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Lecture 5

FINE 3200 Lecture Notes - Lecture 5: Modern Portfolio Theory, Risk Premium, Irving Fisher


Department
Finance
Course Code
FINE 3200
Professor
George Klar
Lecture
5

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Chapter 5:
5.1 Risk and Risk Aversion
Risk, Speculation and Gambling
- Speculation: considerable business risk (risk sufficient to affect the decision) in obtaining commensurate gain
(positive expected profit beyond the risk-free alternative = risk premium) risk-premium trade-off
- Gale lak of oesurate gai enjoyment of risk only
- Heterogeneous expectations: same scenario but people will assign different probabilities for each outcome
merging info to revolve the question
Risk Aversion and Utility Values
- Fair game: zero-risk premium risk-averse investor rejects fair game or worse
- Risk-averse only risk-free or speculative prospects w/ positive risk premiums penalize the expected
rate of return of a risky portfolio by a certain percentage to account for risk involved
- Utility: scored assigne to port based on expected return and risk
- Utility value: higher expected return + lower risk = more attractive
, A = ide of iestor’s aersio more risk aversion penalizes risky investments more
severely the primary goal is to max return
- Certainty equivalent rate: rate risk-free investment would need to offer w/ certainty to be considered
equally attractive to a risky portfolio
- Risk-averse: even w/ positive risk premium, a CER of return that's below the risk-free alternative will lead to
rejection
- Risk-neutral: judge risky prospects by their expected rates of return level of risk is irrelevant (certainty
equivalent rate = expected rate of return
- Risk lover: okay with fair games and gamble adjust expected return upward CER of the fair game
exceeds risk-free investment bt adjusting risk utility upward
- Mean-Variance(W-V) criterion
A dominates B if E(rA)>= E(rB) and SDA<=SDB at least one inequality is strict
- All portfolios in QI is preferable to P(intersection); Portfolios in QII and QIII will be decide based on risk-
aversion of investors form of indifference curve (where U is the same for every portfolio)
calculate use formula above
Estimating Risk Aversion
- Questionnaires (hypothetical lotteries choices); investment accounts of active investors (port composition
oer tie; ehaior aalsis of groups of idi purhase of isurae poliies, durale arraties…et.
5.2 Capital Allocation across Risky and Risk-free Portfolios
- Capital Allocation Decision: choice among broad investment classes (risk-free vs. risky asset)
- Complete portfolio: includes both risk (E+B considered as one) and risk-free investments
- Allocation choices can help explain 90% of the variation within the returns but not the return itself
5.3 The Risk-free Asset
- Only risk-free asset in real terms is a perfectly price-indexed bond
- Guaranteed real rate to an investor only when maturity = desired holding period
- Real interest change unpredictably future uncertainty = index bonds are not risk-free
- T-bill: relatively better w. short-term (insensitive to interest and inflation fluctuation) money market
instrument short term + safe default/credit risk (T-bills, BDNs and CP)
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