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

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**preview**shows half of the first page. to view the full**3 pages of the document.**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

- Gale lak of oesurate 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 = ide of iestor’s aersio 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

oer tie; ehaior aalsis of groups of idi purhase of isurae poliies, durale arraties…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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