Lecture 5 Flashcards
What is the discount rate in asset prices
Risk free rate or rate of return
What is the probability distribution
Set of all possible values of a random variable and probability associated with each possible outcome
What are the rules of probability distribution
- Each outcome is assigned a probability
- Each probability is non negative
- Probabilities must sum to 1
What is the best guess for future retune
Expected return
What is expected return
Probability weighted average return of all possible outcomes
How to properly measure risk
Look at how much the value of the stock varies
What it is the variance
Expected value of the squared deviation from the mean
What is standard deviation
How far returns are from expected value
What is volatility
Standard deviation
How do you compute historical returns
Counting the number of times a realized return falls within a particular range
What is empirical distribution
When the probability distribution is plotted using historical data
What happens when inflation rate increases?
Investors demand higher nominal rates of return
What are tax liabilities based on?
Nominal income
What are examples of negative and positive skewed assets?
Bonds and loans
Would investors prefer positive or negative skews?
Negative
What are examples of fat tailed distributed assets?
All financial assets
What if excess returns are not normally distributed at value at risk
VaR is the quantile of distribution below which lies q % of the possible values of that distribution
What does the VAR provide
A threshold for the losses at a given percentile
What do the expected shortfall provide
Expected loss when the losses exceed the VaR threshold value
What are some caveats
- Return appear normally distributed
- SD goes down over long time periods
What does the utility model give
Optimal Allocation between risky portfolio and risk free asset
What is diminishing marginal utility
Utility of expectation is higher than expected utility, they prefer certain payoffs to uncertain pay off
What are risk premiums
Expected additional return for making a risky investment rather than a safe one
Why do we need risk premiums
Investors are risk averse and demand for extra compensation for investing in assets with risky payoffs
What happens if there is no risk premiums
Risk averse investors will invest in risk free assets
What are the assumptions for investors
Investors like returns and dislike risk
What do indifference curves describe
Describes different combinations of return and risk that provide equal utility
What does it mean when there’s a steeper curve
More risk averse
Why are indifference curve curvilinear
Exhibits diminishing marginal utility of wealth
How do investors choose a preferred portfolio
Estimate expected returns with investor preferences to find optimal asset allocation
What is the capital allocation line (CAL)
Depicts investment opportunity and shows all risk return combination available to investors
What will investors choose based on the CAL
Choose the highest indifference curve given the investment opportunity set
What is the Sharpe ratio
Slope of the CAL and it is the ratio of excess return of the risky asset to its SD
What does the Sharpe ratio tell us
How much extra return per unit of risk since this is a risk adjusted measure that quantifies the risk return trade off
What are the rules of optimal allocation
Increase weight on the risky asset, utility increases and then declines (Curve)
Optimal weight = maximize utility
