CHAPTER 3 Optional Risk-free and Risky, and Risky Portfolio 1 4.1 Asset Allocation across Portfolios • Capital Allocation • Choice between risky and risk-free assets • Risky asset: Stocks and corporate bonds •The Risk-Free Asset •Treasury bonds (still affected by inflation) •Price-indexed government bonds •Money market instruments effectively risk-free •Risk of CDs and commercial paper is miniscule compared to most assets Portfolio Asset Allocation: Expected Return and Risk Expected Return of the Complete Portfolio E (rC ) = y E (rp ) + (1 − y) r f where E (rC ) = Expected Return of the complete portfolio E (rp ) = Expected Return of the risky portfolio rf = Return of the risk free asset y = Percentage assets in the risky portfolio Standard Deviation of the Complete Portfolio C = y p where C = Standard deviation of the complete portfolio P = Standard deviation of the risky portfolio 4.4 Portfolio Asset Allocation: Expected Return and Risk • Example, risk-free, rf=7%, E(rp) =15%, p=22%, • Risk premium= 15%-7%=8% • If you decide to invest half in risk-free and half in portfolio P. Your complet expected return and SD of the portfolio P: E(rc) = 0.5×15 +0.5(7) = 11% and c = y p = 0.5 22 = 11% Slope = E (rp ) − rf p 15 − 7 8 = = = 0.36 22 22 Figure4.1 Investment Opportunity Set CAL: Plot of risk-return combinations available by varying allocation between risky and risk-free 4.3 Risk Aversion and Capital Allocation • The utility function: U = E(r) -0.5A2 • Portfolios receives higher utility scores, is more attractive. • The expected return of the complete portfolio is E(rc) = rf + y[E(rp) – rf ] and c = y p, then the variance of the overall portfolio is 2c= y22p Dr. Lay SAU 6 • Max U = E(rc) -0.5Ac2 = rf + y[E(rp) – rf ] - 0.5Ay22p To solve this, we set the derivate of this expression to zero Max U’ = [E(rp) – rf ] – 2× 0.5Ay 2p = 0 Y*= make Utility function optimal A= coefficient of risk aversion, ranges from 2 to 4. The larger A is higher risk aversion Dr. Lay SAU 7 Going back to numerical example, rf=7%, E(rp) =15%, p=22%. Investor with coefficient of risk aversion A=4 is 0.15 − 0.07 y = = 0.41 2 4 0.22 If you have $100,000, you should invest: •0.41 x $100,000 =$41,000 in risky portfolio (equities) and bonds, and • 0.59 x $100,000 = $59,000 in T-bill. Dr. Lay SAU 8 Table 4.1 Utility Levels for Various Position in Risky Asset (y) for an Investor with Risk Aversion A=4 y 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 E(rc) 0.07 0.078 0.086 0.094 0.102 0.110 0.118 0.126 0.134 0.142 0.150 c 0.0 0.022 0.044 0.066 0.088 0.110 0.132 0.154 0.176 0.198 0.220 U 0.0700 0.0770 0.0821 0.0853 0.0865 0.0858 0.0832 0.0786 