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Lecture 7

BU473 Lecture Notes - Lecture 7: Risk Aversion, United States Treasury Security, Risk Premium

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David Cimon

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BU-473 Lecture 7
Risk Aversion
In economics and finance, most people are risk averse
o They must be compensated for risk to achieve a higher return
The additional return a risk-averse investor must be given to compensate for taking risk is
referred to as the risk premium
Risk Aversion and Gambling
A risk averse investor will not accept a fair gamble (expected return of 0)
o Investor takes risk but requires a positive expected return
Risk Neutrality and Risk Loving
Risk Neutral investors (larger investors and financial institutions) will accept fair gambles
Risk Lowers will accept unfair gambles (casino gamblers)
Certainty Equivalent
Risk-averse investors realize a lower utility when they take a risky decision than if they received
the same money with certainty
Certainty equivalent
o The safe amount of money that an investor would be willing to accept, that would give
them the same utility as a higher, but uncertain outcome
Capital Allocation: Risky vs. Risk Free
In capital allocation, we decide how to allocate funds between a risk-free asset and a set of risky
The risk-free asset pays a certain return, (variance = 0)
Risky asset pays a higher, uncertain return and has a variance greater than 0
Risk Free Asset
Treasury bills, Repos, Commercial paper, Banker’s Acceptances
Risk Free Asset Pays 𝑟
𝑓 with certainty
Risky portfolio pays 𝑟
𝑝 with standard deviation 𝜎𝑝
Allocation: 𝑥% to risky portfolio and (1 − 𝑥)% to risk-free asset
Total Expected Return
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