L4: Static Portfolio Choice 1 Static Portfolio Choices (L4) Following topics are covered: –Mean and Variance as Choice Criteria – an example –Insurance Optimal insurance with loading Optimal coinsurance Optimality of deductible insurance –Optimal Investment Portfolio Portfolio of single risky and risk-free assets The effect of background risk Portfolio of multiple risky assets and risk-free assets Materials covered in Chapter 5, CWS Efficient frontier Materials from CWS3&5 and EGS3&4

L4: Static Portfolio Choice 2 Using Mean and Variance as Choice Criteria: An Example If the distribution of return offered by assets is jointly normal, then we can maximize expected simply by selecting the best combination of mean and variance. Assuming the return on an asset is normal distributed with mean E and variance σ 2, we can write the utility function as: U=U(R, E, σ) Then the expected utility is: We want to show that the marginal rate of substitution between return and risk is positive and that the indifference curves are convex.

L4: Static Portfolio Choice 3 Positive Slope in Indifference Curve Converting R to a standard normal variable, Z=(R-E)/σ. –then f(R;E;σ)=(1/σ)f(Z;0;1) An indifference curve is defined as the locus of points where the change in expected utility is zero – dE(U)=0. The denominator must be positive because U’(.) must be positive. The numerator is negative (why?)

L4: Static Portfolio Choice 4 Means in Managing Risks Insurance –Risky assets with a full insurance is like investing in a risk-free asset –Partial insurance is like a combo of risk free assets (full insurance) and risky assets Diversified portfolio –Risk-free asset and single risky asset –Multiple risky assets –Risk-free asset and multiple risky assets

L4: Static Portfolio Choice 5 Static Portfolio Choice I: Insurance Maximize an agent’s utility when there is costly or costless hedging contract available The case of actuarially fairly priced insurance Assuming loss follows a distribution of x (where x>=0); premium = P; Indemnity schedule = I(x) Insurer reimburses policyholder for the full value of any loss, I(x)=x When the premium is actuarially fair, P=EI(x)=E(x) Suppose the insured is risk averse, how much is he willing to pay for the insurance? –With insurance, his expected utility is u(E(x)) –Without insurance, his expected utility is E(u(x))=u(E(x)-П) –Insurance increases the certainty equivalent by П As a result, risk-averse agents would take full insurance when insurance prices are actuarially fair When the insurance has loading, optimal insurance amount is determined by the transaction cost and risk reduction.

L4: Static Portfolio Choice 6 Insurance Loading Suppose the chance of the ship being sunk is ½. Insurer’s loading is 10% of the actual value of the policy Suppose the amount of insurance purchased is I, P(I)=(I/2)+0.1(I/2)=0.55I A square-root utility function Questions –What is the expected wealth? –What is the expected utility? –What is maximum utility?

L4: Static Portfolio Choice 7 Optimal Coinsurance Definition: I(x)=βx Insurance pricing rule: –P(β)=(1+λ)EI(x)= βP 0, where P 0 =(1+ λ)Ex Random final wealth = w 0 - βP 0 -(1- β)x

L4: Static Portfolio Choice 8 Mossin’s Theorem Full insurance (β*=1) is optimal at an actuarially fair price, λ=0, while partial coverage (β* 0. –An intuition is that full insurance may be still optimal if the degree of risk aversion of the policyholder is sufficiently high. –This is not correct given that risk aversion is a second-order phenomenon. For a very small level of risk, individual behavior toward risk approaches risk neutrality. For risk neutral policyholder, any saving in transaction cost is good. –Also may have corner solution of β*=0 when λ>0, occurring λ≥λ* where –Undiversified risk is an alternative form of transaction cost (page 52)

L4: Static Portfolio Choice 9 Comparative Statics in Coinsurance Problem The effect of risk aversion Proposition 3.2: Consider two utility function u 1 and u 2 that are increasing and concave, and suppose that u 1 is more risk averse than u 2 in the sense of Arrow and Pratt (Equation 1.7, page 11). Then, β 1 *>β 2 * –Sounds natural

L4: Static Portfolio Choice 10 Comparative Statics in Coinsurance Problem Effect of initial wealth: Proposition 3.3: An increase in initial wealth will (i) decrease the optimal rate of coinsurance β* if u exhibits decreasing absolute risk aversion (proof see page 54 and the next slide) (ii) increase the optimal rate of coinsurance β* if u exhibits increasing absolute risk aversion (iii) cause no change in optimal rate of coinsurance β* if u exhibits constant absolute risk aversion The sign ofis same as

L4: Static Portfolio Choice 11 Proof of Proposition 3.3 The sign of әβ*/ әw is same as әH’(β)/ әw

L4: Static Portfolio Choice 12 Comparative Statics in Coinsurance Problem Effect of loading Proposition 3.4: An increase in the premium loading factor λ will cause β* to (i) decrease if u exhibits constant or increasing absolute risk aversion (ii) either increase or decrease if u exhibits decreasing absolute risk aversion Look at To evaluate

