CHAPTER 5

RISK AVERSION AND CAPITAL ALLOCATION TO RISKY

ASSETS
1. a. The expected cash flow is: (0.5 x $70,000) + (0.5 x 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is
14%. Therefore, the present value of the portfolio is:

$135,000/1.14 = $118,421

b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of
$135,000, then the expected rate of return [E(r)] is derived as follows:

$118,421 x [1 + E(r)] = $135,000

Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return
with the required rate of return.

c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407

d. For a given expected cash flow, portfolios that command greater risk premia must
sell at lower prices. The extra discount from expected value is a penalty for risk.

2. When we specify utility by U = E(r) – .005A2, the utility from bills is 7%, while that
from the risky portfolio is U = 12 – .005A x 182 = 12 – 1.62A. For the portfolio to be
preferred to bills, the following inequality must hold: 12 – 1.62A > 7, or,
A < 5/1.62 = 3.09. A must be less than 3.09 for the risky portfolio to be preferred to
bills.

3. Points on the curve are derived as follows:

U = 5 = E(r) – .005A2 = E(r) – .0152

The necessary value of E(r), given the value of 2, is therefore:

 2 E(r)
0% 0 5.0%
5 25 5.375
10 100 6.5
15 225 8.375

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 20 400 11.0
25 625 14.375

The indifference curve is depicted by the bold line in the following graph (labeled
Q3, for Question 3).

4.
Repeating the analysis in Problem 3, utility is:
E(r) U(Q4,A=4)
U(Q3,A=3)
U = E(r) – .005A2 = E(r) – .022 = 4

5
U(Q5,A=0)
4


U(Q6,A<0)

leading to the equal-utility combinations of expected return and standard deviation

presented in the table below. The indifference curve is the upward sloping line appearing
in the graph of Problem 3, labeled Q4 (for Question 4).

 2 E(r)
0% 0 4.00%
5 25 4.50
10 100 6.00
15 225 8.50
20 400 12.00
25 625 16.50

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 The indifference curve in Problem 4 differs from that in Problem 3 in both slope and
intercept. When A increases from 3 to 4, the higher risk aversion results in a greater
slope for the indifference curve since more expected return is needed to compensate for
additional . The lower level of utility assumed for Problem 4 (4% rather than 5%),
shifts the vertical intercept down by 1%.

5. The coefficient of risk aversion of a risk neutral investor is zero. The corresponding
utility is simply equal to the portfolio's expected return. The corresponding indifference
curve in the expected return-standard deviation plane is a horizontal line, drawn in the
graph of Problem 3, and labeled Q5.

6. A risk lover, rather than penalizing portfolio utility to account for risk, derives greater
utility as variance increases. This amounts to a negative coefficient of risk aversion. The
corresponding indifference curve is downward sloping, as drawn in the graph of Problem
3, and labeled Q6.

7. 3. [Utility for each portfolio = E(r) – .005 x 4 x 2. We choose the portfolio with the
highest utility value.)

8. 4. [When investors are risk neutral, A = 0, and the portfolio with the highest utility is the
one with the highest expected return.]

9. b

10. The portfolio expected return can be computed as follows:

Portfolio Portfolio
Wbills x + Wmarket x = standard deviation
_______________________________________________________________(=w x17.12%)___
market

0.0 5% 1.0 9.20% 9.20% 17.12%

.2 5 .8 9.20 8.36 13.70
.4 5 .6 9.20 7.52 10.27
.6 5 .4 9.20 6.68 6.85
.8 5 .2 9.20 5.84 3.42
1.0 5 0.0 9.20 5.00 0

11. Computing the utility from U = E(r) – .005 x A2 = E(r) – .0152 (because A = 3), we
arrive at the following table.

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 Wbills Wmarket E(r)  2 U(A=3)

U(A=5)
___________________________________________________________________

0. 1.0 9.20% 17.12 293.09 4.80 1.87

.2 .8 8.36 13.7 187.69 5.54 3.67
.4 .6 7.52 10.27 105.47 5.93 4.88
.6 .4 6.68 6.85 46.92 5.97 5.51
.8 .2 5.84 3.42 11.70 5.66 5.55
1.0 0 5.0 0 0 5.0 5.0

The utility column implies that investors with A = 3 will prefer a position of 60%
in the market and 40% in bills over any of the other positions in the table; those
with A = 5 will prefer 20% in the market and 80% in bills.

12. The column labeled U(A = 5) in the table above is computed from U = E(r) – .005 A2 =
E(r) – .0252 (since A = 5). It shows that the more risk averse investors will prefer the
position with 20% in the market index portfolio, rather than the 40% market weight
preferred by investors with A = 3.

