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2011/2012  KAN-CM_F89  Asset Allocation

English Title
Asset Allocation

Course Information

Language English
Point 7,5 ECTS (225 SAT)
Type Elective
Level Full Degree Master
Duration One Semester
Course Period Autumn
Please see e-campus
Time Table Please see course schedule at e-Campus
Max. participants 60
Study Board
Study Board for MSc in Economics and Business Administration
Course Coordinator
  • Claus Parum - Department of Finance
Administration: Louise Bruun Christensen - lbc.fi@cbs.dk
Main Category of the Course
  • Finance

Taught under Open University-Taught under open university.
Last updated on 29 maj 2012
Learning Objectives
To attain the top grade, students are required to have a deep understanding of the field of asset allocation and the various factors affecting optimal portfolio choice. This – among others – includes
• Dealing with the concepts of preferences and utility.
• Computing risk measures and critically judge about their information content.
• Implementing methods and models discussed in class using e.g. Excel or some other common programming language.
• Deriving formal conditions for optimal portfolio choice (including settings with market frictions) and computing optimal portfolio weights.
• Identifying, classifying and applying appropriate portfolio choice model in various settings.
• Distinguish between one and multi-period models and identify when a portfolio choice problem can be solved in a one-period setting and where a multi-period setting is needed.
• Generalizing arguments/methods/concepts to problems that have not been analyzed explicitly throughout the course.
The course Asset Allocation builds on introductory finance courses like “Financial Markets and Instruments” for instance. A good working knowledge in linear algebra, calculus, optimization as well as basic concepts of probability theory are necessary to follow the course.
4 hour written exam (open book)
Asset Allocation:
Assessment Written Exam
Marking Scale 7-step scale
Censorship No censorship
Exam Period Winter Term
Aids Open Book, Written Aid is permitted
Duration 4 Hours

4 hour written final exam “open book”, “written aids”: Students are allowed to bring written aids like books and notes to the final exam. Furthermore, students may bring pocket calculators fulfilling CBS’s “Rules for Using Electronic Aids During Written Examinations” to the final exam.
Course Content

The objective of the course ''Asset Allocation'' is to enable you to make ''clever'' portfolio choice decisions based on more advanced portfolio choice models than Markowitz -- irrespective of whether you want to use these skills in your future profession or just want to manage your own private portfolio an intelligent way. In order to do so, it is both the objective of the course to give you an overview of portfolio choice models and their limits as well as to provide you with the necessary mathematical tools that are required to determine these portfolios.

After a brief introduction into the concepts of preferences and utility that are required for understanding what properties optimal portfolios should have, we turn to different risk measures. We will argue that standard deviation (as used in the Markowitz model) only covers some part of the risk investors are facing in the market.

Having discussed these concepts, we are able to turn to the core part of the course, namely portfolio choice models. We first turn to one-period models where (as e.g. in the Markowitz model) it is assumed that the investor’s investment horizon is one period. In particular, the investor once chooses his portfolio and then holds it until the end of his investment horizon. After a brief recap of the famous Markowitz model and discussing its limitations, we will turn to several extensions of this approach that try to overcome some of these limitations. In addition, we will cover portfolio choice models that have been quite successful from an empirical point of view. In particular, we will discuss so-called Fama/French portfolios as well as parametric portfolios as a very recent innovation in portfolio choice.

In the presence of market frictions, we will argue that one-period models may not be sufficient to cover the dynamics of varying investment opportunity sets. Such variations in the investment opportunity set might e.g. be caused by time-varying labor income, wash sale constraints, transaction costs, and the illiquidity of housing wealth or tax-effects for instance. Introducing these factors into portfolio choice models complicates finding optimal portfolios by an order of magnitude. However, choosing a portfolio based on a model that does not take these frictions into account can result in suboptimal portfolios. One of the most important market frictions private investors are dealing with are taxes. We will see that tax-effects can significantly alter portfolio choice. Tax-effects we will consider include tax-timing options (capital gains are not taxed when they occur, but when they are realized), the different taxable treatment of capital gains and losses (when you realize capital gains you are subject to taxation, when you realize losses you are only endowed with a tax loss carry-forward you can offset in forthcoming periods) and the different taxable treatment of profits in retirement and conventional savings accounts. In particular, making “clever” portfolio choice decisions for retirement is an issue that is of increasing importance to private investors. Especially due to the length of the investment horizon the impact of portfolio choice on the distribution of retirement wealth is substantial.

The focus of the course Asset Allocation will be on factors driving optimal portfolio choice and discussing methods how optimal portfolios can be determined. Even though the course can be followed without attending other elective courses, actively participating in “Financial Models in Excel” where some of the portfolio choice models discussed in class are implemented, might be a clever combination of courses and should help deepening the understanding of those models.

Teaching Methods

Teaching some of the most recent innovations in portfolio choice is a key objective of the course. There is no therefore text book available covering all the portfolio choice models that will be dealt with throughout the course. The lecturer will therefore provide students with a set of detailed lecture notes of around 120 pages covering all topics of the course. In order to deepen the contents of the course, it will be dealt with some research papers throughout the course. These research papers include:

Brandt, M., Santa-Clara, P., and Valkanov, R. 2009. Parametric portfolio policies: Exploiting characteristics in the cross section of equity returns. Review of Financial Studies 22:3411-3447

Cocco, J., Gomes, F., and Maenhout, P. 2005. Consumption and portfolio choice over the life cycle. Review of Financial Studies 18:491-533.

Dammon, R., Spatt, C., and Zhang, H. 2001. Optimal consumption and investment with capital gains taxes. Review of Financial Studies 14:583-616.

DeMiguel, V., Garlappi, L., Nogales, F., and Uppal, R. 2009. A generalized approach to portfolio optimization: Improving performance by constraining portfolio norms. Management Science 55:798-812

DeMiguel, V., Garlappi, L., and Uppal, R. 2009. Optimal versus naive diversification: How inefficient is the 1/n portfolio strategy? Review of Financial Studies 22:1915-1953

Ehling, P., Gallmeyer, M., Srivastava, S., Tompaidis, S., and Yang, C. 2010. Portfolio choice with capital gain taxation and the limited use of losses. Working Paper, University of Texas at Austin

Fama, E. and French, K. 1992. The cross-section of expected stock returns. Journal of Finance 47:427-465.

Yao, R. and Zhang, H. 2005. Optimal consumption and portfolio choices with risky housing and borrowing constraints. Review of Financial Studies 18:197-239.