Asset Allocation across risky and risk-free portfolios

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Asset Allocation across risky and risk-free
portfolios

• Riccardo Colacito

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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)

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Example
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Expected Returns of complete portfolio
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Standard deviation of complete portfolio
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Investment Opportunity Set with a Risk-Free
Investment
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One additional caveat

• Can we borrow from a bank at the same rate at
  which we lend it money?
• How does it affect the CAL?

Borrowing rate
Lending rate
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Figure 5.6 Investment Opportunity Set with
Differential Borrowing and Lending Rates
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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

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Open question

• How can we estimate expected returns and standard
  deviations?
• Use historical data
• Use survey data