Topic:

Investment &
Risk
Management
Last Week
● The investor can allocate his investment between the risk free asset and P.

• The points along the capital allocation line

represent ALL possible risk-return combinations
available to the investor.
• It is the different possible combinations between
the risky assets and non-risky assets
• Slope of CAL is Sharpe Ratio
 Complete
Portfolio
(C)

Risky Non Risky

Assets (P) Assets (Rf)

Risk Free
Equities Bonds
Assets

Direct Equity Direct Bond

Equities Funds Bonds Funds
Complete Portfolio
(C)
First, we select risky assets (e.g. stocks and bonds) to create an
efficient portfolio (P)
- the best risky-asset portfolio combination
- optimizing your risk/return tradeoff
Then we mix risk free assets into the picture to create the
Complete Portfolio (C)
- a portfolio that allows you to adjust risk exposure level.

Everyone’s portfolio is:

C = x% in P + y% in rf
Question: What should be your x% and y%?
 Objectives: Risk and
Returns
● In formulating investment objectives, the
individual must balance between return
objectives with risk tolerance (or risk aversion
level - can be determined by using
questionnaires).
○ Investors must think about risk and
return.
○ Investors must think about how much risk
they can handle.

● Your risk tolerance is affected by 2 aspects:

○ Your ability to take risk
○ Your willingness to take risk
 Investment Objectives
● Capital appreciation - the investor's goal is likely retirement or another event in the future, where
growth is required and current income is not needed. A diversified stock or mutual fund portfolio is
appropriate.

● Preservation of capital - the investor is more concerned with safety of your capital than return.
Treasury bills and money market funds

● Current income- the investor needs a portfolio that produces steady income for current living expenses.
Bonds, annuities, and stocks with high dividends (such as utility stocks) may be appropriate.

● Growth and income - the investor is looking for a portfolio that generates some amount of income, but
he/she is looking for capital appreciation as well (often for protection against inflation). Appropriate
investments could include a mix of bonds and stocks.

● Aggressive growth - the investor is looking for high-risk investments with a potential for very large
returns. This is rarely the goal for an entire portfolio, but rather for a specific portion of assets.
Aggressive growth funds and small-cap issues may be most appropriate.
Investor’s Constraints

Resources. What is the minimum sum

needed? What are the associated costs?

Horizon. When do you need the money?

Liquidity. How high is the possibility that you

need to sell the asset quickly?

Taxes. Which tax bracket are you in?

Investment Strategies and
Policies
● Investment management. Should you manage your
investments yourself?

● Market timing. Should you try to buy and sell in anticipation of

the future direction of the market?

● Asset allocation. How should you distribute your investment

funds across the different classes of assets?

● Security selection. Within each class, which specific securities

should you buy?
Are you really an INVESTOR?
Think again….

This question arises because

many “investors” ended up
becoming speculators or
gamblers

Answer: It’s all depend on how

you treat risks…….
 Risk treatment: Speculation or Gambling (or Investing)?

Speculation: the assumption of taking calculated considerable investment risk to obtain

a premium gain. A speculator likes to take on more risk when he expects a higher return.
(You LIKE risk!)

Gambling: to bet or wager on an uncertain outcome. A gambler takes on risk just to enjoy
the thrill of risk-taking. (You LOVE risk!)

Investing (risk averse): this is similar to speculation in that there must be a risk premium
to undertake additional risk. It is the measurement of how much premium return does a
person demand from an amount of risk. (You DON’T LIKE risk!)
 How to measure risk aversion level? Degrees of Risk Aversion

“A” is used as a measure of an investor’s level of risk aversion.

There are degrees of risk aversion. For all risk averse
investors, (A > 0). Some people like much more return for
adding risk (more risk averse: high A, eg. A=5) while some will
settle for a smaller risk premium to take on additional risk (less
risk averse: low A, eg. A=2).