0.0720 0.0636 0.0532 Dr. Lay SAU • E (rc) = y15% + (1-y)7% • c = y22 + (1-y) 0 • U = E(rc) -0.5(4)c2 9 Dr. Lay SAU 10 4.4 Passive Strategies and the Capital Market Line • Passive Strategy •Investment policy that avoids security analysis, not attempt to identify miss-priced securities. Indexing has become a popular strategy for passive investors. • Capital Market Line (CML) •a passive strategy using T-bill and the broad stock market index as the risky portfolio generates and investment opportunity set that is represented by the CML. 4.5 Passive Strategies and the Capital Market Line • Cost and Benefits of Passive Investing • Passive investing is inexpensive and simple • Expense ratio of active mutual fund averages 1% • Expense ratio of hedge fund averages 1%-2%, plus 10% of returns above risk-free rate • Active management offers potential for higher returns • Historical data, based on 1926 to 2005, approximately 75% invested risky assets. • We assume this portfolio has the same reward–risk characteristics that the S&P 500 has exhibited since 1926, that is, a risk premium of 8.4% and standard deviation of 20.5%. Substituting these value in equation 3.5, we obtain y = E (rp ) − rf A 2 p (3.5) 8.4% Y = = 0.75 2 A 20.5 • Which implies a coefficient of risk aversion, A = 2.7. • This means that passive investors allocate their investment budget among instrument according to their risk aversion (in this case, A =2.7). • A broad range of studies, A ranges from 2.00 to 4.00 Dr. Lay SAU 14 4.6 Covariance and Correlation Review Day X Return Y Return 1 1.1 1.7 3 4.2 2.1 4.9 1.4 4.1 0.2 1.30 2.5 3.74 2 3 4 5 Mean 15 4.7 Portfolios of Two Risky Assets • Portfolios of two risky assets principles can be applied to portfolios of many assets. • The rate of return on a portfolio consist of bond fund, D and stock fund, E: 𝑟𝑝 = 𝑤𝐷 𝑟𝐷 +𝑤𝐸 𝑟𝐸 (6.1) where wD and wE are proportions invested in bond D and stock E, respectively. rD and rE are rates of return on bond D and stock E, respectively. 𝐸(𝑟𝑝 ) = 𝑤𝐷 𝐸(𝑟𝐷 )+𝑤𝐸 𝐸(𝑟𝐸 ) (6.2) 16 • The variance of the two-asset portfolio is Using example 4.3 in Excel to illustrate this formula. ❖Note: The Covariance of a variable with itself is the variance of that variable: 2𝑝 = 𝑤𝐷2 2𝐷 +𝑤𝐸2 2𝐸 +2𝑤𝐷 𝑤𝐸 𝐶𝑜𝑣 𝑟𝐷 𝑟𝐸 (6.3) ❖Correlation of two assets: Cov(𝑟𝐷 ,𝑟𝐸) Corr(𝑟𝐷 , 𝑟𝐸 ), = 𝐷 𝐸 or Cov(𝑟𝐷 , 𝑟𝐸 )= ∗ 𝐷 𝐸 (6.4) 17 • Therefore, equation (6.3) can be express as: 2𝑝 = 𝑤𝐷2 2𝐷 +𝑤𝐸2 2𝐸 +2𝑤𝐷 𝑤𝐸 ∗ ∗ 𝐷 𝐸 • In case of perfect positive correlation, DE=1 2𝑝 = (𝑤𝐷 𝐷 + 𝑤𝐸 𝐸 )2 and 𝑝 = 𝑤𝐷 𝐷 + 𝑤𝐸 𝐸 • (6.5) (6.6) In case of perfect negative correlation, DE= -1 2𝑝 = (𝑤𝐷 𝐷 − 𝑤𝐸 𝐸 )2 and 𝑝 = 𝑤𝐷 𝐷 − 𝑤𝐸 𝐸 (6.7) 18 • When =-1, a perfectly hedged position can be obtained by choosing the portfolio proportion to solve system equation. 