Asset Pricing: Chapter V. Risk Aversion and Investment Decisions, Part I

5.2 Risk Aversion and Portfolio Allocation; Risk Free vs.
Risky Assets
5.3 Portfolio Composition, Risk Aversion and Wealth
5.4 Risk Aversion and Risky Portfolio Composition
5.5 Risk Aversion and Saving Behavior
5.6 Key Concepts and Results
Asset Pricing
Chapter V. Risk Aversion and Investment Decisions, Part I
June 20, 2006
Asset Pricing
5.2 Risk Aversion and Portfolio Allocation; Risk Free vs. Risky Assets
5.4 Risk Aversion and Risky Portfolio Composition The Canonical Portfolio Problem
The various problems considered in this chapter (and

the next)
max EU(Ỹ1 ) = max EU (Y0 (1 + rf ) + a (r̃ − rf )) , (1)

a
Consider first an agent solving the following two period

consumption-savings problem:
maxE{U(Y0 − s) + δU(sR̃)},
s (2)
s.t. Y0 ≥ s ≥ 0
max U(Y0 − s) + δEU(s(1 + rf ) + a(r̃ − rf )), (3)

{a,s}
Asset Pricing
max EU(Ỹ1 ) = max EU (Y0 (1 + rf ) + a (r̃ − rf )) , (4)

a
First order condition (FOC):
E U 0 (Y0 (1 + rf ) + a (r̃ − rf )) (r̃ − rf ) = 0

(5)
Theorem (Theorem 5.1:)

0
Assume U ( ) > 0, and U 00 ( ) < 0 and let â denote the solution
to problem (1). Then
â > 0 ⇔ E r̃ > rf
â = 0 ⇔ E r̃ = rf
â < 0 ⇔ E r̃ < rf
Asset Pricing
Theorem (Proof of Theorem 5.1:)

Define W (a) = E {U (Y0 (1 + rf ) + a (r̃ − rf ))}. The FOC (5) can then
be written W 0 (a) = E [U 0 (Y0 (1 + rf ) + a (r̃ − rf )) (r̃ − rf )] = 0 . By
risk aversionh (U 00 < 0), i
2
W 00 (a) = E U 00 (Y0 (1 + rf ) + a (r̃ − rf )) (r̃ − rf ) < 0, that is, W 0 (a)
is everywhere decreasing. It follows that â will be positive if and only
if W 0 (0) = U 0 (Y0 (1 + rf )) E (r̃ − rf ) > 0 (since then a will have to be
increased from the value of 0 to achieve equality in the FOC). Since
U 0 is always strictly positive, this implies â > 0 if and only if
E (r̃ − rf ) > 0.
The other assertion follows similarly.
Asset Pricing
U(Y ) = ln Y
a −(1 + rf )[E r̃ − rf ]
= > 0. (6)
Y0 (r1 − rf )(r2 − rf )
Asset Pricing
Theorem (5.2:)
Suppose, for all wealth levels Y , RA1 (Y ) > RA2 (Y ) where RAi (Y )
is the measure of absolute risk aversion of investor i, i = 1, 2.
Then â1 (Y ) < â2 (Y )
Theorem ( 5.3:)
Suppose, for all wealth levels Y > 0, RR1 (Y ) > RR2 (Y ) where
RRi (Y ) is the measure of relative risk aversion of investor
i, i = 1, 2. Then â1 (Y ) < â2 (Y ).
Asset Pricing
Theorem (5.4 (Arrow, 1971))

Let â = â (Y0 ) be the solution to problem (1) above; then:
(i) RA0 (Y ) < 0 ⇔ â0 (Y0 ) > 0

(ii) RA0 (Y ) = 0 ⇔ â0 (Y0 ) = 0
(iii) RA0 (Y ) > 0 ⇔ â0 (Y0 ) < 0.
Asset Pricing
d â/â Y d â
η(Y , â) = dY /Y = â dY
Theorem (5.5 (Arrow, 1971):)

If, for all wealth levels Y ,
(i) RR0 (Y ) = 0 (CRRA) then η=1

(ii) RR0 (Y ) < 0 (DRRA) then η>1
(iii) RR0 (Y ) > 0 (IRRA) then η<1
Asset Pricing
Theorem (5.6 (Cass and Stiglitz, 1970):)

