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Asset Allocation across risky and risk-free portfolios

Asset Allocation across risky and risk-free portfolios. Riccardo Colacito. Allocating Capital Between Risky & Risk-Free Assets. Possible to split investment funds between safe and risky assets Risk free asset: T-bills Risky asset: stock (or a portfolio). Example. r f = 7%. s f = 0%.

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Asset Allocation across risky and risk-free portfolios

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  1. Asset Allocation across risky and risk-free portfolios Riccardo Colacito

  2. Allocating Capital Between Risky & Risk-Free Assets • Possible to split investment funds between safe and risky assets • Risk free asset: T-bills • Risky asset: stock (or a portfolio)

  3. Example rf = 7% sf = 0% E(rp) = 15% sp = 22% y = % in p (1-y) = % in f

  4. Expected Returns of complete portfolio

  5. Standard deviation of complete portfolio

  6. Investment Opportunity Set with a Risk-Free Investment

  7. Can we borrow from a bank at the same rate at which we lend it money? How does it affect the CAL? One additional caveat Lending rate Borrowing rate

  8. Figure 5.6 Investment Opportunity Set with Differential Borrowing and Lending Rates

  9. 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

  10. Open question • How can we estimate expected returns and standard deviations? • Use historical data • Use survey data

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