Lecture 3 - Optimal Capital Allocation

Question 1

What is the capital allocation decision?

Answer 1

• The most basic asset allocation choice.
• It is the allocation of the overall portfolio to safe assets versus risky assets.
• It is the simplest way to control risk.

Question 2

The optimal capital allocation depends on what?

Answer 2

1. The risk return trade off offered by the risky portfolio.
2. The investor’s attitude towards risk (i.e. risk aversion level/ index of risk aversion, which is A). The goal is to maximise the utility value.

Question 3

Explain how treasury bills are a risk free asset.

Answer 3

• It is short term, usually less than one year.
• It is not affected by inflation rates or interest rates.
• It is issued by the government, so it does not have any credit risk or default risk.

Question 4

What does the capital allocation line (CAL) show?

Answer 4

It is a graph of all feasible risk return combinations of a risky and risk free asset. It is the investment opportunity set of risky and risk free assets.

Question 5

Non government investors cannot borrow at the…

Answer 5

Risk free rate. They have risks. There are possibilities that money cannot be paid back in the future. They have default and credit risk.

Question 6

Higher indifference curves correspond to…

Answer 6

Higher levels of utility.