A risk neutral: The risk factor of an investment does not matter

to you (A=0). As long as the portfolio gives a better expected
return, you will go for it.

A risk lover is one who likes fair games and gambles. (A<0).

Questionnaires can be used to determine an investor’s

preferences of risk/return in order to determine his level of risk-
aversion.
 Utility
The utility is a measure of the satisfaction an investor gets in choosing a
risk-return combination.

Eg. E(rX) = 16%, σX= 5%

E(rY) = 16%, σY= 7%.

All risk-averse investors would choose asset X as they get more

satisfaction or utility than with asset Y.

Suppose E(rX) = 10%, σX= 6%

E(rY) = 12%, σY= 7%.

There is no “correct” choice. One investor may prefer asset X while

another may prefer asset Y.

This choice is based on what utility they get from the risk-return
combinations. This utility is based on their level of risk aversion.

The more risk-averse an investor is, the less utility he gets from a given
portfolio.
Can we calculate Utility?
 Measuring Utility
One way to quantify utility: U = E(r) - ½ Aσ2
See the table below: Calculate the U score for each value of A.

E(r) 4% 5.1% 8.2% 12.3%

σ 0% 6% 14% 22%
A=1 0.0400 0.0492 0.0722 0.0988
A=3 0.0400 0.0456 0.0526 0.0504
A=5 0.0400 0.0420 0.0330 0.0020

Each A reacts differently to each set of E(r) and σ.

The higher the U value, the more “satisfied” the person feels towards the
risk and return.
 Measuring Utility
At a given A, there is a few set of different investments that give same utility level
Calculate the U score below, for an investor with an A=3.

E(r)
4% 4.375% 5.5% 7.375%
σ 0% 5% 10% 15%
U 0.04 0.04 0.04 0.04

E(r) 5% 5.375% 6.5% 8.375%

σ 0% 5% 10% 15%
U
U 0.05 0.05 0.05 0.05
Measuring Utility
E(r)
6% 6.375% 7.5% 9.375%
σ 0% 5% 10% 15%
U 0.06 0.06 0.06 0.06

For an investor’s given risk aversion, A, there are an infinite number

of E(r) - σ combinations that will give him the same utility.

If he gets the same utility from any of the combinations of risk and
return, we say he is indifferent to choosing one or the other.

Of the three utility levels calculated, which would he prefer? (A or B

or C)
Indifference Curve
Plotting these three sets of figures on one graph:
E(r)

They are curves of just ONE client, with different sets of risk vs return.
(Same Risk Aversion A=3)
These are just three of an infinite number of parallel curves for one investor.
Another investor would have a different set of curves.
Utility Aversion Ratio
Calculate the utility of the investor with A = 1:

E(r) 4% 4.125% 4.5% 5.125%

σ 0% 5% 10% 15%
U 0.04 0.04 0.04 0.04

Calculate the utility of the investor with A = 5:

E(r) 4% 4.625% 6.5% 9.625%
σ 0% 5% 10% 15%
U 0.04 0.04 0.04 0.04

If there is a portfolio that has a E(r) of 5.5% and σ of 10%, who will accept or
reject the investment?
 U = E(r) -½ Aσ2

 For A=1; U = 0.055 – 0.5 (1)(0.1)(0.1) = 0.05

 For A=5; U = 0.055 – 0.5(5)(0.1)(0.1) = 0.03
By now you should have a good understanding of the concepts of Utility and Risk Aversion:

Let’s go back to the CAL to determine “C’

U = E(r) - ½ Aσ2
If we assume an investor with A=4

% in P % in rf E(r) Volatility U

100% 0% 12.0% 20.0% 0.0400

80% 20% 10.2% 16.0% 0.0508

60% 40% 8.4% 12.0% 0.0552
40% 60% 6.6% 8.0% 0.0532
20% 80% 4.8% 4.0% 0.0448
0% 100% 3.0% 0.0% 0.0300
 Example
● The investor can allocate his investment between the risk free asset and P.
A Different Set of Numbers
What other pairs of risk and return give us the same Utility score?

