Lecture 8- Risk and real rate of return Flashcards
What are risk premiums?
Expected return in excess of that on risk-free securities
What is excess return?
Rate of return in excess of risk-free rate
What is risk aversion?
Reluctance to accept risk
Describe an example of a risk premium (Treasury Bills)
Issued by the treasury of the country concerned.
Regarded as risk-free assets as the government guarantees paying their face value upon maturity.
Highly liquid
What is the general relationship between risk and returns?
Returns (over a long period of time) should be consistent with risk.
Supported by evidence from historical risk and returns.
What is the formula for risk premiums?
Risk premium= Expected HPS - Risk- free return
E(r)-rf
Explain the importance of risk premiums to adverse investors.
In order to convince investors to commit funds to risk assets, a positive risk premium is necessary.
A risk premium of 0 is called a fair game.
Risk premiums is what distinguishes gambling from speculation.
What is speculation in relation to risk aversion?
The assumption of considerable investment risk to obtain commensurate gain (Hedge funds).
Describe the word gamble in context to risk aversion.
gamble to to bet on uncertain outcomes.
A gamble is the assumption of risk for not purpose beyond the enjoyment of risk itself.
How is investor utility used?
It is used to map investor preferences to their optimum portfolio.
Where an optimum portfolio is the combination of expected returns and standard deviation.
Describe the differences between investors and their preferences on risk levels.
Risk averse: Require risk premiums, wiling to take risk only when the risk premium is positive.
Risk neutral: Does not react to risks, expected return is the only decision role.
Risk loving/seeking: Does not require positive risk premium, satisfied by taking risks rather than expected returns. Will participate fair game or gambling.
What is the formula that can be used to explain investors balance between investment risk and investment return.
u=E(r) - 0.5A * * 𝜎^2
E(r)= Expected return on the asset
𝜎^2= Risk (variance of returns)
A= The degree (coefficient) or risk aversion
How do we define and find the indifference curve?
It represents an investors willingness to trade-off risk and return.
Find all the combinations of [E(r),* 𝜎], link them together, then we have the indifference curve.
