POLI 410 Lecture Notes - Lecture 8: Money Market Fund, Asset Allocation, Risk Aversion
15 Jun 2018
School
Department
Course
Professor
Capital Allocation to Risky Assets
To present the basics of individual decision-making under risk
- The utility function
- Indifference curves
To examine the asset allocation decision between risky and riskless asset
- T-bills and a stock portfolio
- The capital allocation line
Utility Function: Choice between expected return and risk (measured by
variance or standard deviation) → quadratic
- E(r) = expected return on the asset or portfolio
- A = coefficient of risk aversion (degree of risk aversion)
- S2 = variance of returns
Indifference Curve: shows equally preferred portfolios
for an investor
- Steeper slope = requires more compensation
for the same level of risk
Allocating Capital Between Risky and Risk Free
Assets
- Possible to split investment between safe and risky assets
-Risk free asset: T-Bills
- Perfectly price-indexed bond
- Money market funds = the most accessible risk-free asset for most investors
-Risky asset: stock (or a portfolio)
- Examine risk/return tradeoff
- Demonstrate how different degrees of risk aversion will affect allocations between risky and risk
free assets
Risk Aversion and Allocation
- Greater levels of risk aversion lead to larger proportions of the risk free rate
- Lower levels of risk aversion lead to larger proportions of the portfolio of risky assets
- Willingness to accept high levels of risk for high levels of returns would result in leveraged
combinations
Document Summary
To present the basics of individual decision-making under risk. To examine the asset allocation decision between risky and riskless asset. Utility function: choice between expected return and risk (measured by variance or standard deviation) quadratic. E(r) = expected return on the asset or portfolio. A = coefficient of risk aversion (degree of risk aversion) Indifference curve: shows equally preferred portfolios for an investor. Steeper slope = requires more compensation for the same level of risk. Possible to split investment between safe and risky assets. Money market funds = the most accessible risk-free asset for most investors. Demonstrate how different degrees of risk aversion will affect allocations between risky and risk free assets. Greater levels of risk aversion lead to larger proportions of the risk free rate. Willingness to accept high levels of risk for high levels of returns would result in leveraged. Lower levels of risk aversion lead to larger proportions of the portfolio of risky assets.
