ACTSC371 Chapter Notes - Chapter 5: Risk Premium, Risk Aversion, Standard Deviation

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Speculation ( ): the assumption of considerable business risk in obtaining commensurate gain. Commensurate gain: a positive expected pro t beyond the risk-free alternative. This is the risk premium, the incremental expected gain from taking on the risk. Considerable risk: the risk is suf cient to affect the decision. An individual might reject a prospect that has a positive risk premium because the added gain is insuf cient to make up for the risk involved. A prospect that has a zero-risk premium is called a fair game. Investors who are risk-averse reject investment portfolios that are fair games or worse. Risk-averse investors consider only risk-free or speculative prospects with positive risk premiums. Loosely speaking, a risk-averse investor penalizes the expected rate of return of a risky portfolio by a certain percentage (or penalizes the expected pro t by a dollar amount) to account for the risk involved. The greater the risk, the larger the penalty.

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