Household Finance Flashcards
What are the equations for risk and return of assets?
E(R) = sum[π(Ri)] var(x) = sum[π( Xi - E(X))2 ]
What is the sharpe ratio?
[E(R) -Rf] /sd
Why doesn’t u’‘(x) give a reliable measure of Risk Aversion?
- A linear transformation of a utility function should present the same preferences -V(w) = aUw + b (a,b>0) -V’‘(w) = aU’‘(w) not the same!!!
What is the measure of absolute risk aversion?
- concerns absolute levels of wealth -A(w) = -U’‘(w) / U’(w) - higher A(w) = more risk averse
What is the measure of relative risk aversion?
-relates to a % change in wealth -R(w) = -WU’‘(w) / U’(w) -R(w) = WA(w)
What is increasing/decreasing absolute and relative risk aversion?
- Tells us how risk aversion (absolute or relative) changes with changing wealth. - eg A’(w) >0 = increasing absolute risk aversion -R’(w) <0 = decreasing relative risk aversion
For a decreasing risk averse individual, how would investment in risky assets change after an increase in wealth?
Absolute: ^w = fall RA = ^AMOUNT invested in risky asset Relative: ^w= fall in RA = ^PERCENTAGE invested
What does the budget constraint show in the optimality diagram?
The price of an increased return in terms of risk. -intercept = risk free rate -slope = sharpe ratio
does the indifference curve and budget constraint slope up or down?
UP
What is the equilibrium condition?
MRS = Sharpe ratio
What can be said about the expected preferences of individuals given the indifference curve analysis?
All consumers should hold a combination of risky and risk free assets. -This allows them to be on a higher indifference curve.
What are the expected returns and risk for portfolios?
E(R) = k E(Rf) + (1-k) E(Ra) var = K^2 VarA + (1-k)^2 VarB -2(k)(1-k)cov(A,B)
What are the two types of risk?
1) Systematic - diversifiable, risk is unique to a specific asset 2) Unsystematic - Cannot be reduced, affects all assets in an economy.
What are the three empirical puzzles?
1) Failure to participate 2) Failure to diversify 3) Failure to re-mortgage
What is the stockholding puzzle?
-HH don’t hold stocks despite them having a return premium compared to risk free
What is a potential cause of the stockholding puzzle?
Risk in consumption stream -consumers don’t like risk in the consumption stream - Stocks superior to risk free if returns are higher AND contribution of risk to C stream is not deemed too high
What is the equity premium puzzle?
- Mehra & Prescott 1985 suggested the maximum possible relative RA coefficient is 10 - Coefficient of >10 needed to justify stock market risk premia
What is the relationship between stockholding and equity premium puzzle?
- High premium makes SHP more pronounced - Low SM participation suggests low D for stocks, may explain high risk premia
What are the 4 potential explanations of the equity premium puzzle?
1) Fixed Costs 2) Background Risk 3) Financial literacy 4) Behavioural reasons
Explain how fixed costs affect the EPP.
-Monetary and non-monetary costs (eg. admin, time, stress) -Makes it hard to invest in small amounts - HH more likely to invest if they have more financial resources and face high premium. -However, costs have fallen over time and participation hasn’t improved.
Explain the effects of background risk on EPP.
-Other sources of risk have a big impact on an individuals decision to invest -eg. Risk of job loss, health concerns, future tax liabilities -Exposure to risk out of stock market impacts participation
Explain the effects of financial literacy on the EPP.
Financial literacy has huge implications - Influences a wide variety of financial decision making - Van Rooj (20110 found that low literacy = low participation, even if other variables are controlled
What are the Behavioural reasons for the EPP?
-Loss aversion in prospect theory, losses avoided more than gains chased -Myopic loss aversion (Thaler) > idea that we are loss aversion in short term > myopic loss averse individuals will avoid investing as not much SR gain but lots to lose.