13. Expected return = .3  8% + .7  18% = 15% per year.

Standard deviation = .7  28% = 19.6%

14. Investment proportions: 30.0% in T-bills

.7  27% = 18.9% in stock A
.7  33% = 23.1% in stock B
.7  40% = 28.0% in stock C

15. Your reward-to-variability ratio = = .3571

Client's reward-to-variability ratio = = .3571

16.

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17. a. E(rC) = rf + [E(rP) – rf] y = 8 + l0y

If the expected return of the portfolio is equal to 16%, then solving for y we get:

16 = 8 + l0y, and y = = .8

Therefore, to get an expected return of 16% the client must invest 80% of total funds in
the risky portfolio and 20% in T-bills.

b. Investment proportions of the client's funds:

20% in T-bills,
.8  27% = 21.6% in stock A
.8  33% = 26.4% in stock B
.8  40% = 32.0% in stock C

c. C = .8  P = .8  28% = 22.4% per year

18. a. C = y  28%. If your client wants a standard deviation of at most 18%, then

y = 18/28 = .6429 = 64.29% in the risky portfolio.

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 b. E(rC) = 8 + 10y = 8 + .6429  10 = 8 + 6.429 = 14.429%

19. a.
y* = = = = .3644

So the client's optimal proportions are 36.44% in the risky portfolio and 63.56% in T-
bills.

b. E(rC) = 8 + 10y* = 8 + .3644  10 = 11.644%

C= .3644  28 = 10.20%

20. a. Slope of the CML = = .20

The diagram is on the following page.

b. My fund allows an investor to achieve a higher mean for any given standard deviation than would a
passive strategy, i.e., a higher expected return for any given level of risk.

21. a. With 70% of his money in my fund's portfolio the client gets a mean return of 15% per
year and a standard deviation of 19.6% per year. If he shifts that money to the passive

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 portfolio (which has an expected return of 13% and standard deviation of 25%), his
overall expected return and standard deviation become:

E(rC) = rf + .7[E(rM)  rf]

In this case, rf = 8% and E(rM) = 13%. Therefore,

E(rC) = 8 + .7  (13 – 8) = 11.5%

The standard deviation of the complete portfolio using the passive portfolio would be:

C = .7  M = .7  25% = 17.5%

Therefore, the shift entails a decline in the mean from 14% to 11.5% and a decline in the
standard deviation from 19.6% to 17.5%. Since both mean return and standard deviation
fall, it is not yet clear whether the move is beneficial or harmful. The disadvantage of
the shift is that if my client is willing to accept a mean return on his total portfolio of
11.5%, he can achieve it with a lower standard deviation using my fund portfolio, rather
than the passive portfolio. To achieve a target mean of 11.5%, we first write the mean of
the complete portfolio as a function of the proportions invested in my fund portfolio, y:

E(rC) = 8 + y(18  8) = 8 + 10y

Because our target is: E(rC) = 11.5%, the proportion that must be invested in my fund is
determined as follows:

11.5 = 8 + 10y, y = = .35

The standard deviation of the portfolio would be: C = y  28% = .35  28% = 9.8%.
Thus, by using my portfolio, the same 11.5% expected return can be achieved with a
standard deviation of only 9.8% as opposed to the standard deviation of 17.5% using the
passive portfolio.

b. The fee would reduce the reward-to-variability ratio, i.e., the slope of the CAL. Clients
will be indifferent between my fund and the passive portfolio if the slope of the after-fee
CAL and the CML are equal. Let f denote the fee.

Slope of CAL with fee = =

Slope of CML (which requires no fee) = = .20. Setting these slopes equal we get:

= .20

10  f = 28  .20 = 5.6

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 f = 10  5.6 = 4.4% per year

22. a. The formula for the optimal proportion to invest in the passive portfolio is:

y* =

With E(rM) = 13%; rf = 8%; M = 25%; A = 3.5, we get

y* = = .2286

b. The answer here is the same as in 9b. The fee that you can charge a client is the same
regardless of the asset allocation mix of your client's portfolio. You can charge a fee that
will equalize the reward-to-variability ratio of your portfolio with that of your
competition.

