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Bus 315 > Lecture 5 > Flashcards

Lecture 5 Flashcards

1
Q

What is the discount rate in asset prices

A

Risk free rate or rate of return

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2
Q

What is the probability distribution

A

Set of all possible values of a random variable and probability associated with each possible outcome

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3
Q

What are the rules of probability distribution

A
  1. Each outcome is assigned a probability
  2. Each probability is non negative
  3. Probabilities must sum to 1
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4
Q

What is the best guess for future retune

A

Expected return

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5
Q

What is expected return

A

Probability weighted average return of all possible outcomes

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6
Q

How to properly measure risk

A

Look at how much the value of the stock varies

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7
Q

What it is the variance

A

Expected value of the squared deviation from the mean

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8
Q

What is standard deviation

A

How far returns are from expected value

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9
Q

What is volatility

A

Standard deviation

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10
Q

How do you compute historical returns

A

Counting the number of times a realized return falls within a particular range

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11
Q

What is empirical distribution

A

When the probability distribution is plotted using historical data

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12
Q

What happens when inflation rate increases?

A

Investors demand higher nominal rates of return

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13
Q

What are tax liabilities based on?

A

Nominal income

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14
Q

What are examples of negative and positive skewed assets?

A

Bonds and loans

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15
Q

Would investors prefer positive or negative skews?

A

Negative

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16
Q

What are examples of fat tailed distributed assets?

A

All financial assets

17
Q

What if excess returns are not normally distributed at value at risk

A

VaR is the quantile of distribution below which lies q % of the possible values of that distribution

18
Q

What does the VAR provide

A

A threshold for the losses at a given percentile

19
Q

What do the expected shortfall provide

A

Expected loss when the losses exceed the VaR threshold value

20
Q

What are some caveats

A
  1. Return appear normally distributed
  2. SD goes down over long time periods
21
Q

What does the utility model give

A

Optimal Allocation between risky portfolio and risk free asset

22
Q

What is diminishing marginal utility

A

Utility of expectation is higher than expected utility, they prefer certain payoffs to uncertain pay off

23
Q

What are risk premiums

A

Expected additional return for making a risky investment rather than a safe one

24
Q

Why do we need risk premiums

A

Investors are risk averse and demand for extra compensation for investing in assets with risky payoffs

25
Q

What happens if there is no risk premiums

A

Risk averse investors will invest in risk free assets

26
Q

What are the assumptions for investors

A

Investors like returns and dislike risk

27
Q

What do indifference curves describe

A

Describes different combinations of return and risk that provide equal utility

28
Q

What does it mean when there’s a steeper curve

A

More risk averse

29
Q

Why are indifference curve curvilinear

A

Exhibits diminishing marginal utility of wealth

30
Q

How do investors choose a preferred portfolio

A

Estimate expected returns with investor preferences to find optimal asset allocation

31
Q

What is the capital allocation line (CAL)

A

Depicts investment opportunity and shows all risk return combination available to investors

32
Q

What will investors choose based on the CAL

A

Choose the highest indifference curve given the investment opportunity set

33
Q

What is the Sharpe ratio

A

Slope of the CAL and it is the ratio of excess return of the risky asset to its SD

34
Q

What does the Sharpe ratio tell us

A

How much extra return per unit of risk since this is a risk adjusted measure that quantifies the risk return trade off

35
Q

What are the rules of optimal allocation

A

Increase weight on the risky asset, utility increases and then declines (Curve)
Optimal weight = maximize utility

Bus 315 (6 decks)

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