Lecture 3 Flashcards
To construct overall portfolio (2)
- Select composition of risky portfolio
- Decide how much to invest in portfolio, remainder goes into risk free
Gamble =
Assumption of risk for enjoyment of risk itself
Speculation =
Undertaken in spite of risk involved
Investors should not have
Gambling/ speculative mindsets
Investors assign utility score to portfolios based on
Expected risk and return
Higher expected return =
Higher utility score
Certainty equivalent rate of return =
Rate that the risk free investment would need to offer to provide same utility score as risky portfolios
Utility score of risky portfolios can be interpreted as
Certainty equivalent rate of return
Risk neutral investors (A = 0) judge risky prospects
Solely on expected rate of return
Risk lover (A < 0)
Adjusted expected return upwards
Investors are equally attracted to portfolios with
High risk and expected returns to portfolios with low risk and returns (both will lie on indifference curve)
Indifference curve
Connects portfolio points with the same utility value
Capital allocation line (CAL)
Depicts all risk-return combinations available to investors
Slope of CAL =
Increase in expected return of complete portfolio per unit of additional standard deviation (incremental return per incremental risk)
Slope of CAL (formula) =
Reward to volatility ratio / Sharpe ratio
Investors chose allocation to risk asset that
Maximises utility function
As allocation to risky asset increases
Expected return increases, volatility increases too, therefore utility can increase/ decrease
Passive strategy =
Avoids direct/ indirect security analysis, hold investments for long periods of time
Passive strategy benefits from
Free-rider effect
Passive strategy must..
Invest in two passive portfolios:
- Risk free
- Common stocks that mimic market index
Capital allocation line representing passive strategy =
Capital market line
