolio. Assuming $90,000 will be invested in the risk-free security, the total amount in the risk-free security will be $90,000 + $90,000 = $180,000.

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Example: Risky portfolio (cont.)

After the sale, the important point is that the proportions of stocks A and B in the risky portfolio should be again 60% and 40%. Thus, the investor should sell the following amounts: Stock A: (0.60)(90,000) = $54,000 Stock B: (0.40)(90,000) = $36,000 Check: weights of A and B in the risky portfolio Stock A: [(0.6)(210,000) 54,000)]/(210,000 90,000) = 60% Stock B: [(0.4)(210,000) 36,000]/(210,000 90,000) = 40%

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Capital allocation
Given these weights (60% in stock A and 40% in stock B), the purpose of the investor is to reduce risk by changing the risky/riskfree asset mix. To find the optimal portfolio for the investor, we need to consider two things: The risk-return combination available to the investor. Personal risk-return preferences of the investor. We will first examine the risk-return combination available to the investor.

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Portfolio of a risky asset and a risk-free asset

It is possible to split investment funds between safe and risky assets. Risk free asset: proxy = T-bills Risky asset: stock (or a portfolio or stocks) Example: rf = 7%, rf = 0%, E(rp) = 15%, p = 22% The investor puts y in the risky portfolio and 1-y in the risk-free portfolio. The expected return of the complete (or combined) portfolio is:
E (rc ) = yE (rp ) + (1 y )rf E (rc ) = rf + y[ E (rp ) rf ] = 0.07 + 0.08 y

and the standard deviation is: c = p y = 0.22 y

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Combinations without leverage

E (rc ) = r f + y[ E (rp ) r f ] = 0.07 + 0.08 y
Example: y = 0.75 E(rc) = 0.07+0.08(0.75) = 13% If y = 0 If y = 0.5 If y = 1 E(rc) = 7% and c = 0(0.22) = 0% E(rc) = 11% and c = 0.5(0.22) = 11% E(rc) = 15% and c = 1(0.22) = 22%

We can plot these combinations of portfolio risk (standard deviation) and expected return. We obtain the capital allocation line (CAL).

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The investment opportunity set

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The Capital Allocation Line (CAL)

The CAL illustrates all the risk-return combinations available to the investor. Increasing the fraction y of the overall portfolio invested in the risky asset increases expected return at a rate of 8%. But, the portfolio risk also increases (at a rate of 22%). The extra return per extra risk is, then, 8/22 = 0.36%. 0.36% is also called the Sharpe ratio.

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Capital Allocation Line with leverage

What about points on the CAL to the right of portfolio P? If investors borrow at the risk-free rate, we can extend the CAL without changing its slope. However, no one can borrow at the risk-free rate, except the government. Example: Borrowing rate is 9%. Using 50% Leverage: E(rc)= (-0.5) (0.09) + (1.5) (0.15) = 18% c = (1.5) (.22) = 33% The Sharpe ratio is = (18-9)/0.33 = 0.27% Therefore, the CAL will have a kink at point P.

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The opportunity set with different borrowing and lending rates

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Personal preferences and asset allocation

Lets introduce personal risk-return preferences. The investor, now, needs to choose among many possible portfolios on the CAL. And this choice involves a trade-off between risk and return. Different investors will choose different portfolios (different combinations of risky and risk-free assets). More risk averse investors will choose to hold more of the risk-free asset and less of the risky asset. While choosing the optimal portfolio, the investor tries to maximize his/her utility:

U = E (r ) 1 A 2 2

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Utility levels (A = 4)
y
0 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

E(rc )
0.070 0.078 0.086 0.094 0.102 0.110 0.118 0.126 0.134 0.142 0.150

c
0 0.022 0.044 0.066 0.088 0.110 0.132 0.154 0.176 0.198 0.220

Utility
0.0700 0.0770 0.0821 0.0853 0.0865 0.0858 0.0832 0.0786 0.0720 0.0636 0.0532

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Utility as a function of allocation to the risky asset

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Utility maximization
Mathematically,
2 MaxU = E (r ) 1 A 2 = r f + y[ E (rp ) r f ] 1 Ay 2 P 2 2

Set the fist derivative with respect to y equal to zero and obtain the optimal share invested in the risky asset

y =
*

E (rp ) r f
2 A P

Graphically, we find the tangency point of the highest indifference curve with the CAL (see below).

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Example: Capital allocation

Suppose that the risk-free rate is 6% and the expected return of the risky portfolio is 18% with a standard deviation of 25%. Assume that a particular investor has a coefficient of risk aversion of 5. The proportion of funds invested in the risky portfolio is: (0.18 0.06) y* = = 0.384 2 (5)(0.25 ) The expected return and the standard deviation of the complete portfolio are then: E (rc ) = 0.06 + [(0.384)(0.18 0.06)] = 10.61% c = (0.384)(0.25) = 9.6% The Sharpe ratio is:
S= (0.1061 0.06) = 0.48 0.096
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Indifference curves for different As

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Utility maximization
Higher indifference curves correspond to higher utility levels. The investor would like to choose a portfolio on the higher indifference curve. Portfolios on the higher indifference curves provide a higher expected return for a given level of risk. More risk-averse investors have steeper indifference curves. These investors require a greater increase in expected return for an increase in portfolio risk.

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Optimal complete portfolio

Given the indifference curves, the investor attempts to find the complete portfolio on the highest indifference curve that still touches the CAL (tangent to the CAL). The tangency point corresponds to the combination of expected return and standard deviation of the optimal portfolio that maximizes utility.

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Optimal complete portfolio (A = 4)

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The Capital Market Line (CML)

The risky portfolio in the optimal complete portfolio can be a stock market index (usually a value-weighted portfolio). In this case, we distinguish between passive and active portfolio management approaches: Passive portfolio management: Investing in an index of stock returns, for example the ASX200. Passive managers can replicate the index without too many (buy and sell) transactions. Active portfolio management: Deliberately deviating from an index with the hope to achieve a higher expected return than the index. This is done by temporary overweighting selected stocks while at the same time underweighting the remaining stocks within an index. Important for institutional asset management
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The Capital Market Line (CML)

There are two main reasons why a passive investment strategy may have advantages: Transaction costs: active strategies require more frequent rebalancing which is costly. Free-rider benefit: the index is the outcome of the market transactions of all investors. By investing in the index, you can participate in the joint knowledge of the market. The capital allocation line that corresponds to a passive strategy is called the capital market line.

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Lecture Summary
Risk-averse investors demand compensation for risk. Investors preferences toward the expected return and volatility of a portfolio may be expressed by a utility function. More risk averse investors will apply greater penalties for risk. These preferences can be depicted graphically using indifference curves. The optimal position in the risky asset is proportional to the risk premium and inversely proportional to the variance and degree of risk aversion. The optimal portfolio is the point at which the highest indifference curve is tangent to the CAL and the one that maximizes utility.
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