𝑤𝐷 + 𝑤𝐸 =1 (1) 𝑤𝐷 𝐷 − 𝑤𝐸 𝐸 = 0 (2) (1) we get 𝑤𝐸 =1-𝑤𝐷 , then substitute this into equation (2), we get: 𝑤𝐷 𝐷 − (1−𝑤𝐷 )𝐸 = 0 𝑇ℎ𝑒𝑛, 𝑤𝐷 𝐷 − 𝐸 + 𝑤𝐷 𝐸 = 0, 𝑤𝐷 (𝐷 + 𝐸 )= 𝐸 . Therefore: 𝐸 𝐷 𝑤𝐷 = and 𝑤𝐸 = 𝑜𝑟 = 1 − 𝑤𝐷 𝐷 + 𝐸 𝐷 + 𝐸 (6.8) 19 Correlation Effects Possible value of correlation 1,2 : -1.0 +1.0 • If = 1.0, perfectly positively correlated, no advantage of hedging • If = - 1.0, perfectly negatively correlated, maximum hedging advantage • See next example: 20 Example: Portfolio Risk and Return Debt Equity Expected return, E(r) Standard deviation, Covariance, Cov(rD,rE) Correlation coefficient, DE 8% 12% 13% 20% • 𝐸(𝑟𝑝 )=8𝑤𝐷 +13𝑤𝐸 (6.9), and we have 72 0.30 2𝑝 = 𝑤𝐷2 2𝐷 +𝑤𝐸2 2𝐸 +2𝑤𝐷 𝑤𝐸 ∗ ∗ 𝐷 𝐸 (6.5) 2𝑝 = 122 𝑤𝐷2 +202 𝑤𝐸2 +2𝑤𝐷 𝑤𝐸 ∗ 0.30 ∗ 12 ∗ 20 (6.10) and then, 𝑝 = 2𝑝 (6.11) 21 2𝑝 = 122 𝑤𝐷2 +202 𝑤𝐸2 +2𝑤𝐷 𝑤𝐸 ∗ 0.30 ∗ 12 ∗ 20 (6.10) and then, 22 Figure 3.3 Portfolio Standard Deviation as a Function of Investment Proportions 23 • Note: At DE = -1, the minimum weight in bond funds is 0.625 and equity funds 0.375 (equation 3.12) 𝐸 𝐷 𝑤𝐷 = and 𝑤𝐸 = 𝑜𝑟 = 1 − 𝑤𝐷 𝐷 + 𝐸 𝐷 + 𝐸 𝑤𝐷 = 20 12+20 (6.8) = 0.625 and the 𝑤𝐸 = 1-0.625 =0.375 • Look at the solid curve in Figure 3.3 for DE=0.3 (assumed value). The weight increases from 0 to 1, p first fall with the initial diversification from bond to stocks, then rises again. 24 1. Minimum Variance Portfolio Calculation • Table 3.1 At a given DE=0.30, the portfolio weights result in minimum standard deviation of 11.45%, at wD =0.82 and wE =0.18. How to calculate? 2𝐸−𝐶𝑜𝑣(𝑟𝐷 ,𝑟𝐸) 𝑤𝑚𝑖𝑛 𝐷 = 2 2 (6.11) 𝐷+𝐸−2𝐶𝑜𝑣(𝑟𝐷 ,𝑟𝐸) For our example (DE=0.30) 𝑤𝑚𝑖𝑛 𝐷 202 −72 = 2 2 12 +20 −2(72) = 0.82, and 𝑤𝐸 =1-0.82 =0.18 • 𝐸(𝑟𝑝 )=8𝑤𝐷 +13𝑤𝐸 =8(0.82)+13(0.18) =8.9% 25 4.8 The Optimal Risky Portfolio with Two Risky Assets and a Risk- Free Asset Figure 3.5 shows two CALs drawn from rf = 5% • The first possible CAL drawn through portfolio A, which invested 82% in bonds and 18% in stocks (Table 3.1 bottom panel), with E(rp) =8.9% and p=11.45% • The slope of the CAL combining with T-bill and with the minimum-variance of portfolio ( the reward-to-variability or Sharpe ratio) is 𝑆𝐴 = 𝐸 𝑟𝐴 −𝑟𝑓 𝐴 = 8.9−5 = 11.5 0.34 26 Figure 3.5 The Opportunity Set of the Debt and Equity Funds and Two Feasible CALs 27 • Now consider the CAL that uses portfolio B invests 70% in bonds and 30% in stocks. Its E(rp)=9.5% and p=11.70%. Slope B is 𝐸(𝑟𝐵 ) = 𝑤𝐷 𝐸(𝑟𝐷 )+𝑤𝐸 𝐸(𝑟𝐸 ) (6.2) 𝐸(𝑟𝐵 ) = 0.70 ∗ 8 + 0.30 ∗ 13= 9.5% 𝐵 = [122 𝑤𝐷2 +202 𝑤𝐸2 +2𝑤𝐷 𝑤𝐸 ∗ 0.30 ∗ 12 ∗ 20]0.5 (6.10) and then, 𝐵 = [122 ∗0.702 +202 ∗ 0.702 +2(0.70 ∗ 0.30) ∗ 0.30 ∗ 12 ∗ 20]0.5 =11.70 𝑆𝐵 = 𝐸 𝑟𝐵 −𝑟𝑓 𝐵 = 9.5−5 = 11.70 0.38 Thus, portfolio B dominates A. We can continue to yield the CAL with the highest feasible reward-to-variability ratio labeled P in Figure 3.6 is the optimal risky portfolio to mix with T-bills. 