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• Utility
• In economics, utility is a measure of a person’s
preferences over some set of goods and services;
• Here we use utility as a measure of attractiveness
of portfolios to an investor:
U E r 1 A 2
2
• Portfolio attractiveness increases with expected
return and decreases with risk;
• Utility Function
U E r 1 A 2
2
• U = Utility
• E(r) = Expected return on the asset or portfolio
• A = Coefficient of risk aversion (of an investor)
• σ2 = Variance of returns
• ½ = A scaling factor
• Utility Function
U E r 1 A 2
2
• A>0 risk averse investor
• A=0 risk-neutral investor
• A<0 risk lover
• Mean-SD plane:
U E r 1 A 2
2
1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
2
A constant
∙T
∙O
∙S
1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
2
1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
P1
2
P2
Investor B
1 2
𝐸 𝑟 = 𝑈 + 𝐴𝜎
Investor C
2
• Q: How to split?
• y = Portion allocated to risky asset P
• (1 - y) = Portion to be invested in risk-free asset F
6-15 INVESTMENTS | BODIE, KANE, MARCUS
Portfolios of One Risky Asset and a
Risk-Free Asset
P P
𝜎𝑐 = 𝑦𝜎𝑃
• Rearrange and substitute 𝑦 = σC/σP:
C
E rC rf E rP rf
P
8
E rC 0.07 C
22
Indifference
curve
Optimal Portfolio
Indifference
curve
Optimal Portfolio
1
Max 𝑈 = 𝐸 𝑟𝑐 − 𝐴𝜎𝑐 2
2
8
where E rC 0.07 C 𝐴=4
22
8
Max 𝑈 = 0.07 + 𝜎𝑐 − 2𝜎𝑐 2
22
8
Max 𝑈 = 0.07 + 𝜎𝑐 − 2𝜎𝑐 2
22
𝑑𝑈 𝑑𝑈 8
1st derivative: =0 = − 4𝜎𝑐 = 0
𝑑𝜎𝑐 𝑑𝜎𝑐 22
𝑑2𝑈 𝑑2 𝑈
2nd derivative: <0? = −4 yes
𝑑𝜎𝑐 2 𝑑𝜎𝑐 2
∗
8 1
𝜎𝑐 = × = 9.09%;
22 4
∗
𝜎 0.0909 8
𝑦∗ =
𝑐
= = 0.41; 1 − 𝑦 ∗ = 0.59; E * rC 0.07 0.0909 10.31%
𝜎𝑃 0.22 22
• Chapter 6:
• 6.1, 6.2, 6.3, 6.4, 6.5, 6.6