23. If rf = 5% but r= 9%, then the CML and indifference curves are as follows:

E(r)

borrow

lend CAL
CML
P
13


25

24. For y to be less than 1.0 (so that the investor is a lender), risk aversion must be large
enough that:

y= < 1

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 = 1.28

For y to be greater than 1.0 (so that the investor is a borrower), risk aversion must be
small enough that:

y = > 1

= .64

For values of risk aversion within this range, the investor neither borrows nor lends, but
instead holds a complete portfolio comprised only of the optimal risky portfolio:

y = 1 for .64 1.28

25. a. The graph of problem 23 has to be redrawn here with E(r) = 11% and  = 15%

b. For a lending position, = 2.67

For a borrowing position, = .89

In between, y = 1 for .89 A2.67

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E(r)

CML
M
13 F CAL
11
9


15 25

26. The maximum feasible fee, denoted f, depends on the reward-to-variability ratio.

For y < 1, the lending rate, 5%, is viewed as the relevant risk-free rate, and we solve for f
from:
=

f = 6 = 1.2%

For y > 1, the borrowing rate, 9%, is the relevant risk-free rate. Then we notice that even
without a fee, the active fund is inferior to the passive fund because:

= .13 < = .16

More risk tolerant investors (who are more inclined to borrow) therefore will not be
clients of the fund even without a fee. (If you solved for the fee that would make
investors who borrow indifferent between the active and passive portfolio, as we did
above for lending investors, you would find that f is negative: that is, you would need to
pay them to choose your active fund.) The reason is that these investors desire higher
risk-higher return complete portfolios and thus are in the borrowing range of the relevant
CAL. In this range the reward to variability ratio of the index (the passive fund) is better
than that of the managed fund.

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27. a. If 1957 - 2009 is assumed to be representative of future expected performance, A = 2,
E(rM)  rf = 4.20%, and M = 17.74% (we use the standard deviation of the risk
premium from the last column of Table 6.8), then y* is given by:

y* = = 4.20/(.01 x 2 x 17.742)= .6672

That is, 66.72% should be allocated to equity and 33.28 % to bills.

b. If 1993 - 2009 is assumed to be representative of future expected performance, A = 2,

E(rM)  rf = 7.56%; and M = 18.89%, then y* is given by:

y* = 7.56/(.01x2x18.892)= 1.0593

Therefore, 105.93% of the complete portfolio is allocated to equity and -5.93% to bills.

c. In (a) the market risk premium is expected to be lower while the market risk is expected
to be at a lower level than in (b). The fact that the reward-to-variability ratio is expected
to be much lower in (a) (4.20/17.74 = 0.2368) versus 7.56/18.89=0.40) explains the
much smaller proportion invested in equity.

28. Assuming no change in tastes, that is, an unchanged risk aversion coefficient, A, the
denominator of the equation for the optimal investment in the risky portfolio will be
higher. The proportion invested in the risky portfolio will depend on the relative change
in the expected risk premium (the numerator) compared to the change in the perceived
market risk. Investors perceiving higher risk will demand a higher risk premium to hold
the same portfolio they held before. If we assume that the risk-free rate is unaffected, the
increase in the risk premium would require a higher expected rate of return in the equity
market.

29. The expected return of your fund = T-bill rate + risk premium = 6% + 10% = 16%.
The expected return of the client's overall portfolio is .6  16% + .4  6% = 12%.
The standard deviation of the client's overall portfolio is .6  14% = 8.4%.

30. Reward to variability ratio = = = .71.

31. [.6  50,000 + .4  (30,000)  5,000 = 13,000]

32. b

33. a) Curve 2
b) Point F

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 Appendix 5A

1. Your $50,000 investment will grow to $50,000(1.06) = $53,000 by year end. Without
insurance your wealth will then be:

Probability Wealth
No fire: .999 $253,000
Fire: .001 $ 53,000

which gives expected utility

.001xloge(53,000) + .999 x loge(253,000) = 12.439582

and a certainty equivalent wealth of

exp(12.439582) = $252,604.85

With fire insurance at a cost of $P, your investment in the risk-free asset will be only
$(50,000 – P). Your year-end wealth will be certain (since you are fully insured) and equal
to

(50,000 – P) x 1.06 + 200,000.

Setting this expression equal to $252,604.85 (the certainty equivalent of the uninsured house)
results in P = $372.78. This is the most you will be willing to pay for insurance. Note that
the expected loss is "only" $200, meaning that you are willing to pay quite a risk premium
over the expected value of losses. The main reason is that the value of the house is a large
proportion of your wealth.

2. a. With 1/2 coverage, your premium is $100, your investment in the safe asset is $49,900
which grows by year end to $52,894. If there is a fire, your insurance proceeds are only
$100,000. Your outcome will be:

Probability Wealth
Fire .001 $152,894
No fire .999 $252,894

Expected utility is

.001xloge(152,894) + .999xloge(252,894) = 12.440222

and WCE = exp(l2.440222) = $252,767

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