E(r) Volatility U
13.52% 20.00% 0.0552
10.64% 16.00% 0.0552
8.40% 12.00% 0.0552
6.80% 8.00% 0.0552
5.84% 4.00% 0.0552
5.52% 0.00% 0.0552
Rationale behind Point C
Why point C?
The investor can allocate his investment between the risk in accordance to your risk aversion
free asset and P level

The CAL represents the possible

choices of asset allocation to the
investor.

Point C is the point of tangency

between the CAL and the
indifference curve.

For other investors, the CAL will be

the same but their indifference
curves will be different so their
version of Point C will be different.
Issues with risk aversion and utility score
● Uses historical data on risk and return to make
decisions on asset allocation.

● Risk aversion (A) is a very subjective matter.

Different ways on finding out an individual’s A.
Questionnaire, tests, future commitments, age,
income etc.

● Results on asset allocation with risk aversion

and utility may not be realistic due to different
regions have different risk and return volatility.
Aspect Of Risk Management
Asset allocation – to diversify the risk by constructing a
well-diversified portfolio (Optimal Portfolio, P)

Risk profile (capital allocation)– to invest in accordance to

your risk profile by adding risk-free assets into your P
portfolio along the CAL / CML (Complete Portfolio, C)

Rebalancing - a process of realigning the weightings of a

portfolio of assets. Rebalancing involves periodically
buying or selling assets in a portfolio to maintain an
original desired level.
Post-decision on asset allocations
Rebalance the Portfolio - Risk Management

Rebalancing a portfolio is the process of periodically

adjusting it to maintain the original conditions after the
prices/values of assets change.

• To safeguards the investor from being overly

exposed to undesirable risks.
• To ensure that the portfolio exposures remain within
the manager's area of expertise.
Constant Strategy Mix

Is one in which the manager makes adjustments to maintain

the relative weighting of the asset classes within the portfolio
as their prices change

Requires the purchase of securities that have performed

poorly and the sale of securities that have performed the best

For Example

A portfolio has a market value of $2 million. The investment

policy statement requires a target asset allocation of 60%
stock and 40% bonds.
 Constant Strategy Mix
The portfolio value after one quarter are:

Date Portfolio Value Actual Allocation Stock Bonds

1 Jan $2,000,000 60%/40% $1,200,000 $800,000

1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar
amount of bonds should he sell?
Constant Strategy
Mix
Solution:
A 60/40 percent asset allocation for a $2.5 million
portfolio means the portfolio should contain $1.5
million in stock and $1 million in bonds.
Thus, the manager should buy $100,000 worth of
stock and sell $100,000 worth of bonds.
 Constant Proportion Portfolio Insurance
A constant proportion portfolio insurance (CPPI) strategy requires the manager to
invest a percentage of the portfolio in (risky asset) stocks:

$ in stocks = Multiplier × (Portfolio value – Floor value)

“Cushion Value”
Risk tolerance
Example

A portfolio has a market value of $2 million.

The investment policy statement specifies a
floor value of $1.7 million and a multiplier of 2.

What is the dollar amount that should be

invested in stocks according to the CPPI
strategy?
Solution:
$600,000 should be invested in stock:

$ in stocks = 2.0 × ($2,000,000 – $1,700,000)

= $600,000

If the portfolio value is $2.2 million one quarter later, with $650,000 in
stock, what is the desired equity position under the CPPI strategy? What
is the ending asset mix after rebalancing?
Solution:
The desired equity position after one quarter should
be:

$ in stocks = 2.0 × ($2,200,000 – $1,700,000)

= $1,000,000

The portfolio manager should move $350,000

worth of stock into the portfolio.
Efficient Market Hypothesis, CAPM Issues and Alternatives
CAPM and the SML
Issues with CAPM
Multifactor Arbitrage Pricing Theory
Fama-French Three Factor Model