 
â1 (Y0 )
 . 
Let the vector   denote the amount optimally
 . 
âJ (Y0 )
invested
 in the J risky assetsif the wealth level is Y0 .
â1 (Y0 ) a1
 .   . 
Then    .  f (Y0 )
= 
 .
âJ (Y0 ) aJ
(for some arbitrary function f (·)) if and only if either
(i) U 0 (Y0 ) = (θY0 + κ)∆ or

(ii) U 0 (Y0 ) = ξe−vY0
Asset Pricing
maxE{U(Y0 − s) + δU(sR̃)},
s (7)
s.t. Y0 ≥ s ≥ 0
U 0 (Y0 − s) = δE{U 0 (sR̃)R̃} (8)
Theorem (5.7 (Rothschild and Stiglitz,1971):)

Let R̃A , R̃B be two return distributions with identical means
such that R̃A SSD R̃B , and let sA and sB be, respectively, the
savings out of Y0 corresponding to the return distributions R̃A
and R̃B .
If RR0 (Y ) ≤ 0 and RR (Y ) > 1, then sA < sB ;
If RR0 (Y ) ≥ 0 and RR (Y ) < 1, then sA > sB .
Asset Pricing
−U 000 (c)
P(c) = U 00 (c)
000 (c)
P(c)c = −cUU 00 (c)
Theorem (5.8)
Let R̃A , R̃B be two return distributions such that R̃A SSD R̃B ,
and let sA and sB be, respectively, the savings out of Y0
corresponding to the return distributions R̃A and R̃B . Then,
sA ≥ sB iff c P(c) ≤ 2,
and conversely,
sA < sB iff c P(c) > 2
Asset Pricing
max U(Y0 − s) + δEU(s(1 + rf ) + a(r̃ − rf )), (9)

{a,s}
Assume CRRA
s : (Y0 − s)−γ (−1) + δE [s(1 + rf ) + a(r̃ − rf )]−γ (1 + rf ) = 0

a : E (s(1 + rf ) + a(r̃ − rf ))−γ (r̃ − rf ) = 0

Solution: a/s independent of s
Asset Pricing
Increasing, decreasing, constant abosolute/relative risk

aversion and their effects on portfolio composition ( risk
free asset vs. Risky portfolio)
Risk aversion and the composition of the optimal risky
portfolio (Cass-Stiglitz)
Prudence and Savings behavior
Asset Pricing

Asset Pricing: Chapter V. Risk Aversion and Investment Decisions, Part I

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5.2 Risk Aversion and Portfolio Allocation; Risk Free vs.

June 20, 2006

The various problems considered in this chapter (and

max EU(Ỹ1 ) = max EU (Y0 (1 + rf ) + a (r̃ − rf )) , (1)

Consider first an agent solving the following two period

max U(Y0 − s) + δEU(s(1 + rf ) + a(r̃ − rf )), (3)

max EU(Ỹ1 ) = max EU (Y0 (1 + rf ) + a (r̃ − rf )) , (4)

First order condition (FOC):

E U 0 (Y0 (1 + rf ) + a (r̃ − rf )) (r̃ − rf ) = 0

Theorem (Theorem 5.1:)

Theorem (Proof of Theorem 5.1:)

Theorem (5.4 (Arrow, 1971))

(i) RA0 (Y ) < 0 ⇔ â0 (Y0 ) > 0

Theorem (5.5 (Arrow, 1971):)

(i) RR0 (Y ) = 0 (CRRA) then η=1

Theorem (5.6 (Cass and Stiglitz, 1970):)

(i) U 0 (Y0 ) = (θY0 + κ)∆ or

U 0 (Y0 − s) = δE{U 0 (sR̃)R̃} (8)

Theorem (5.7 (Rothschild and Stiglitz,1971):)

sA < sB iff c P(c) > 2

max U(Y0 − s) + δEU(s(1 + rf ) + a(r̃ − rf )), (9)

s : (Y0 − s)−γ (−1) + δE [s(1 + rf ) + a(r̃ − rf )]−γ (1 + rf ) = 0

a : E (s(1 + rf ) + a(r̃ − rf ))−γ (r̃ − rf ) = 0

Solution: a/s independent of s

Increasing, decreasing, constant abosolute/relative risk

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