RSM332H1 Lecture Notes - Lecture 7: Portfolio Investment, Utility, Risk Premium
Document Summary
Portfolio investment is passive, portfolio is different for everyone. Case 1: one risky and one riskless assets. An investor is allocating money between one risky asset and one riskless asset. We use utility function to compare e[r] and (sigma) U = e as^2 where a is the risk aversion level. Suppose that a = 2 in u(e,s) = e as2 and let w be allocation to stocks (more risky asset) Maximize the utility function: plug in expected returns and s2, take derivatives in terms of w, formula is given: W* = emkt rf / 2as2 mkt. The higher the risk premium, i should invest more in stocks all else equal. In the mean-variance formula, liquidity could be a problem in but not included in the formula. Step 1) obtain (parameters) from forecasts about the basic assets. Step 2) figure out the set of feasible portfolios in the e-s diagram.
