Capital Allocation between Risky and Risk-Free Assets Flashcards
What are the three types of investors based on risk preferences?
- Risk-Averse (A > 0) – Prefers lower risk and requires extra return for extra risk.
- Risk-Neutral (A = 0) – Indifferent to risk, focuses on expected return only.
- Risk-Lover (A < 0) – Prefers risk and is willing to accept lower returns for higher risk.
What is the assumption about risk aversion in most financial models?
Most models assume that investors are risk-averse.
How do investors use a utility function?
They use it to rank competing investments based on risk and expected return.
What is the risk aversion parameter (A)?
A measure of an investor’s risk preference, determined through behavioral tracking or risk tolerance questionnaires.
What happens to the utility function for risk-free assets?
Since risk is zero, the utility function simplifies, serving as a benchmark for evaluating risky investments.
What is an indifference curve in investment theory?
A curve showing all combinations of expected return (E(r)) and risk (σ) that provide the same level of utility.
What does the shape of the indifference curve indicate?
It shows that to maintain the same utility level, an increase in risk must be accompanied by a higher expected return.
What is the goal of an investor when selecting a portfolio?
To maximize utility by choosing the optimal mix of risk-free and risky assets.
What are the two key stages of portfolio management?
- Capital Allocation – Deciding how much capital to allocate between risk-free and risky assets.
- Security Selection – Choosing specific securities within each asset class.
Why is capital allocation more important than security selection?
It accounts for 94% of differences in total returns among pension funds.
What are the components of a risky and risk-free portfolio?
- Risky Portfolio (P): Made of mutual funds, including stocks and long-term bonds.
- Risk-Free Portfolio (F): A money market fund with T-bills, CDs, and commercial paper.
What is the difference between the money market and capital markets?
- Money Market: Deals with short-term liquid assets (e.g., T-bills).
- Capital Market: Involves long-term investments (e.g., stocks, bonds).
Why are money market funds considered risk-free?
They have minimal risk compared to stocks or long-term bonds.
How can investors create a complete portfolio?
By dividing funds between the risk-free asset (F) and the risky portfolio (P).
What is the Capital Allocation Line (CAL)?
A line showing all possible portfolios combining a risk-free asset and a risky portfolio.
What is the significance of the slope of the CAL?
It represents the reward-to-variability ratio (Sharpe ratio) and shows the increase in expected return per unit of risk.
What is leverage in portfolio management?
Borrowing to invest more in a risky portfolio to increase potential returns.
How does an investor determine their optimal portfolio?
By maximizing utility based on their risk tolerance, choosing the best mix of risk-free and risky assets.
What happens to investment in the risky asset (P) when:
1. Risk aversion (A) increases?
2. The risk premium increases?
- Investment in P decreases when A increases.
- Investment in P increases when the risk premium increases.
What is a passive investment strategy?
A strategy that avoids security analysis and relies on well-diversified portfolios.
How is the Capital Market Line (CML) formed?
By investing in two passive portfolios:
1. Risk-free short-term T-bills.
2. A broad market index fund of common stocks.
How do active portfolio managers influence asset prices?
By buying undervalued assets and selling overvalued ones, pushing prices toward fair value.