28 2. Weight of the Optimal Risky Portfolio • In the case of two risky assets, the solution for the weight of the optimal risky portfolio, P, can be shown to be as follow: For example, using our data, the solution for the optimal portfolio is: 29 The expected return and standard deviation of this optimal portfolio, P, is 𝐸(𝑟𝑝 ) = 𝑤𝐷 𝐸(𝑟𝐷 )+𝑤𝐸 𝐸(𝑟𝐸 ) (6.2) 𝑃 = [122 𝑤𝐷2 +202 𝑤𝐸2 +2𝑤𝐷 𝑤𝐸 ∗ 𝐶𝑜𝑣(𝑟𝐷 𝑟𝐸 )]0.5 (6.10) 𝑃 = [122 ∗0.42 +202 ∗ 0.62 +2∗0.4 ∗ 0.6(72)]0.5 =14.2% 𝑇ℎ𝑒𝑛, 𝑆𝑃 = 𝐸 𝑟𝑃 −𝑟𝑓 𝑃 = 11−5 = 14.2 0.42 The slope P has exceeded any slopes we have considered. 30 31 32 Optimal Complete Portfolio with T-bill Example: • An investor with A = 4 would take a position in Portfolio P of • Thus, 74.39% in Portfolio P, and 25.61% in T-bill. • While, portfolio P consists of 40% in bonds, ywD=0.4×0.7439=29.76% and 60% in stocks, ywE=0.6 ×0.7439 = 44.63%. • Graphical solution of this asset allocation problem is presented in Figures 4.7 and 4.8. 33 If you have $100,000, you should invest: • 0.2561 x $100,000 = $25,610 in T-bill • 0.7439 x $100,000 = $74,390 in portfolio P, which consists of: • 0.2976 x $100,000 = $29,760 in bonds • 0.4463 x $100,000 = $44,630 in stocks E(rc) = wfrf +wDrD + wErE E(rc) = (0.2561x 5)+(0.2976 x 8)+(0.4463 x13) = 9.46% 34 Figure 3.7 Determination of the Optimal Overall Portfolio • Note: Slope C and P are the same. E(rc)=9.46% and c=10.57% 𝑆𝐶 = 𝑆𝑃 = 𝐸 𝑟𝑃 −𝑟𝑓 𝑐 𝐸 𝑟𝑃 −𝑟𝑓 𝑃 = 9.46−5 = 10.57 = 11−5 = 14.2 0.42 0.42 35 Figure 3.8 The Proportions of the Optimal Overall Portfolio 36 4.9 Markowitz Portfolio Selection Model • Two methods of computing the efficient set of risky portfolio: • First using minimization program. The points marked by squares are result of a variance minimization program (Figure 3.11). • Second method, draw a vertical line that represents the SD constraint. We then consider all portfolio plot on this line (have the same SD) and choose the one with the highest expected return. • Repeating this procedure for many vertical lines (levels of SD) give us the points marked by cycles (Figure 4.11) that trace the upper portion of the minimum-variance, the efficient frontier emerges. • All portfolios that lie on the minimum-variance frontier from the global minimum-variance portfolio and upward provide the best risk-return combination 37 Figure 3.11The Efficient Portfolio Set 38 39 Figure 3.9 The Minimum-Variance Frontier of Risky Assets 40