ECON FINANCIAL ECONOMICS

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1 ECON FINANCIAL ECONOMICS Peter Ireland Boston College April 26, 2018 These lecture notes by Peter Ireland are licensed under a Creative Commons Attribution-NonCommerical-ShareAlike 4.0 International (CC BY-NC-SA 4.0) License.

2 Final Exam Monday, May 14: 12:30-2:00pm. Short answer questions like from the homeworks, covering: 1. Making Choices in Risky Situations 2. Measuring Risk and Risk Aversion 3. Risk Aversion and Investment Decisions 4. Modern Portfolio Theory 5. Capital Asset Pricing Model Bring a pen or pencil. You probably won t need a calculator, but you can use one if you want to.

3 Final Exam Review problem sets 7-11 and, for extra practice: Midterm, Fall 2013: Questions 2, 3, 4, 5 Final, Fall 2013 (both versions): Questions 1, 2 Midterm, Spring 2014: Questions 3, 4, 5 Final, Spring 2014 (both versions): Questions 1, 2 Midterm, Spring 2015: Questions 4, 5 Final, Spring 2015 (both versions): Questions 1, 2, 3, 4 Midterm from Fall 2015: Questions 4, 5 Final, Fall 2015: Questions 1, 2, 3, 4 Midterm, Spring 2016: Questions 4, 5 Final, Spring 2016: Questions 1, 2, 3, 4 Midterm, Spring 2017: Question 5 Final, Spring 2017: Questions 1, 2, 3, 4, 5 Final, Fall 2017: Questions 1, 2, 3, 4, 5

4 The Efficient Frontier Tracing out the minimized σ p for each value of µ p = µ produces the minimum variance frontier.

5 The Efficient Frontier Adding assets shifts the minimum variance frontier to the left, as opportunities for diversification are enhanced.

6 The Efficient Frontier However, the minimum variance frontier retains its sideways parabolic shape.

7 The Efficient Frontier The minimum variance frontier traces out the minimized variance or standard deviation for each required mean return.

8 The Efficient Frontier But portfolio A exhibits mean-variance dominance over portfolio B, since it offers a higher expected return with the same standard deviation.

9 The Efficient Frontier Hence, the efficient frontier extends only along the top arm of the minimum variance frontier.

10 The Efficient Frontier Recall that any of the following assumptions imply that indifference curves in this σ µ diagram slope upward and are convex: 1. Risks are small enough to justify a second-order Taylor approximation to any increasing and concave Bernoulli utility function within the vn-m expected utility framework 2. Investors have vn-m expected utility with quadratic Bernoulli utility functions 3. Asset returns are normally distributed and investors have vn-m expected utility with increasing and concave Bernoulli utility functions

11 The Efficient Frontier Portfolios along U 1 are suboptimal. Portfolios along U 3 are infeasible. Portfolio P, located where U 2 is tangent to the efficient frontier, is optimal.

12 The Efficient Frontier Investor B is less risk averse than investor A. But both choose portfolios along the efficient frontier.

13 The Efficient Frontier Thus, the mean-variance utility hypothesis built into Modern Portfolio Theory implies that all investors choose optimal portfolios along the efficient frontier.

14 The Efficient Frontier Fund managers should construct portfolios along the efficient frontier that are not dominated in mean-variance by any other.

15 The Efficient Frontier Individual investors can then choose the portfolio along the efficient frontier that is best suited to their individual levels of risk aversion.

16 A Separation Theorem So far, however, our analysis has assumed that there are only risky assets. An additional, quite striking, result emerges when we add a risk free asset to the mix. This implication was first noted by James Tobin (US, , Nobel Prize 1981) in his paper Liquidity Preference as Behavior Towards Risk, Review of Economic Studies Vol.25 (February 1958): pp

17 A Separation Theorem Consider, therefore, the larger portfolio formed when an investor allocates the fraction w of his or her initial wealth to a risky asset or to a smaller portfolio of risky assets and the remaining fraction 1 w to a risk free asset with return r f.

18 A Separation Theorem If the risky part of this portfolio has random return r, expected return µ r = E( r), and variance σr 2 = E[( r µ r ) 2 ] then the larger portfolio has random return r P = w r + (1 w)r f with expected return and variance µ P = E[w r + (1 w)r f ] = wµ r + (1 w)r f σp 2 = E[( r P µ P ) 2 ] = E{[w r + (1 w)r f wµ r (1 w)r f ] 2 } = E{[w( r µ r )] 2 } = w 2 σ 2 r.

19 A Separation Theorem The expression for the portfolio s variance implies and hence σ 2 P = w 2 σ 2 r σ P = wσ r w = σ P σ r. Hence, with σ r given, a larger share of wealth w allocated to risky assets is associated with a higher standard deviation σ P for the larger portfolio.

20 A Separation Theorem But the expression for the portfolio s expected return µ P = wµ r + (1 w)r f indicates that so long as µ r > r f, a higher value of w will yield a higher expected return as well. What is the trade-off between risk σ P and expected return µ P of the mix of risky and riskless assets?

21 A Separation Theorem To see, substitute into to obtain w = σ P σ r µ P = wµ r + (1 w)r f µ P = r f + w(µ r r f ) ( ) σp = r f + (µ r r f ) σ ( r ) µr r f = r f + σ P σ r

22 A Separation Theorem The expression ( µr r f µ P = r f + σ r ) σ P shows that for portfolios of risky and riskless assets: 1. The relationship between σ P and µ P is linear. 2. The slope of the linear relationship is given by the Sharpe ratio, defined here as the expected excess return offered by the risky components of the portfolio divided by the standard deviation of the return on that risky component: µ r r f σ r = E( r) r f σ r

23 A Separation Theorem Hence, any investor can combine the risk free asset with risky portfolio A to achieve a combination of expected return and standard deviation along the red line.

24 A Separation Theorem And the slope of the red line equals rise µ A r f over run σ A. That is, the slope equals the Sharpe ratio (µ A r f )/σ A of portfolio A.

25 A Separation Theorem However, any investor with mean-variance utility will prefer some combination of the risk free asset and risky portfolio B to all combinations of the risk free asset and risky portfolio A.

26 A Separation Theorem And all investors with mean-variance utility will prefer some combination of the risk free asset and risky portfolio T to any other portfolio.

27 A Separation Theorem Investor B is less risk averse than investor A. But both choose some combination of the tangency portfolio T and the risk free asset.

28 A Separation Theorem Note that the tangency portfolio T can be identified as the portfolio along the efficient frontier of risky assets that has the highest Sharpe ratio.

29 A Separation Theorem This is the two-fund theorem or separation theorem implied by Modern Portfolio Theory. Equity mutual fund managers can all focus on building the unique portfolio that lies along the efficient frontier of risky assets and has the highest Sharpe ratio. Each individual investor can then tailor his or her own portfolio by choosing the combination of the riskless assets and the risky mutual fund that best suits his or her own aversion to risk.