L4: Static Portfolio Choice 13 Deductible Insurance Deductible provide the best compromise between the willingness to cover the risk and the limitation of the insurance deadweight cost. Suppose a risk-averse policyholder selects an insurance contract (P, I(.)) with P=(1+λ)EI(x) and I(x) nodecreasing and I(x)≥0 for all x. Then the optimal contract contains a straight deductbile D; that is I(x)=max(0, x-D)

L4: Static Portfolio Choice 14 Static Portfolio Choice II: Diversification Investors who consume their entire wealth at the end of the current period The case containing a risk-free asset and a risky asset The risk-free rate of return of the bond is r. the return of the stock is a random variable x Initial wealth w 0 α is invested in stock Ending Portfolio Value =(w 0 - α)(1+r)+ α(1+x)=w 0 (1+r)+a(x-r)=w+ αy

L4: Static Portfolio Choice 15 Optimal Investment in Risky Assets Other results in proposition 4.1 should also follow. What can we learn from the above condition?

L4: Static Portfolio Choice 16 Further Thoughts As long as there is a positive excess return y, investors should invest in the stock market –Participation puzzle Under constant relative risk aversion (CRRA), the demand for stocks is proportional to wealth: a*=kw. More specifically, we have –Equity premium puzzle Assuming a reasonable level of risk aversion lead to unreasonable shares of investment in common stocks Using historical data, μ=6%, and σ=16%. If R=2, the investment in equity is 117%. Evan when R=10, equity investment would be 23%. (EGS page 66) Mehra and Prescott (85)

L4: Static Portfolio Choice 17 The Effect of Background Risk One way to explain the surprisingly large demand for stocks in the theoretical model is to recognize that there are other sources of risk on final wealth than the riskiness of assets returns. We want to compare α** with α*, the demand for risky asset when there is no background risk. Assuming v(z)=Eu(z+ε), we have We just need to check if v is more concave than u, utility function corresponding to y without background risk.

L4: Static Portfolio Choice 18 v and u To show v is more concave than u, we need show

L4: Static Portfolio Choice 19 Conditions regarding Background Risk Consider the following three statements: 1. any zero-mean background risk reduces the demand for other independent risk 2. for all z, -u’’’’(z)/u’’’(z)>=-u’’(z)/u’(z) 3. absolute risk aversion is decreasing and convex. Condition 2 is necessary for condition 1 under the assumption that u’’’ is positive. Condition 3 is sufficient for condition 1 and 2. Power utility function satisfies (3).

L4: Static Portfolio Choice 20 Portfolio of Risky Assets Two assets following the same distributions of x 1 and x 2 that are independently and identically distributed Perform expected utility maximization If two assets are i.i.d., holding a balanced portfolio is optimal –Home bias

L4: Static Portfolio Choice 21 Diversification in Mean-Variance Model There are n risky assets, indexed by i = 1, 2, …, n The return of asset i is denoted by x i, whose mean is µ i and covariance between returns of assets I and j is σ ij Risk free asset whose return r= x 0

L4: Static Portfolio Choice 22 Diversification in Expected-Utility Model

L4: Static Portfolio Choice 23 Interpretation Investment Implication: all investors, whatever their attitude to risk, should purchase the same portfolio of risky assets. Two-fund Separation

Frontier Portfolios A portfolio is a frontier portfolio if it has the minimum variance among portfolios that have the same expected rate of return. A portfolio p is a frontier portfolio if and only if w p, the N-vector portfolio weights of p, is the solution to the quadratic program: L4: Static Portfolio Choice 24 s.t., See HL, page

Frontier in Mean-Variance Space L4: Static Portfolio Choice 25 See HL, page 66 (3.11.2a)

Minimum Variance Portfolio Minimum variance portfolio (mvp): expected return=A/C; var=1/C The covariance of the minimum variance portfolio and any portfolio (not only those on the frontier) is always equal to the variance of the rate of return on the minimum variance portfolio L4: Static Portfolio Choice 26

Efficient Portfolios Those frontier portfolios which have expected rates of return strictly higher than that of the minimum variance portfolios Inefficient portfolios Any combination of efficient portfolios will be an efficient portfolio. For any portfolio p on the frontier, expect for mvp, there exists a unique frontier portfolio, denoted by zc(p), which has a zero covariance with p. (HL, page 70) L4: Static Portfolio Choice 27

Portfolios with Risk Free Assets L4: Static Portfolio Choice 28 s.t. Solution see HL, page How does it differ from EGS’s derivations?

L4: Static Portfolio Choice 29 Materials covered in Ch5, CWS Two-asset portfolios –Minimum variance portfolio –Minimum variance opportunity set –Efficient set Efficent set with one risky and one risk-free asset – page 126 Many assets –CML

L4: Static Portfolio Choice 30 Technical Note on Comparative Statics Comparative statics: how the equilibrium condition changes when an exogenous variable changes

L4: Static Portfolio Choice 31 Technical Note on Differentiation Leibnitz’s Rule

L4: Static Portfolio Choice 32 Example

L4: Static Portfolio Choice 33 Exercises EGS, 3.2; 3.3; 4.2 Set up a model for one of your ongoing projects –Provide a non-technical (i.e., no reference please) introduction of the paper –Identify the primary tradeoff in your story –Setup the model