Household Finance

Question 1

What are the equations for risk and return of assets?

Answer 1

E(R) = sum[π(R_i)] var(x) = sum[π( X_i - E(X))² ]

Question 2

What is the sharpe ratio?

Answer 2

[E(R) -Rf] /sd

Question 3

Why doesn’t u’‘(x) give a reliable measure of Risk Aversion?

Answer 3

• 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!!!

Question 4

What is the measure of absolute risk aversion?

Answer 4

• concerns absolute levels of wealth -A(w) = -U’‘(w) / U’(w) - higher A(w) = more risk averse

Question 5

What is the measure of relative risk aversion?

Answer 5

-relates to a % change in wealth -R(w) = -WU’‘(w) / U’(w) -R(w) = WA(w)

Question 6

What is increasing/decreasing absolute and relative risk aversion?

Answer 6

• 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

Question 7

For a decreasing risk averse individual, how would investment in risky assets change after an increase in wealth?

Answer 7

Absolute: ^w = fall RA = ^AMOUNT invested in risky asset Relative: ^w= fall in RA = ^PERCENTAGE invested

Question 8

What does the budget constraint show in the optimality diagram?

Answer 8

The price of an increased return in terms of risk. -intercept = risk free rate -slope = sharpe ratio

Question 9

does the indifference curve and budget constraint slope up or down?

Answer 9

UP

Question 10

What is the equilibrium condition?

Answer 10

MRS = Sharpe ratio

Question 11

What can be said about the expected preferences of individuals given the indifference curve analysis?

Answer 11

All consumers should hold a combination of risky and risk free assets. -This allows them to be on a higher indifference curve.

Question 12

What are the expected returns and risk for portfolios?

Answer 12

E(R) = k E(Rf) + (1-k) E(Ra) var = K^2 VarA + (1-k)^2 VarB -2(k)(1-k)cov(A,B)

Question 13

What are the two types of risk?

Answer 13

1) Systematic - diversifiable, risk is unique to a specific asset 2) Unsystematic - Cannot be reduced, affects all assets in an economy.

Question 14

What are the three empirical puzzles?

Answer 14

1) Failure to participate 2) Failure to diversify 3) Failure to re-mortgage

Question 15

What is the stockholding puzzle?

Answer 15

-HH don’t hold stocks despite them having a return premium compared to risk free

Question 16

What is a potential cause of the stockholding puzzle?

Answer 16

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

Question 17

What is the equity premium puzzle?

Answer 17

• Mehra & Prescott 1985 suggested the maximum possible relative RA coefficient is 10 - Coefficient of >10 needed to justify stock market risk premia

Question 18

What is the relationship between stockholding and equity premium puzzle?

Answer 18

• High premium makes SHP more pronounced - Low SM participation suggests low D for stocks, may explain high risk premia

Question 19

What are the 4 potential explanations of the equity premium puzzle?

Answer 19

1) Fixed Costs 2) Background Risk 3) Financial literacy 4) Behavioural reasons

Question 20

Explain how fixed costs affect the EPP.

Answer 20

-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.

Question 21

Explain the effects of background risk on EPP.

Answer 21

-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

Question 22

Explain the effects of financial literacy on the EPP.

Answer 22

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

Question 23

What are the Behavioural reasons for the EPP?

Answer 23

-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.