Preliminaries

Optimal portfolio allocation

Conclusion

Lecture 3: Risk and return

SAPM [Econ F412/FIN F313 ]

Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15

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Lecture 3: Risk and return

Ramana Sonti

Preliminaries

Optimal portfolio allocation

Conclusion

Agenda

1 Preliminaries

Introduction
2 Optimal portfolio allocation

The capital allocation line

Optimal portfolio
3 Conclusion

Differential lending and borrowing rates

Final thoughts

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Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

Introduction

The basic problem

Investor has the following investment alternatives
1 risky asset with random returns: expected return E(r) and standard
deviation
1 risk-free asset with constant return

For a portfolio of these two assets (with weight w on the risky asset),
h
i
Portfolio expected return: E(rp ) = wE(r) + (1 w)rf = rf + w E(r) rf
Portfolio variance: p2 = w2 2
Portfolio standard deviation: p = w
Recall our earlier example: E(r) = 22%; rf = 5%; = 34.29%. A

60:40 portfolio of the two assets has

Expected return: E(rp ) = (0.6 22%) + (0.4 5%) = 15.2%
Standard deviation: (rp ) = 0.6 34.29% = 20.57%

Big Question
How should the investor optimally allocate his investment?

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Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

Introduction

Investor with A = 3.0

Utility calculations
Asset
Risk free
Risky
60:40 portfolio

E(r)
0.05
0.22
0.152

(r)

Utility

0
0.3429
0.2057

0.05
0.22 (0.5)(3)(0.34292 ) = 0.0436
0.152 (0.5)(3)(0.20572 ) = 0.0885

Obviously, the 60:40 portfolio is better than either asset alone

But which is the optimal portfolio?

Algorithm
Step 1: Generate the feasible set of all possible combinations of the

risky and the risk-free assets

Step 2: Among all feasible combinations, choose the one with the

highest utility
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Lecture 3: Risk and return

Ramana Sonti

Preliminaries

Optimal portfolio allocation

Conclusion

The capital allocation line

The feasible set of investment opportunities

Portfolio expected return:

h
i
E(rp ) = wE(r) + (1 w)rf = rf + w E(r) rf
Portfolio variance: p2 = w2 2
Putting together
we get
h these equations,
i
h E(r)r
i
f
E(rp ) = rf + w E(r) rf = rf +
p

i
h
0.17
For our example, E(rp ) = 0.05 + 0.3429 p
Thus, we see that the feasible set is represented by the equation of

a straight line
This feasible set is known as the capital allocation line (CAL)
i
h

The slope of the CAL is

E(r)rf

. This ratio is the expected excess

return per unit standard deviation

In other words, the slope represents the reward-to-risk ratio, and has a
special name: the Sharpe ratio

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Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

The capital allocation line

Going up the CAL

0.4

0.35

CAL
w=147.06%

Portfolio expected return

0.3

0.25
w=100%
0.2
w=58.82%
0.15

0.1
w=0%
0.05

0
0

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0.1

0.2

0.3
0.4
Portfolio standard deviation

Lecture 3: Risk and return

0.5

0.6

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Preliminaries

Optimal portfolio allocation

Conclusion

The capital allocation line

Lending and borrowing portfolios

Investor Lalita wants an expected return of 15%
Solve: w(22) + (1 w)5 = 15 w = 58.82%
Lalita starts with Rs. 100, invests Rs. 58.82 of her money in the

risky asset, and invests the remaining Rs. 41.18 in T-bills, i.e. lends
this money to the government
Portfolio standard deviation: w = 0.5882 34.29% = 20.17%

Investor Bharati wants an expected return of 30%

Solve: w(22) + (1 w)5 = 30 w = 147.06%
Bharati starts with Rs. 100, borrows Rs. 47.06 (at the risk-free rate),

and invests the sum Rs. 147.06 in the risky asset

Portfolio standard deviation: w = 1.4706 34.29% = 50.43%
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Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

The capital allocation line

Lending and borrowing on the CAL

0.4

0.35

CAL
w=147.06%

Portfolio expected return

0.3

0.25

0.2
w=58.82%
0.15

0.1

0.05

0
0

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0.1

0.2

0.3
0.4
Portfolio standard deviation

Lecture 3: Risk and return

0.5

0.6

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Preliminaries

Optimal portfolio allocation

Conclusion

Optimal portfolio

The optimal allocation

Mathematics
Since we can calculate the utility of a particular investor (fixed A) for different values of
w, an obvious way to get the optimal portfolio is to maximize the utility function over w
1
= E(rp ) Ap2
w
2
i
h
s.t. E(rp ) = rf + w E(r) rf and p2 = w2 2

The problem is: max U(w)

Standard calculus solution sets the first derivative of the utility with respect to w to
zero:

h
i 1
E(r) rf
= E(r) rf A(2w ) 2 = 0 w =
w
2
A 2

For our example investor (with A = 3), we have: w =

0.220.05
3(0.34292 )

= 0.4819

Intuition: Optimal allocation to risky asset increases as

expected return on risky increases
risk of risky asset decreases
investor risk aversion decreases
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Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

Optimal portfolio

The highest utility allocation

0.2

0.1

Optimum w *=0.4819, Optimum U *=0.09096

Utility

-0.1

-0.2

-0.3
0

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0.5

1
Risky asset weight

Lecture 3: Risk and return

1.5

Ramana Sonti

Preliminaries

Optimal portfolio allocation

Conclusion

Optimal portfolio

Analysis using indifference curves

0.4

0.35

Optimal U=0.09096

Portfolio expected return

0.3

U=0.12

CAL

U=0.05

0.25

0.2

0.15

0.1

0.05

0
0

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0.1

0.2

0.3
0.4
Portfolio standard deviation

Lecture 3: Risk and return

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0.6

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Preliminaries

Optimal portfolio allocation

Conclusion

Optimal portfolio

Lalita and Bharati again

0.4

0.35

CAL

0.3
Portfolio expected return

Bharati
0.25

0.2

0.15
Lalita
0.1

0.05

0
0

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0.1

0.2

0.3
0.4
Portfolio standard deviation

Lecture 3: Risk and return

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Preliminaries

Optimal portfolio allocation

Conclusion

Differential lending and borrowing rates

Differential rates
Can we usually borrow at the risk-free rate?
What if the borrowing rate were some rb greater than rf ?
Note that hwith a higher
rate, the reward-to-risk ratio of the new CAL
i
E(r)r

b
becomes
, lower than before

This leads to a kinked CAL, instead of the usual straight one

b
The optimal allocation becomes w = E(r)r
, less aggressive than
A 2
before

Allocation algorithm
Step 1: Calculate the formula w =

E(r)rf
A 2

Step 2: If answer from Step 1 is greater than 1, recalculate using the

revised formula w =

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E(r)rb
A 2

Lecture 3: Risk and return

Ramana Sonti

Preliminaries

Optimal portfolio allocation

Conclusion

Differential lending and borrowing rates

With a kinked CAL, allocation becomes less aggressive

0.4

0.35

Portfolio expected return

0.3

New CAL

0.25

Bharati

0.2

0.15
Lalita
0.1

0.05

0
0

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0.1

0.2

0.3
0.4
Portfolio standard deviation

Lecture 3: Risk and return

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0.6

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Ramana Sonti

Preliminaries

Optimal portfolio allocation

Conclusion

Final thoughts

Final thoughts

So far, we have assumed only one risky asset: how general is this?
Actually quite so; remember that the sole risky asset we looked at

could be a portfolio of assets

In fact, we will derive the optimal risky portfolio in the next lecture

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Lecture 3: Risk and return

Ramana Sonti