One of the factors to consider when selecting the optimal portfolio for a particular investor is the degree of risk aversion. This level of aversion to risk can be characterized by defining the investor's indifference curve. This curve consists of the family of risk/return pairs defining the trade-off between the expected return and the risk. It establishes the increment in return that a particular investor requires to make an increment in risk worthwhile. Typical risk aversion coefficients range from 2.0 through 4.0, with the higher number representing lesser tolerance to risk. The equation used to represent risk aversion in Financial Toolbox™ software is
U = E(r) - 0.005*A*sig^2
U is the utility value.
E(r) is the expected return.
A is the index of investor's aversion.
sig is the standard deviation.
An alternative to using these portfolio optimization functions is to use the
Portfolio object (
Portfolio) for mean-variance
portfolio optimization. This object supports gross or net portfolio returns as
the return proxy, the variance of portfolio returns as the risk proxy, and a
portfolio set that is any combination of the specified constraints to form a
portfolio set. For information on the workflow when using Portfolio objects, see
Portfolio Object Workflow.
This example computes the optimal risky portfolio on the efficient
frontier based on the risk-free rate, the borrowing rate, and the
investor's degree of risk aversion. You do this with the function
First generate the efficient frontier data using
ExpReturn = [0.1 0.2 0.15]; ExpCovariance = [ 0.005 -0.010 0.004; -0.010 0.040 -0.002; 0.004 -0.002 0.023];
Consider 20 different points along the efficient frontier.
NumPorts = 20; [PortRisk, PortReturn, PortWts] = portopt(ExpReturn,... ExpCovariance, NumPorts);
specifying output arguments, returns the corresponding vectors and
arrays representing the risk, return, and weights for each of the
portfolios along the efficient frontier. Use these as the first three
input arguments to the function
Now find the optimal risky portfolio and the optimal allocation of funds between the risky portfolio and the risk-free asset, using these values for the risk-free rate, borrowing rate, and investor's degree of risk aversion.
RisklessRate = 0.08 BorrowRate = 0.12 RiskAversion = 3
specifying any output arguments gives a graph displaying the critical
portalloc (PortRisk, PortReturn, PortWts, RisklessRate,... BorrowRate, RiskAversion);
specifying the output arguments returns the variance (
the expected return (
RiskyReturn), and the weights
RiskyWts) allocated to the optimal risky portfolio.
It also returns the fraction (
the complete portfolio allocated to the risky portfolio, and the variance
OverallRisk) and expected return (
of the optimal overall portfolio. The overall portfolio combines investments
in the risk-free asset and in the risky portfolio. The actual proportion
assigned to each of these two investments is determined by the degree
of risk aversion characterizing the investor.
[RiskyRisk, RiskyReturn, RiskyWts,RiskyFraction, OverallRisk,... OverallReturn] = portalloc (PortRisk, PortReturn, PortWts,... RisklessRate, BorrowRate, RiskAversion) RiskyRisk = 0.1288 RiskyReturn = 0.1791 RiskyWts = 0.0057 0.5879 0.4064 RiskyFraction = 1.1869 OverallRisk = 0.1529 OverallReturn = 0.1902
The value of
RiskyFraction exceeds 1 (100%),
implying that the risk tolerance specified allows borrowing money
to invest in the risky portfolio, and that no money is invested in
the risk-free asset. This borrowed capital is added to the original
capital available for investment. In this example, the customer tolerates
borrowing 18.69% of the original capital amount.