COMMERCE 4FF3 Lecture Notes - Lecture 3: Risk Aversion, Arbitrage, Standard Deviation
30 Sep 2016
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Document Summary
Portfolio theory & management the mean-variance approach: fundamental concepts. Making assumption that prices will adjust based on some model. Want to minimize cost of portfolio subject to the constraint that return in both cases should be greater than zero. Negative portfolio cost implies arbitrage: gain from zero risk and zero investment. Turning a constrained optimization problem into an unconstrained optimization problem. Optimal point is when the partial derivatives for the function are all zero. Measure utility in terms of future wealth. If the future distribution has a mean payoff of 10% and the price is currently 100, then if 10% is a really good return people will want to buy it and push price to 200 and return to 5% What justifies using the mean-variance approach: assume that the return distribution is normal, assume investors care only about mean and return. Case 1: means are different but variance is the same: cannot be equilibrium.
